Chicago Mercantile Exchange: Better Odds

By Larry Dignan  |  Posted 2005-06-10 Email Print this article Print
 
 
 
 
 
 
 

Traders on the Chicago Mercantile Exchange swap everything from interest rates to the weather. The challenge: build systems to handle ballooning volume.

In April, the Chicago Mercantile Exchange's average daily volume hit 4.9 million, up 47% from a year ago. Its 2004 earnings hit $219.6 million, up 80% from 2003. Traders bet on everything from weather movements to future market index moves. CEO Craig Donohue's challenge: keep it up.

Donohue's tack: Make his technology department—responsible for the information systems allowing traders to move ever higher volumes of increasingly exotic financial products—slow down and think.

The result: The exchange delivered a three-year technology strategy in October. Previously, strategy was set annually.

"Great businesses are built first on planning, and I want us to have a stake in the sand in regards to technology," Donohue says. "You may reset the stake later, but that's better than having no stake at all."

Donohue's strategy is to build a technology infrastructure that can adapt to handle a wide range of financial instruments.

To the exchange, the real innovation is creating hits that generate lots of trading. One hit: the "e-mini future," a contract to buy a specific value of a market index at a certain date. The bet might be that the Nasdaq 100 stock index value would finish above 1,500 in September. With an e-mini, a small investor can buy such 10 contracts worth $20 times the index value, or $30,000, for $3,750 in collateral. In a conventional futures contract, the multiplier is $100 and the collateral needed is $19,000.

The exchange's focus on new markets—and investors' penchant to protect against volatile price movements—drove total trading volume for 2004 to 787 million, up from 620 million in 2003 and 231 million in 2000. The exchange began electronic trading in 1987, and today 70% of trades are executed electronically.

At the Merc, which swaps everything from interest-rate targets to commodities such as cattle and milk, "we're only limited by our imagination when it comes to financial derivatives," Donohue says.

So how do you build an infrastructure that can handle increased electronic trading volume cheaply? The exchange's approach revolves around three basic ideas: simplify, standardize what you do and then create new systems that encourage more trading.

If the exchange succeeds with the first two items, it will have a simple network of hardware and software using standard parts such as Intel-based blade servers running Linux. That will make it easy to add capacity. A daily boost of 500,000 to 750,000 in the amount of trades executed means that 12 to 15 new servers need to be added.

That simplification comes in handy as the exchange pursues new markets such as trading arcades, small venues in Dublin, London and Gibraltar that host a new generation of traders who can use joysticks instead of computers to swap financial derivatives. "They trade as if it were a video game," says Steve Goldman, director of network architecture at the exchange, holding up a PlayStation joystick. "And we want to make sure they have something to trade here."

These traders follow set systems and algorithms and chase seemingly minuscule market moves. Under these systems, rapid hand-eye coordination is critical.

To target this market, Goldman says the Merc has plugged the arcades right into its international data communications network. So, bandwidth costs for arcade traders shrink, and they trade derivatives and options as if they were in Chicago.

That will hopefully entice more traders across the globe to use the exchange, according to Goldman. "We're competing for volume against all electronic exchanges," he says. "We have to lower the costs to attract traders."

However, lowering costs for traders is only possible if the exchange keeps its own costs low. The company plans to spend $80 million to $90 million on technology in 2005, with the biggest share being allocated to information technology. The exchange doesn't disclose its technology budget.

The exchange cut costs by deploying Linux. It began investigating how to install Linux in 2001 and 2002, and got serious in 2003 as the technology and support from vendors like Red Hat matured, says Joe Panfil, director of distributed computing.

In 2003, the exchange started to develop its applications on Linux instead of Sun's Solaris operating system. Panfil determined that it could add a Linux-based server for $5,000 a box compared to $50,000 for a Sun-driven box. Meanwhile, Linux machines were anywhere from 5 milliseconds to 30 milliseconds faster than the exchange's older Solaris 8 servers.

A millisecond lasts one-thousandth of a second, less than the time it takes to blink your eyes. Assuming the exchange takes 10 cents for every transaction at its record rate of 1,200 transactions per second, that's $120 per second, $7,200 a minute and $432,000 an hour. By the end of 2004, the exchange had 700 Linux boxes compared to 50 in 2003 for a savings of $3.5 million.

The exchange's next big goal is moving more of its options trading online. Currently, fewer than 5% of the options listed on the exchange trade electronically. Donohue says it's critical for the exchange to build a "matching engine" that allows traders to incorporate their trading algorithms, automated systems and interdependent trades. For instance, one function will allow traders to exit multiple positions at once because options on, say, the Standard & Poor's 500 index, Euro and Japanese yen may be interconnected.

Meanwhile, Donohue is plotting his next strategy mission. He's creating a three-year plan for software functionality for the exchange's trading systems. The goal: accommodate every flavor of trader—the gamer, the weatherman who trades the jet stream and the guy swapping cattle—so they'll do more business with the exchange.

"More functionality means more volume," Donohue explains. "We want a broader range of functionality to enhance the inventiveness of how people trade."

Is Linux a Nice Trade?
The Chicago Mercantile Exchange's switch to Linux increased performance and cut cost per server from $50,000 to $5,000.

EXPENDITURES 2002 2003 2004
Testing costs* $5,000,000 $0 $0
Training costs** $0 $90,000 $0
Server costs*** $0 $250,000 $3,250,000
TOTAL: $5,000,000 $340,000 $3,250,000
SAVINGS
Server Costs† $0 $2,250,000 $29,250,000
TOTAL $0 $2,250,000 $29,250,000
NET ($5,000,000) $1,910,000 $26,000,000
NET in first-year dollars (2002)
Discounted to present at 10% a year
($5,000,000) $1,736,364 $21,476,000
Dashboard Decision

GREEN LIGHT Go

YELLOW LIGHT Evaluate

RED LIGHT Stop

GREEN LIGHT Proceed to cut server expenses.
NET PRESENT VALUE:
$18,212,364
*Yankee Group says 10% to 15% of technology budget can be spent on testing Linux. CME doesn't reveal its budget. Assumption for 2002: $50 million. **Assumes 30 workers trained and certified on Linux at $3,000 each. CME focused all application development on Linux in 2003. ***CME had 50 Linux servers in 2003, adding 650 by the end of 2004. Each server includes hardware and software. †CME says Linux servers cost $45,000 less than their Unix-based predecessors. SourceS: Chicago Mercantile Exchange, Yankee Group, Baseline research


 
 
 
 
Business Editor
ldignan@ziffdavisenterprise.com
Larry formerly served as the East Coast news editor and Finance Editor at CNET News.com. Prior to that, he was editor of Ziff Davis Inter@ctive Investor, which was, according to Barron's, a Top-10 financial site in the late 1990s. Larry has covered the technology and financial services industry since 1995, publishing articles in WallStreetWeek.com, Inter@ctive Week, The New York Times, and Financial Planning magazine. He's a graduate of the Columbia School of Journalism.
 
 
 
 
 
 

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