Social Networks on the Exchange Floor Mark W. Geiger 1 geiger_SSHA_2011_ppr_1 1/31/2014 Paper presented at the Social Science History Association Annual Conference, November 2011 in Boston, MA. ABSTRACT This paper describes progress on continuing research into the role of social networks at the early Chicago Board of Trade. Founded as a chamber of commerce in 1848, within ten years CBOT had transformed into the world’s first derivatives exchange. CBOT remained the largest such exchange for over 150 years, and its revolutionary market model spread to all major world financial centers by 1900. What I have found so far is that within a few years of its founding in 1848, the Board of Trade already had an entrenched network of influence and patronage. A small, tightly knit clique of members dominated the organization, and extended family and clan alliances competed with one other for money and power on the exchange floor. Much work remains, but the emerging picture is of a pattern of connections known as a small-world network. The existence of this well articulated social network is significant, because it suggests that exchange members acted on complex personal agendas as well as economic motives. The network also may have offered some protection from risks stemming from the highly unstable character of the exchange and its business in this period. [SLIDE 1] This paper is about social networks within exchanges, that is, specialized, closed marketplaces for financial instruments and commodities. Social networks are an enduring feature of financial markets generally, not only within exchanges, as anyone with experience on a trading floor or in a dealing room will know. This topic is important, I believe, because membership in any social network entails many obligations. The existence of such networks on exchanges suggests that members have complex personal agendas as well as more visible economic motives. The whole topic of decision-making—economically driven and otherwise—in financial markets has gained new urgency since the beginning of the world financial crisis. The research I will describe is part of a longer-term project to discover the effect that social networks have on exchange governance, and on the markets that exchanges serve. There is some recent work on social networks in the new virtual trading environments that have developed in the past few years. [SLIDE 2] There is little such research, however, on the older, bricks-and-mortar exchanges, where members came in person to do business. [SLIDE 3] Open-outcry trading is not dead yet, however, and the older exchange model remains an important topic for economists, historians, and policymakers. Exchanges are and always have been core institutions of capitalism. Major exchanges produce an enormous cash flow, and events on exchanges affect even the largest business enterprises. Exchanges set interest rates and prices for financial
Transcript
Social Networks on the Exchange Floor
Mark W. Geiger
1 geiger_SSHA_2011_ppr_1
1/31/2014
Paper presented at the Social Science History Association Annual Conference, November 2011 in Boston, MA.
ABSTRACT
This paper describes progress on continuing research into the role of social networks at the early Chicago Board of Trade. Founded as a chamber of commerce in 1848, within ten years CBOT had transformed into the world’s first derivatives exchange. CBOT remained the largest such exchange for over 150 years, and its revolutionary market model spread to all major world financial centers by 1900. What I have found so far is that within a few years of its founding in 1848, the Board of Trade already had an entrenched network of influence and patronage. A small, tightly knit clique of members dominated the organization, and extended family and clan alliances competed with one other for money and power on the exchange floor. Much work remains, but the emerging picture is of a pattern of connections known as a small-world network. The existence of this well articulated social network is significant, because it suggests that exchange members acted on complex personal agendas as well as economic motives. The network also may have offered some protection from risks stemming from the highly unstable character of the exchange and its business in this period.
[SLIDE 1] This paper is about social networks within exchanges, that is, specialized, closed marketplaces for financial instruments and commodities. Social networks are an enduring feature of financial markets generally, not only within exchanges, as anyone with experience on a trading floor or in a dealing room will know. This topic is important, I believe, because membership in any social network entails many obligations. The existence of such networks on exchanges suggests that members have complex personal agendas as well as more visible economic motives. The whole topic of decision-making—economically driven and otherwise—in financial markets has gained new urgency since the beginning of the world financial crisis. The research I will describe is part of a longer-term project to discover the effect that social networks have on exchange governance, and on the markets that exchanges serve.
There is some recent work on social networks in the new virtual trading environments that have developed in the past few years. [SLIDE 2] There is little such research, however, on the older, bricks-and-mortar exchanges, where members came in person to do business. [SLIDE 3] Open-outcry trading is not dead yet, however, and the older exchange model remains an important topic for economists, historians, and policymakers. Exchanges are and always have been core institutions of capitalism. Major exchanges produce an enormous cash flow, and events on exchanges affect even the largest business enterprises. Exchanges set interest rates and prices for financial
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instruments, raw materials, and many finished goods. Sharp movements in these prices can unsettle entire national economies.
I am presenting this material at an earlier stage of my research that I normally would, but I'm filling in for another paper that was withdrawn. Rather than research results, I will describe the research question, some preliminary findings, speculation about what I think these findings mean, and how I plan to go forward.
My starting hypothesis is that exchange members with strong connections to social networks have a competitive advantage over members without such ties. If this is true, I would expect that over time “connected” members would crowd out “unconnected” members. I am testing this hypothesis using data from the Chicago Board of Trade, 1858-1880. For several reasons, social networks would not have been extensive or influential in the years immediately following the Board’s founding. Such networks arose later, and remain prominent within CME Group, since 2007 the successor organization to the Board of Trade. Since the Board of Trade is of relatively recent origin for a major exchange, primary-source materials are plentiful.
The Board of Trade is worthy of study in its own right, and I originally intended to write a general economic history of the institution. Founded in 1848 when Chicago had a population of twenty thousand, by 1880 the Board of Trade had become a key financial center of the first age of globalization. The Board of Trade dominated world agricultural markets for over a century, and introduced many innovative financial practices, exchange-traded futures contracts being the most prominent. By 1880, in the US only the New York Stock Exchange eclipsed the Board of Trade in importance. I have found that Chicago-style futures trading spread to New York by 1870, to Liverpool by 1873, and to London by 1878. By the early 1890s, futures trading had spread to other locations as well in the US and Canada, and to Berlin, Paris, and Hamburg.
Using Microsoft Access for exploratory research, I have found that within a decade of its founding the Board of Trade already had an entrenched network of influence and patronage. A small, tightly knit clique of members dominated the organization. Through 1880, the terminus of this study, over ninety percent of exchange presidents and vice presidents had joined by 1860 or earlier. On the various governance committees, the same names appear year after year in different combinations. I have found that during the Board of Trade’s period of early growth, a high rate of membership turnover accompanied rapid increases in total membership. Exiting members were more than replaced by new members, a disproportionate number of whom had family ties to holdover members. Increasingly, exchange members joined extended family and clan alliances that contested turf, sometimes ferociously, on the trading floor.
Much work remains, but the emerging picture is of a pattern of connections known in sociology as a small-world network. [SLIDE 4] In contrast to a hierarchical network, such as a corporation, a small-world network consists of regional clusters loosely linked
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to one another. National and transnational criminal gangs and Islamic terrorist groups are notable contemporary examples of small-world networks. Clusters consist of individuals—nodes, in network terminology—connected through multiple relationships. In small-world networks, relations among members within clusters are much closer than in hierarchical networks. Thus, information flows more freely and news spreads faster than in hierarchical networks. Though decentralized, leadership still exists in small-world networks, but usually extends only to the boundary of the cluster. Some individuals, called hubs, are more “popular” than others, having a greater number of affiliations. The hubs are leaders, who draw their power from their personal influence with other group members.1
A closer look at the early years of the Board of Trade yields clues to how these member networks developed. During the period under study, the organization became increasingly specialized. The Board of Trade originated as a chamber of commerce, not an exchange. In its earliest period, from the Board’s founding in 1848 and through the middle 1850s, members concerned themselves with topics of general civic interest, such as street lighting and harbor improvements. The organization fared poorly, and almost expired for lack of interest and member support. I have found that the institution survived because members started using its daily meetings as an all-purpose marketplace, where goods of every sort changed hands.2 But geography gave Chicago unbeatable advantages in the grain trade and meat packing, and the organization found its true calling as a market for these items. From the latter 1850s on, the Board of Trade increasingly became a meeting place for men engaged in these two businesses. Men engaged in other pursuits found that their concerns received little attention, and gradually dropped away.
As the exchange took shape, the membership changed. In the first years of the Board of Trade, its members held a wide range of occupations. But annual membership turnover was as high as 30% in the later 1850s and early 1860s, while total membership was growing quickly. Gradually the membership narrowed down to men working within a few linked industries. Members with ties to the grain trade included elevator operators, commission merchants, millers, bakers, shipbrokers, and wholesale grocers, to name a few. A new, separate chamber of commerce formed in 1863, a mark of the altered character of the Board of Trade.3 [SLIDE 5]
The Board of Trade further consolidated its membership by raising the standards for admission. As a chamber of commerce, the Board of Trade assessed only token annual dues and membership was open to any businessperson of good character. For the first 21 years of the Board’s existence, new members paid an entry fee of $5. Beginning in 1869, however, the fee rose successively to $25, $100, $1000, and finally to $10,000 in 1883. The purpose of this policy, the president of the exchange stated, was “to exclude men of whom we know nothing." This effort only partly succeeded, however. Once the entry fee reached $1000, in 1876, new members stopped joining by that route.4 Instead, new members entered by buying memberships from existing members, leaving the total number of members of the exchange roughly unchanged. Still, the raised entry fee
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sharply decreased the proportion of new members. Also, these new members joined because they had business to do on the trading floor. A president of the exchange noted in his annual report that many of the exiting members had never attended trading sessions anyway, but the incoming members came regularly. [SLIDE 6]
To recap, two long-term trends at the Board of Trade cleared the way for tightly-knit social networks to form. The first was specialization. The Board of Trade changed from a service club with a diverse membership into an institution serving specific industries. An increasing proportion of members worked in a handful of linked occupations. Such men had reason to know each other, unlike members in more distant lines of work. Second, the organization took steps to exclude members it considered undesirable.
But these developments made it easier for networks to form, rather than caused them to form. To rephrase my hypothesis, I think that members formed social networks because they got a survival advantage by doing so. That is, connected members remained on the exchange longer and made more money than unconnected members. Further, I think that this survival advantage worked by reducing risk. Reducing risk also would be consistent with a major objective of any organized exchange: to uphold an artificial environment for members to transact business more efficiently, profitably and safely than would be possible otherwise.
Risk were high in mid-nineteenth century Chicago. Some risks were systemic, and beyond anyone’s control. Agricultural prices are inherently unstable, and the macro economy suffered repeated shocks in this period: the Panic of 1857, the Civil War, Black Friday, the Chicago Fire, and the Panic of 1873. Meanwhile Chicago was growing rapidly and newcomers crowded into the city, all of them strangers to one another. Inside the exchange members could exert some degree of control over business conditions, but risks were high there as well. During the years of simultaneously rapid membership growth and high turnover, over half the members in any given year had belonged to the exchange less than twelve months. Business partnerships of members often were short-lived, forming and dissolving with startling rapidity. Finally, owing to the new railroad and telegraph networks, the Chicagoans transacted business in distant cities, with counterparties they had never met and never would.
I now want to move on to how I plan to test the survival-advantage hypothesis. To map the member networks within the exchange my study population will be the 1,648 Board of Trade members who were broker-dealers in the grain trade between 1860 and 1880.5 From this group, I will research member persistence rates with a sample of 355 members divided into groups that joined in the same year. To discover the overall shape of the network, I will take a snowball sample, total size so far unknown. I plan to use Pajek to map the network. I will use the manuscript census and property tax records to measure the members’ relative wealth.
I have some guesses about what this network data will look like: [SLIDE 7]
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1. Data exist to identify relationships based on family, locational, and social ties; 2. Members of social networks occasionally will engage in concerted action; and 3. Networks will be relatively stable, though individual members will come and go
Data on member relationships are available from many sources. From 1858 on, the Board of Trade published statistical annuals that included names of members and other information such as firm name, nature of business, and business address. The manuscript census contains demographic, genealogical, and household location data. Other useful sources include city directories, county, state, and municipal records, judicial records, and personal papers.
My problem thus is not how to locate source data, but how to manage it. An even bigger data management issue than the number of sources will be to locate useful data in huge pools of irrelevant data. For example, I could infer that in 1875 two Board of Trade members shared a social connection if they were officers of the same fraternal lodge in that year. The Chicago Tribune often published such information then. To find this connection, however, I would have to do a huge amount of manual processing. I would have to match each possible pair of the 988 Board of Trade members connected with the grain trade in 1875, and see if those names appeared in the same newspaper article. The Tribune was, and is, a daily newspaper. Counting advertisements and other notices, each issue likely contains several hundred articles.
Data in such volume clearly calls for automated rather than manual processing. To this end, I am collaborating with Dr. Tanu Malik at the University of Chicago Computation Institute to apply for grant funding from the National Science Foundation. The purpose of the grant would be to create software to streamline the manual processing necessary for social network analysis. We will propose a system to extract relationship data from textual sources and that will then use the data to create a preliminary network map. The NSF has previously supported exploratory research on automated data extraction and network mapping, and our work would represent a logical next step.6 The proposed system will use Unstructured Information Management Architecture (UIMA) and employ techniques from computational linguistics and quantitative sociology, which are Dr. Malik’s areas of competence rather than my own. To use a mundane analogy, a successful result would be analogous to a Cavitron—the dental tool that cleans teeth using high-frequency sound. A Cavitron does not replace manual cleaning, but substantially reduces it. We plan to develop general-use software that will further my own project, but also make social network analysis easier for all researchers, regardless of their discipline. My particular interest is to develop a standardized method to efficiently collect data and map social networks in other exchanges.
To close, this project could contribute to the continuing policy debates on market oversight and exchange governance. The switch to screen trading has not ended social networks in financial markets, but rather created new channels for such relationships. Current members and officers of CME Group whom I have interviewed all speak of the generations-long kinship and personal connections in the CME “family”—their term.
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These member networks could affect more than the fortunes of individual members: for example, the spread of financial innovation. In a famous article, Mark Granovetter argued that open networks, with many weak ties and social connections, expose their members to more new ideas and opportunities than closed networks with many redundant ties. In other words, cliques are less likely to innovate than looser, more diffuse groups.7
Another promising line of future inquiry would be into the role that such networks play in insider trading. [SLIDE 8] Being illegal, insider trading is hard to study because no one will admit to it. But as I know from personal experience, Wall Street runs on rumors and backchannel communication. Anthropologically speaking, the exchange of market information resembles an exchange of gifts, and helps to cement relationships. Privileged information is more valuable, and creates a stronger shared bond between the parties. Straightforward profit-and-loss considerations supplement psychological motives here. A good tip can make the difference between earning a profit and getting wiped out. This information exchange also produces a strong us-versus-them attitude and a gang ethic: members agree not to rat each other out. I frankly doubt that regulators can change these practices. The whole currency of social networks of financial professionals is information, and favors done and repaid. But an improved understanding of relations among exchange members is essential to creating more effective policies, either to reduce the incidence of insider trading or to buffer its effects.
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ENDNOTES
1 Sageman, Understanding Terrorist Networks, 137-58. Gould, “Why Do Networks Matter?” 233-57. Marsden and Friedkin, “Network Studies of Social Influence,” 2-26.
2 Cereal grains, but beef cattle, hides, lumber, salt, highwines (distilled spirits), hops, coal, stone, lead, fish, to name a few.
3 Chicago Tribune, February 2, 1864, 4.
4 Chicago Tribune, March 5, 1875, 4.
5 Detailed membership data is available only from 1858.
6 NSF Award IIS-0935360, EAGER: Corpus-Based Narrative Semantics. Kathleen McKeown, Principal Investigator.
7 Mark S. Granovetter, "The Strength of Weak Ties," American Journal of Sociology 78, no. 6 (May, 1973): 1360-1380.
Social Networks on the Exchange Floor: The Chicago Board of Trade, 1848-1880
