07.13.2012
By Terry Flanagan

Arbor and Shatkin Recall Futures-Market Evolution


What do George Seals, Johnny Musso, Matt Suhey, George Altman and Glenn Beckert have in common besides playing professional baseball or football in Chicago? After their sports careers ended, each bought seats on the storied Chicago Board of Trade and traded in the pits.

Going from physical contact sports to buying and selling complex derivatives contracts may seem an unlikely leap. In both professions, however, discipline and stamina are essential, and it doesn’t hurt to be able to see over the next guy.

“If you were tall, athletic and good with numbers, you could do well,” said Patrick Arbor, who along with Henry (Hank) Shatkin co-founded Shatkin Arbor, a futures commission merchant (FCM) incorporated in 1990. No slouch himself, Arbor has climbed some of the world’s tallest peaks, including the Matterhorn and Mounts Kilimanjaro and Elbrus.

Shatkin and Arbor have traded futures longer than most traders on the floor today have been alive, and each has held lofty positions in the industry. Arbor was the CBOT’s longest-running chairman, serving three consecutive terms from 1993 to 1998, while Shatkin, 84, served as the exchange’s director starting in 1969 and has traded futures for more than 50 years.

The trading pits at the CBOT and the Chicago Mercantile Exchange — now both owned by CME Group — were once dominated by men who succeeded in part by shouting over competing traders. Technology has long since removed the advantages of height, reach and voice projection, as Arbor noted, and computers “democratized” the market and “expanded the trade” by drawing in more people and liquidity.

“We grew up in open outcry markets, and we liked it,” Arbor said, adding that technology’s impact, while sometimes painful for long-time floor trading practitioners, has been positive overall. “The computer now allows everyone equal access, and that’s a good thing,” he said.

“If you were tall, athletic and good with numbers, you could do well,” said Patrick Arbor, co-founder, Shatkin Arbor

Arbor, 75, is chairman of Livevol, a technology provider and broker-dealer that sells data including implied and historical volatility to traders and exchanges, and plans to soon launch a trading platform using that data. The Chicago-based firm supports trading in equities and options, and it plans to add futures.

Trading Starts

Arbor and Shatkin are traders at heart. Shatkin graduated from the University of New Mexico in 1952. He returned to Chicago in search of work and heard that a high school friend, Lee Stern, who eventually founded his eponymous FCM, was doing well at the exchange. Shatkin entered the futures-trading business as a clerk at Uhlmann Grain Co., a family-run futures brokerage.
“I used to go down and watch the guys trading on the floor and saw all the excitement,” Shatkin told Markets Media in a May 23 telephone interview. “I was always kind of an ‘action’ guy.”

He supplemented his day job by tending bar and driving a cab and bought his first exchange membership in 1953, for $3,000. After a somewhat difficult adjustment period, Shatkin learned arbitrage techniques such as ‘spreading’, where a trader buys a commodity and sells a futures contract on the same commodity, and discovered he had a natural talent for it.
“I don’t know if I have a talent for anything else, but I was a good pit mechanic,” Shatkin said.

Arbor graduated from Loyola University Chicago in 1958 and taught high-school math for two years. He then answered a blind ad in the newspaper and took a job in a local bank that was in proximity to LaSalle Street, which ends at the Art-Deco CBOT building. Intrigued by the futures industry, he answered another blind ad and landed a trainee position in commodities and securities at Uhlmann Grain.

As Shatkin’s career progressed, he perhaps set the record for partnering with the most future CBOT Chairmen. Aside from Arbor, there was William Mallers, who later became the CBOT’s youngest chairman, as well as Les Rosenthal and Edward Wilson.
Shatkin noted that when he became CBOT director in 1969, the exchange handled trades on a relatively small number of products — mostly future contracts in agricultural commodities including wheat, corn, oats, beans, and soybean oil.

“I was chairman of the new-products committee and at the time I said, ‘Things are going pretty good here; I think we have enough to trade,’” Shatkins said, adding, “I was wrong.”

In fact, Shatkin quickly saw the potential for new products and acted on it. Richard Sandor, chairman and chief executive of Environmental Financial Products and considered by some as the father of financial futures, said Shatkin was a strong innovator in the field.

Sandor first crossed paths with Shatkin in 1969, when the Vietnam War was raging and the U.S. first landed men on the moon. At the time a professor at the University of California at Berkeley, Sandor was working on developing electronic trading — two decades before the computer age — and he had to learn about trading pits.

“The big challenge for exchanges today is to replicate that new-product-development atmosphere within a publicly traded company.” richard Sandor, chairman and chief executive of environmental Financial Products.

The Commodity Club of San Francisco, which was sponsoring a new Pacific Commodities Exchange, gave him a grant and told him to meet some “critical traders in Chicago,” one of them being Shatkin. At their first meeting, they spoke for a time after the market close, and Shatkin invited Sandor home for dinner where they continued the discussion for another three hours.

“Hank taught me an incredible amount,” Sandor said, adding that he mentioned his dream of creating financial futures at that first meeting.

Innovative Times

While on sabbatical from Berkeley in 1972, Sandor became chief economist at CBOT, where he developed the Treasury-bond futures contract and other financial futures. Nothing of that nature had ever traded on futures exchanges before, but Shatkin and other local market makers saw their potential and supported the fledgling contracts.

“Henry was very helpful,” said Sandor, whose book Good Derivatives: A Story of Financial and Environmental Innovation was published in earlier this year. “The capital and liquidity providers he brought to bear were very important.”

Sandor said that today, market participants often fail to recognize the importance of local clearing members. Typically smaller, self-clearing market makers with an entrepreneurial spirit and a strong interest in maximizing the value of their exchange memberships, such firms are constantly on the lookout for new products and markets.

The four-decades-ago environment consisting of exchange-member trading firms and individuals like Shatkin, “who were interested in talking to a young professor and teaching him how the pit operated, and listening to crazy ideas about computer trading in 1969,” has largely disappeared at the more buttoned-down, publicly traded futures exchanges, Sandor said.

“The big challenge for exchanges today is to replicate that new-product-development atmosphere within a publicly traded company,” Sandor said, adding that likely would require developing new governance and incentive models.

Arbor was a partner for years at the FCM Shatkin had established, and its name went through iterations before they changed it in 1990 to Shatkin Arbor Inc., a market maker, broker and clearing firm servicing traders ranging from individuals to hedge funds. Shatkin Arbor was bought by Macquarie Group in 2008, and a year and a half ago Shatkin and Arbor repurchased the name and the introducing business catering to market makers, leaving the institutional and clearing businesses with the Australian financial firm.

Sandor differs somewhat with Arbor on the notion that technology drove the fantastic global growth of exchange-traded derivatives, which he said ran at about 18% annually between 1970 and 2010, more than everything except semiconductors.
Instead, he pointed to innovation in the form of new products. “Whole new verticals were created, ranging from contracts on crude oil to stock options to interest rates,” Sandor said. Technological advances were significant, but they acted more as a trade facilitator than a rising tide for the space, he opined.

Whether driven primarily by technology or by new products, the exchange-traded derivatives market rapidly expanded in the 1970s in terms of product offerings and trading volume. The CBOT formed the Chicago Board Options Exchange (CBOE) in 1973, and many of its members moved to that venue. Also in that decade, both the CBOT and CME introduced financial futures, and the CME launched oil futures.

Arbor said there was some opposition to new products among exchange members, who feared that more choice would dilute the FCMs’ liquidity pool. But as the exchanges sold more memberships — the CBOT’s 1,402 members in 1969 has increased to 3,500 today — those new members brought capital and ideas about potential new markets. The broad membership “provides a great pool of liquidity to trade these products,” Arbor said.

To be sure, not all new ideas worked out. Chicken contracts were a challenge, and futures designed to provide catastrophe insurance — launched during Arbor’s tenure as CBOT chairman — never caught on, although the over-the-counter market in ‘cat bonds’ has since established itself.

CME’s 1992 launch of the Globex platform was another game changer, leading to a “globalization of the trade” and new sources of
liquidity, Arbor said. Globex is an automated trading platform that has facilitated access to new products and cross-border markets such as Brazil and Mexico.

Globex is also a main reason behind the incredibly shrinking open-outcry pits at the exchanges, where Arbor and Shatkin worked most of their careers. More than 90% of futures trading over exchanges today is electronic and the remainder is open outcry; 15 years ago, the percentages were reversed.

Tech’s Benefits

Given the reliance on automation, technology glitches, such as those that plagued the recent Facebook and Bats Global Markets IPOs, are cause for at least short-term concern. But Shatkin noted that glitches occur in the world of bricks and concrete as well; for example, a 1992 flood shut the CME and CBOT. Over the long haul, technology’s benefits far outweigh any downside, according to Shatkin.

“The evidence speaks for itself,” Shatkin said. “Technology has broadened the volume and the types of contracts we’re trading.”

In Arbor’s view, the futures market’s biggest challenge is excessive taxes and regulation. He cited the Foreign Asset Tax Compliance Act, which in part requires foreign banks to disclose information about American account holders to the U.S. Internal Revenue Service. “It’s going to force these banks to do heavy compliance and more bookkeeping, and it’s going to be very costly, which may cause them not to do business with American clients or, worse, not to do business in America,” Arbor said.

Arbor sees the complexity of the Dodd-Frank Wall Street Reform and Consumer Protection Act as problematic. The sheer number of requirements from multiple regulators will unduly burden the industry, and regulators are bound to muddle such a morass of rules, he said.

But Arbor’s regulatory view is nuanced, as he agrees with the Volcker Rule’s aim to protect customer deposits by restricting depository institutions’ proprietary trading bets, and he favors separating investment banking and the deposit-taking function, essentially reinstating the Glass-Steagall Act. But, he said, financial institutions that are predominantly investment banks, such as Goldman Sachs, should be allowed to bet their own capital.

“Capitalism without failure is like Christianity without hell,” Arbor said, channeling former U.S. President Ronald Reagan. “You have to have something to purge the system.”

Arbor believes that much of the OTC business should be cleared, as Dodd-Frank aims to make happen, and also traded over exchanges. “You need both, because you need the transparency, and you don’t get that transparency from clearing,” Arbor said.

Given regulators’ recent record heading off financial calamities, from Bernie Madoff to MF Global, Arbor is skeptical about their ability to enforce the preventative new regulations. In the case of MF Global, he said much damage has been done to the notion of customer-segregated funds, “and the industry has to do something, not so much the regulators.”

He recalled the days before the exchanges went public in the early to mid 2000s, when members of the mutual exchanges came together during crises to work out solutions. “When something like this happened, it was in our self-interest to make these customer segregated funds whole,” Arbor said. “The guaranty was always implicit, never explicit. But that implicit guaranty meant something to us as members.”

Arbor said the most effective solution he sees to shore up investor faith in their futures accounts is to set a guaranty, perhaps up to $500,000 per account, to be financed by the industry via an entity akin to the Securities Investor Protection Corp.

As a public company aiming to satisfy its stock and debt investors, CME Group no longer has on-the-fly flexibility to dip into its coffers to make customers whole. Nor can the exchange company afford lengthy periods to nurture new products when it must meet quarterly growth expectations. Its members mostly trade over computer screens and they no longer have the same skin in the game as members of the former mutual companies, when traders actively sought to develop new products and markets.

Sandor said big futures exchanges will continue developing new products and services, but more meaningful innovations may occur at newer, more entrepreneurial exchanges. For example, Sandor founded Climate Exchange, which created and operated several exchanges worldwide trading emission sources and offsets. It was purchased by Atlanta-based IntercontinentalExchange in 2010.

“New products may be developed by new exchanges and then purchased by the biggest existing ones,” Sandor said.

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