Open outcry versus electronic trading: Tests of market efficiency on crude palm oil futures

• Date: 01 June 2018
• Author: Norzalina Ahmad,Stuart Snaith,Neil M. Kellard
• DOI: http://doi.org/10.1002/fut.21899
• Published date: 01 June 2018

Received: 19 September 2014

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Revised: 20 November 2017

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Accepted: 20 November 2017

DOI: 10.1002/fut.21899

RESEARCH ARTICLE

Open outcry versus electronic trading: Tests of market

efficiency on crude palm oil futures

Stuart Snaith

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Neil M. Kellard

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Norzalina Ahmad

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1

Peter B. Gustavson School of Business,

University of Victoria, Victoria, British

Columbia, Canada

2

Essex Business School, University of

Essex, Wivenhoe Park, Colchester, Essex,

United Kingdom

3

College of Business, Universiti Utara,

Sintok, Malaysia

Correspondence

Neil M. Kellard, Essex Business School,

University of Essex, Wivenhoe Park,

Colchester, Essex CO4 3SQ, United

Kingdom.

Email: nkellard@essex.ac.uk

Funding information

Economic and Social Research Council,

Grant number: ES/L011859/1

Given the widespread transfer of trading to electronic platforms we ask whether such

trading is more efficient than open outcry. Examining the Crude Palm Oil (CPO) market

from 1995:06 to 2008:07, our findings, derived from a novel threshold autoregressive

relative efficiency measure, are that efficiency is conditional on: (i) volatility; (ii) the

maturity of the futures contract; and (iii) the market trading system. Specifically, when

volatility is high, open outcry is superior for shorter maturities and electronic trading for

longer maturities. These results suggest an efficiency skew and that there may be benefits

to the coexistence of trading mechanisms.

KEYWORDS

commodity futures contracts, crude palm oil, electronic trading, market efficiency, open outcry

JEL CLASSIFICATION

G13, G14, G15

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INTRODUCTION

Futures markets provide a tool for risk management and aid in price discovery. However these functions are only optimal in the

presence of market efficiency. As is well known, under the assumptions of rationality and risk neutrality, the futures market is not

only efficient but the price is an unbiased estimator of the corresponding future spot price.

Using cointegration techniques futures market efficiency has been extensively investigated for a number of commodities and

financial assets across a variety of data spans. On the one hand, there is evidence of efficiency (see, e.g., Dolatabadi, Nielsen, &

Xu, 2016; Kawamoto & Hamori, 2011; Kellard, Newbold, Rayner, & Ennew, 1999; Switzer & El-Khoury, 2007), whereas on the

other there is evidence of inefficiency (see, e.g., Chowdhury, 1991; Figuerola-Ferretti and Gonzalo, 2010; Mohan & Love,

2004). The outstanding question is therefore how can this contradictory evidence be reconciled?

Applying Occam's razor, the obvious answer may be that some markets may be efficient, whereas others may not be. This

then points toward unique market specific factors that may contribute to or hinder efficiency. One such factor may be the way in

which, if at all, electronic trading systems are implemented. Many asset and commodity markets have now either abandoned

open outcry for electronic trading platforms, or run both systems side-by-side. However there is some recent evidence that

exchanges see value in the open outcry method of trading, as evidenced by the recent investment in a new open outcry trading

floor by the London Metal Exchange.

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The evidence for either form of trading is mixed, with some work suggesting that a

well-functioning market benefits from the open outcry (Martens, 1998), whereas others posit a fully electronic approach (Tse,

Xiang, & Fung, 2006). However, there is also evidence that when used independently, electronic trading is not as able as open

outcry to impound information into the price when volatility is high (Aitken, Frino, Hill, & Jarnecic, 2004).

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The new “Ring”opened on February18, 2016.

J Futures Markets. 2018;38:673–695. wileyonlinelibrary.com/journal/fut © 2018 Wiley Periodicals, Inc.

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Existing work that focuses on these two methods of trading often uses intrada y data to examine issues such a s liquidity,

trader survival, the size of spr eads, and price discovery, acros s a broad range financial and commo dity futures. Examples of

such work include Boyd and Ku rov (2012), Aitken et al. (20 04), Ates and Wang (2005), Cop eland, Lam, and Jones (2004 ),

Theissen (2002), and Tse and Za botina (2001). However the ma in focus of our study is distinct f rom this literature,

contributing by being the first , to our knowledge, to address predicti ve efficiency in futures markets under discrete market

trading regimes. In other w ords, we utilize daily data o n futures contracts to examine under which trading reg ime the futures

price best predicts the futur e spot price.

For this experiment we choose the crude palm oil (CPO) futures market due to its discrete migration from open outcry to

electronic trading which obviates the need to address a scenario where both open outcry and electronic trading operate

simultaneously. In choosing CPO we also address a gap in the literature as this commodity is under-researched. This is surprising

given its wide spread use globally and the increasing prominence of this commodity on the world food market. Strikingly

production levels are greater than any other edible oil.

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In implementing this experim ent we utilize two sub-samples of da ta pre- and post-introductio n of electronic trading and

initially assess long- and short-run efficienc y using standard cointegrat ion techniques and Kellard e t al.'s (1999) relative

efficiency measure. Unlik e other efficiency measures which classify whether a market is either solely efficient or inefficient ,

this relative measure allo ws an assessment of the degree to which efficiency is present. We furth er contribute by being the

first to examine how well these t wo methods of trading impound in formation as a function of the vola tility of the underlying

asset, which is achieved by adapti ng the relative efficiency meas ure to a threshold autoregressiv e environment with a

bootstrap confidence inte rval. Finally, we examine mark et efficiency at several points across the term structure permitting a

more comprehensive analy sis of the market. It is noteworthy that much of the extant li terature often focuses solely on shorter

terms to maturity.

Our findings indicate that the C PO futures market is long-run eff icient for the vast majority of ma turities tested across

both trading platforms. Howe ver, across the whole sample and op en outcry and electronic trad ing sub-periods there is

evidence of short-run inefficie ncy. Interestingly, applyin g the relative efficiency measu re of Kellard et al. (1999) indicates

that open outcry is more efficie nt at shorter maturities and electr onic trading at longer maturiti es. However, using the new

threshold autoregressive rel ative efficiency measure, boot strap results suggest that the open ou tcry method is superior for

shorter maturities when vo latility is high. Conversely th ere is some evidence that electr onic trading is superior whe n

volatility is high but for long er maturities. Interesting ly the two forms of trading are f ound to be indistinguishabl e from one

another when volatility is lo w. Moreover, we adapt the dela y measure used in the stock mar ket efficiency literature a nd

which, by construction, focuses o n short-horizons and provide fur ther support that open outcry outper forms electronic

trading when volatility is high .

The results presented in this paper suggest the existence of an efficiency skew where in high volatility environments,

improved efficiency is skewed more toward open outcry at short maturities whilst being skewed more toward electronic trading

at longer horizons. This updates and extends the work of Boyd and Kurov (2012) and Martens (1998), suggesting there is still a

role for open outcry in modern futures markets to improve price discovery and related issues of risk management, particularly at

shorter maturities. In the context of the CPO market, this clearly has implications for the price discovery and optimal hedging of a

commodity that is increasingly prominent on the world food market, and one that also has both developmental and environmental

effects.

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The remainder of the paper is organized as follows: section 2 provides a short overview of the CPO market, section 3

examines CPO futures efficiency across the term structure, section 4 examines CPO futures efficiency across periods of

electronic trading and open outcry, and a final section concludes.

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A PRÉCIS: CRUDE PALM OIL

CPO currently represents the largest share of the edible oil market, thus the functioning of this market warrants closeattention in

the current climate of an expanding world population and finite resources. It is derived from the fruit of the oil palm tree and is

used for a range of purposes, including cooking oil, baked goods, soaps, washing powder, and as a bio-fuel. The demand for palm

oil has increased in recent years, linked to: (i) the growth of the Indian and Chinese economies; (ii) the use of palm oil as a

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Based on the latest production data, palm oil presents almost a third of edible oil market (source: Food and Agriculture Organization of the United

Nations). See section 2 for more information on the CPO market.

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See World Bank and IFC (2011) for a discussion of the developmental and environmental effects.

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