For Part 1 of this interview between our CEO, Rick Lane, and Ray Cahnman, Chairman and Founder of TransMarket, see Wizards of Today’s Markets: Ray Cahnman, Part 1.
Rick: Would you say that—we’ve all made bad trades and probably learned more from those than from the good trades—but would you say that [your narrow escape with the back month mortgage spreads] is the story that underscores your approach to the rest of your career?
Ray: That was the worst, and there’s no question that you learn more from your bad trades. You make a good trade and the question you have to ask yourself is, was it skill or luck? And if I had to do it all over again, would I do it the same way? When you have a losing trade, you can’t beat yourself up too bad. If you did everything right, and you still lost, you’d say, “Well, if I had it over again, I’d do it the same way.” In any sport, in any game—trading, tennis, any competitive sport—you learn more from your losses than from your wins. If you win, you kind of chalk it up—that’s on the scoreboard—and you go on to the next. The loss—you have to go back and re-analyze what happened and what you did wrong. And that’s especially true in trading. And you try and avoid making the same mistake twice.
Rick: So you’ve obviously embraced electronic trading, but do you feel that the industry has lost something with the closure of the pits? Are you nostalgic or do you think we’re better off now?
Ray: I’m not nostalgic at all. I’ve been asked by a number of people to talk about the “good old days.” From 2000 to 2003, I was a director at the Board of Trade. I could see electronic trading coming. Open outcry should’ve ended long before it did. It was a very frustrating time, because I had to fight a board that was dead set on preserving open outcry. The mantra at the Board of Trade at the time was, “We’re going to provide the customer with the best of everything. The best of electronic and the best of open outcry.” It made no sense. There should be a single marketplace. The most efficient way to have a market is when everyone knows where the party is. To have both an open outcry party and electronic party is inefficient. And I could see that the technology was catching up, and that electronic trading would be taking over. It should’ve happened many years earlier. Personally, I was focused on getting ready for electronic trading. Back in the early 90s and late 80s, I was following voice recognition. At that time DOS was in use. Windows did not exist. The screens didn’t have the graphics that they do today.
Rick: I remember DOS.
Ray: It now seems inconceivable. But I thought that the future of electronic trading would involve everyone sitting in front of a computer and being able to yell into a microphone. I imagined that the computer would sort out who’s first. I kept paying attention to voice recognition technology. I had predicted the wrong adaptation, but I knew that electronic trading was going to prevail.
Rick: And about six or seven years too far in front, too. 2005 was when I came into this industry, and that’s back when I saw the Eurodollar back-month spread pit for the first time—in the fall of 2005. And then by the summer of 2006, it was like you could hear a pin drop. It was so quick and I’m sure there’s countless other pits that have a very similar story.
Ray: Your experience is interesting, because by that time I had been off the floor for a few years. The Euribor, which was a similar contract but for Deutsche Marks and then eventually the Euro, was traded actively on the screen at LIFFE. Euribor used a pro-rata distribution system. And that’s what made it work. You couldn’t trade Eurodollars, a spread market, on a FIFO distribution system, especially in the back months. I kept telling the CME that they had to go pro-rata. Eurodollars were displayed on GLOBEX but fills were distributed FIFO and it had no traction. So, very little traded on the screen—it was all in the pit. Finally, they made the algorithm pro-rata. Then it had a chance. I started playing Eurodollars electronically and I started playing it big. Most everyone was afraid. In a pro-rata system, you have to bid—if you want—
Rick: If you want ten, you bid—
Ray: You bid for a hundred or whatever. Sometimes, a calendar spread quote might be as much as 50,000 up. So I bid one tenth of it, 5,000. Other clearing members would not allow their traders to place orders that big. They’d have to trade the maximum of what they wanted. So I’m trading and I’m getting the lion’s share of the pro-rata distribution. Everybody else is putting in bids and offers for like maybe a hundred, whereas I’m putting in for a thousand, 5,000, or 10,000.
Rick: As long as when the market turns you’re able to get out.
Ray: My TT machine, every time it made a trade, it would clap. And it was clapping all day long. I didn’t even have to look. I was getting small pieces that added up. And the years 2005, ‘06, and ‘07 were great years for trading Eurodollar calendar spreads. 2008 was my very best year. I was cranking out enormous volume. That lasted through 2009. In the beginning of 2010, it started to diminish. There were two underlying reasons for this. First, Spread Networks came in and sold access to a faster fiber optic connection. Traders were faster, and then also people were smarter. People caught on to what I was doing. And secondly, algorithmic traders started developing programs that tightened up the spread. Spreads didn’t get out of line as often as they did up until 2009. That had a devastating effect on the people that had transformed from the pit to the screen and were still active and viable trading electronically using front ends like Trading Technologies, which was the most popular front end by far.
I have an interesting thought for you. I was always very much in favor of pro-rata distribution for everything. And I kind of wonder what would happen if SPOOs, which are basically a FIFO, were distributed on a pro-rata basis.
Rick: It would be interesting.
Ray: It’s already a done deal, but it would definitely have changed the speed game. And I saw it right from the beginning. I knew that a distribution based on FIFO markets would lead to an Oklahoma land rush. The guy that was the fastest was going to get it all. If you weren’t the fastest, you weren’t going to get it. And eventually—
Rick: Or if you weren’t there the longest. So you had the people that—you’d line both sides of the book with orders, beginning of the day, so that you could work your way to the front of the queue.
Ray: That’s right. Yeah, it was all about getting to the front of the queue. It’s something that, as we’ve gone on, as people have been able to get their orders in quicker, has been to the detriment of traders without access to a fast connection. That’s one of the big problems that the exchanges have.
Rick: I’m curious. You run a principal trading firm. What advice, if any, would you have for the CMEs of the world? Ways that they can improve.
Ray: First of all, you have to understand the CME’s role. They’re like the umpire and commissioner in a baseball game. They set the rules. And it’s real important that they set the rules so that everyone can get a chance to compete fairly. And they have to oversee it and make sure that happens. In baseball, it’s 90 feet from home plate to first. It’s an entirely different game if it’s 89 or if it’s 91. Similarly, the CME has to draw a fine line. I think that they could do a much better job by looking at the game and seeing how they can better level the playing field. The CME should set the rules to drive the maximum amount of volume through the system. They should strive to get large numbers of traders actively participating. This would be in their self-interest.
Currently, 90% of the volume is going to 10% of the participating traders. However, if they had a broader distribution of their trades, they could grow faster, attracting more people to become involved in the game. Is fill distribution today the most efficient? Is the way they’re operating now the best way to drive the most volume and get the most people involved? They can do better. But will they? I don’t know, human beings are creatures of habit. When they get used to something, they’re not likely to change. For instance, in the pit, everyone quoted yield curve spreads based on up or down on the day. And they did that because—I’ll buy the ten-year bond spread. I’ll buy it up one tick on the day, or I’ll buy it up two ticks on the day.
Rick: Because they had positions coming into the day?
Ray: They did that because that was the only way you could communicate in the pit. Because quoting based on three times the TY minus two times U.S. had to be communicated verbally. You had to talk in shorthand in the pit. Now, there’s no pit. So on a computer, it’s pretty easy to create some sort of an index, and if you had an index, then you would be able to attract people. Even though you may not be able to quote it in terms of basis points or yield, you could quote it in terms of an index. On Monday, you could see that you bought the index at one price, and on Friday, the index is higher. I know how much higher and determine what my gain or loss would be. The CME would absolutely get more players trading the yield curve if they could quote it in terms of some sort of an index, as opposed to up or down on the day like they do now. This would be a marketing dream for the CME.
I have a large amount of CME stock, which I have no intention of selling. I think it’s a very safe investment. It pays a good dividend. The CME is a very good company. But on the other hand, I think that they could be a lot more innovative than they are. Take a chance. Quote your yield spreads in some sort of an index. And see what happens. It took so long for the pit to change, for the CME to embrace technology. Learn from one’s mistakes.
Rick: It’s an industry of great inertia, as you know. And sometimes it’s—
Ray: It’s because it’s a monopoly. They’ve got a franchise in interest rates. They’re so entrenched that nobody could possibly come in and take it away because the party is at the CME.
Rick: You’re absolutely right. There is one other thing. I don’t know if—we found this picture when we were doing our homework on you.
Ray: No, I love it. It shows my son—it has to be 2007 or 2008. And we’re in front of my bed. Since trading was going 24 hours a day, and I had orders in all night, I would have my screen on at all times.
Rick: The screens look familiar.
Ray: Yes, it’s Trading Technologies. And it would clap when it made a trade. And my wife was fortunately a sound sleeper.
Rick: I’m sure she was thrilled about that.
Ray: The other thing is that I mentor a lot of people trading from an identical trading setup downstairs in my library. I could see what they were trading. I had to get some sleep, but I often woke up when a trade was made. I was always in a bad mood, and when they did something wrong, I’d make some not-so-gentle criticisms of what their mistakes were.
Rick: Hopefully you didn’t start that young. You didn’t start them that young. (points to photo)
Ray: No, but actually, for some of the people that were down there, when they made a mistake, I would yell down to them. I’d say, “My three-year-old could do a better job than you. Show me your diploma. I don’t believe you ever graduated grammar school.” By the way, TT has been very innovative in terms of creating tools. If it wasn’t for TT, a lot of traders would have never been able to crack into the market and create algos.
Rick: That’s great. Have you dabbled with ADL® yourself?
Ray: I stopped trading about a year and a half ago. At TransMarket, we utilize our own algorithms with proprietary software. We also use TT for markets that aren’t quite as active. ADL looks to be very promising. For new markets, we get access through TT. For the smart guy that wants to figure out the market on his own—the lonesome cowboy-type trader, or perhaps a small group not affiliated with a big company infrastructure—they can work effectively with the tools at TT. You either have to be the fastest, or be smart. Utilizing the tools that TT offers gives traders an opportunity to develop a strategy. There may be a hundred different algorithms that are focused on attacking various things in the interest rate market. There’s always the possibility of creating a new and different algorithm that looks at the market slightly differently. There still exists a population of talented individual traders that have survived. Those traders have no choice but to speculate. They have to be directional, pick their spots, and be very patient. The trades should not be large. They should execute a few trades a day. Consequently, those traders make a fraction of what they were able to do when they could trade a lot of volume. However, the exceptionally bright traders that can work with TT products can have tools to automate, execute, and sit back and see it work. There are likely a few people that have really done well trading through your products.
Rick: We have had our fair share of people.
Ray: If you’re coming out of a good school, you know math, and you know logic, and you can see how the markets work. You have to know how to create an algorithm. You have to broadcast the message to traders that if you’re a capable and creative thinker, our products [futures] are a great fit. You don’t have to be a Nobel Prize candidate.
Rick: I appreciate that. I think it’s where we’re constantly trying to lower the barrier. This even goes to what you’re talking about with CME and trying to increase their distribution and trying to lower the barrier.
Ray: I could tell you something. As long as you said that, “the barrier.” Are you watching membership prices?
Rick: I stopped watching them when I sold mine. Where are they now?
Ray: To apply for a membership, it’s still a $2,000 application fee. But to lease a CBOT Associate Membership, the posted monthly rate is $476, but since there are over 50 available, the offer price is much lower. Posted lease rates for IDEMs and COMs are $30 and $130 respectively, with over 40 IDEMs and 60 COMs available. So, the thing is, the application fee is a big multiple of the monthly lease fee. It makes no sense because the break-even point between being on a membership or trading through a firm under their umbrella is nine cents. The bottom line is that the $2,000 application fee is completely out of line with the low membership lease rates. It just stops people from applying for memberships. And the lower the lease price goes, it just makes it stand out even more. If you want to trade on the CBOE floor, you have to buy a permit. CBOE got rid of all their memberships. So if you want access to their markets, you buy a permit. If CME would get rid of all their memberships and buy them up—all they have to do is bid under the market and catch them as they come in. CME could then issue permits. It would generate revenue. They could find a number that would make it revenue-neutral. In the meantime, I think CME is handicapped by having a complicated pricing structure; impossible to figure out. Right now, it’s much cleaner for a new trader to start trading ICE, or Deutsche Börse or any other exchange that doesn’t have the burden of memberships.
Rick: We could talk for hours.
Ray: I’ve had a unique experience. I was a high volume trader and I ran a clearing firm. I was exposed to everyone’s stories coming through. Sadly, I knew what was going on in the heads of all these people as they were going from big-time success to failure. I’ve had people call me when they’re living out of their cars, doing menial work. Mowing lawns. I’m reminded often of when Shatkin was going to blow me out, and I almost lost it all. I’m never going to let that happen.
I got the sense that we only hit a few of Ray’s best stories, but that’s one of the nice things about having the Tech Tap. I’m confident he will be back when the time is right to share more insights and trading tales from his distinguished career.