HOMECOMING

Presented at the Nihon Keizai Shimbun/Osaka Securities Exchange Seminar on the NIKKEI 225 Stock Index,
Osaka, Japan,
September 2, 1988.

I was honored to be the guest of honor at the opening of the NIKKEI 225 Stock Index contract at the Osaka Securities Exchange. That Japan had moved so quickly in developing a futures contract in stock indices and in achieving government approval for its trade was the most telling evidence that financial futures had made their permanent mark on this financial community.

It was confirmation that our strategy of spreading financial futures knowledge to the Far-East had succeeded and that globalization would ultimately result in Japan opening its financial markets to the world. In the near term, it meant a growing flow of financial futures business from Japan to Chicago, for as the futures learning curve of this community rose, so would its use of the financial futures markets abroad.

Another interesting aspect of the Japanese adoption of stock index futures was its similarity to U.S. financial history with respect to the rivalry between Tokyo and Osaka. Just as the New York Stock Exchange sought to wrest control of this product line from Chicago by instituting futures trade in the New York Stock Exchange Index, so did the Tokyo Stock Exchange attempt to undo Osaka by creating the Tokyo Price Index (TOPIX) contract. The CME bet on the NIKKEI and Osaka, Chicago's sister city.

There is an old American saying: "What goes around, comes around." No doubt there is a Japanese equivalent, for no culture or language has a monopoly on aphorisms. The wise man who first coined this saying might have had this day and age in mind. Futures markets, having moved from country to country around the globe, are about to return to the land of their origin—Japan. It was in Osaka—the Kitchen of the Nation—during the Edo period (1600-1867) that feudal clans established warehouses to store and sell the rice paid to them as land-tax by their villagers. To protect themselves from wide price fluctuations from harvest to harvest, these merchants in 1730 established the first organized futures exchange. It enabled them to hedge the inherent price risk of rice, and for Osaka to become the largest commercial Japanese city of that era.

It is apropos that futures markets return to Japan particularly at this time in its history. Today Japan is the principal source of capital for the world, with the world's largest banks, largest insurance companies, largest brokerage firms, its companies have the highest market value of any industrial country, and its Tokyo Stock Exchange (TSE) is the largest in the world in terms of capitalization. In this financial environment, it would be shortsighted for Japan not to afford its financial institutions and investment community with the same financial tools for risk management available in all other major centers of finance.

After wandering around the globe for two hundred years, futures markets will return to Japan in a somewhat different form from that which their ancestors invented. Instead of an agricultural base, today's futures have a financial foundation. Instead of rice as the instrument of trade, stocks will be traded by virtue of an index. Instead of hand-written tickets, computerized screens will serve as the transaction medium. What will be the same as it was two centuries before is their underlying purpose: to provide a secure market for hedging the inherent forward risk of commercial users.

On the eve of this homecoming, it is important to briefly mention some of the noteworthy milestones encountered by futures markets in their journey around the world, to underscore the lessons we learned, and to attempt to peer over the horizon at what lies ahead.

The most important transformation of futures markets occurred less than two decades ago on the American shore. For it was in Chicago in 1972 that the nature and destiny of futures dramatically changed. It was there that the International Monetary Market (IMM) was born at the Chicago Mercantile Exchange (CME) and the era of financial futures was spawned. Indeed, with the introduction of currency futures, the IMM revolutionized the long agricultural history of futures markets and gave it at once new direction and limitless potential. The event is considered so signal in the annals of finance that the University of Chicago has called it "the most important financial innovation of the last twenty years."

The financial revolution that began with currencies quickly extended to interest rates and fostered the idea of cash-settlement. A decade later, cash-settlement became the gateway to index products—most importantly, stock index futures. Today the CME's S&P 500 futures contract—the most successful stock index futures contract in the world—is an indispensable tool for U.S. portfolio managers, a fact not overlooked by the Japanese government.

Indeed, in May of this year, the Japanese Diet wisely recognized that a market for the hedging of risk endemic to large portfolios of stock is an idea whose time has come. As a result, two markets will be created. In the city that gave birth to futures, the Osaka Securities Exchange will commence futures trading in the NIKKEI 225 stock index contract. In Tokyo, the Tokyo Stock Exchange will trade its new TOPIX index contract.

For the Chicago Mercantile Exchange, this occasion is of special significance. Not only did we launch financial futures, not only were we instrumental in developing stock index futures, but we were first to recognize the potential of the Japanese stock market in the sphere of global equities. In 1985, we forged an agreement with the Nihon Keizai Shimbun (NKS)—your country's giant communications organization—to jointly work toward the development of the NIKKEI 225 index as a futures instrument. To us it was axiomatic. The NIKKEI 225 stock index has a long history as the primary indicator of the performance of the Japanese stock market. It has been so since 1949 when the Tokyo Stock Exchange re-opened after the war. The NIKKEI has become the accepted world benchmark for measuring the performance of Japanese stock portfolios. Toward our mutual goal, NKS and the CME encouraged the Singapore International Monetary Exchange (SIMEX) to begin futures trading in the NIKKEI 225 and assisted its inauguration on September 3, 1986. We rejoiced when on May 6, 1987, the Osaka Securities Exchange introduced the OSF 50 and became the first Japanese exchange to launch stock index futures in this country. Significantly, the OSF 50 was specifically designed to closely correlate with the movements of the NIKKEI 225.

At this juncture in this historical review, it is important to underscore that your government's decision to proceed with the development of stock index futures was made in the wake of last October's worldwide stock market crash. Indeed, even as some individuals cast doubts on the benefits of stock index futures, and still others openly criticized them, the Japanese Diet correctly recognized that all such negativism was unfounded and nonsensical. As subsequent studies of October 19 have shown, U.S. stock index futures markets provided an important safety net for hedgers during the crisis. In the words of U.S. Federal Reserve Chairman Alan Greenspan:

What many critics of equity derivatives fail to recognize is that the markets for these instruments have become so large...because they are providing economic value to their users. By enabling pension funds and other institutional users to hedge and adjust positions quickly and inexpensively, these instruments have come to play an important role in portfolio management.

Simply stated, index futures are but a tool for portfolio management. By definition, therefore, they cannot be the cause of stock market direction. Thus, whether the Japanese stock market continues to move up or down, do not make the irrational mistake of blaming your futures market. In the words of U.S. Treasury Undersecretary George D. Gould, blaming futures markets is a simple case of "wanting to shoot the messenger of bad news." Why the messenger? The reason is obvious. Futures markets are more efficient than cash markets and respond more quickly to information and price adjustment.

From their beginning in Chicago, financial futures markets recognized that the nature of markets was changing as a result of two interconnected causes. First, the effects of specialization. Scientific and technological advancement have forced the world to become highly specialized and professional, a trend that will not abate and is nowhere more obvious than in finance. As a result, a myriad of specialists, techniques, and strategies have evolved that require market mechanisms and products specifically geared to their needs. Futures markets fulfill this need; older traditional markets simply do not.

Second, the effects of technology. The technological revolution of the last two decades has ushered in an information standard which has enabled financial managers to be cognizant of all relevant events anywhere in the world just seconds after their occurrence, and most importantly, to transform this information into market action with lightning speed. Such awesome capability demands markets responsive to the new technology that can accommodate the massive order flow it represents. Futures markets are much closer in meeting this need than traditional stock markets.

Another effect of the technological revolution better accommodated by futures is globalization. As stated in Nikkei 1987, "In today's world, economics transcends geographical and linguistic borders to create what is often referred to as a global economy." Indeed, during the past several decades, the world has steadily shrunk, and the business of money has effectively dissolved both borders and time zones. Increasingly sophisticated satellites, micro-chips and fiber optics have forced exchanges in every financial center to confront a new reality: Today's global market requires a 24-hour trading capability. Modern money managers and traders no longer have the luxury of reserving investment decisions until local trading markets open. Every time zone must now embrace market structures that foster participation from every financial center.

The Far Eastern time zone is of special significance. Where once American equity markets were the world's largest, today that distinction belongs to Japan with 40% of the world's market share. But until the SIMEX began trading the NIKKEI 225 futures contract, a critical component was missing: There existed no means by which portfolio managers could effectively and efficiently hedge risk in large portfolios of Japanese stock. Beginning this fall, money managers will have that capability in Japan as well. That Japan will have two stock index futures markets—the NIKKEI 225 and the TOPIX— will provide a healthy competitive environment and foster arbitrage between the two markets. Since the indexes are weighted differently—the TOPIX is capitalization-weighted and the NIKKEI 225 is a price average—there will be a continuous ebb and flow of the price differential between the two contracts. Such price differentials create an important trading opportunity that will result in providing additional liquidity to both markets.

The launching of stock index futures in Japan is much more than an historic economic event for this country. It is symbolic of the absolute acceptance of futures markets as an indispensable tool for modern risk management. A decade ago, the presence of large banks and a stock exchange was the accepted benchmark for a city to be considered a financial center. Today the global investor's growing dependence on equity indexes and other financial contracts necessitates that a true financial center must have a futures exchange as well. If not, the information standard will drive today's free flowing capital funds to the center that does.

The trend is ubiquitous and worldwide. Osaka and Tokyo join a global family of futures markets. While the axis of futures markets is in Chicago, other major world financial centers have opened or plan to open futures exchanges. In the Asian time zone, there is the Hong Kong Futures Exchange (HKFE) and the SIMEX; yen bond futures on the Tokyo Stock Exchange have become one of the most actively traded futures contracts in the world. In your neighboring Southern Hemisphere is the thriving and successful Sydney Futures Exchange (SFE) as well as the New Zealand Futures Exchange (NZFE). In Europe, LIFFE—the London International Financial Futures Exchange—was the original pioneer, now in France, Le MATIF's French Government Bond futures contract has become the third largest in the world. Amsterdam has the European Options Exchange (EOE), Stockholm has the Sweden Options and Futures Exchange, and Geneva has the Swiss Options and Financial Futures Exchange (SOFFEX). Helsinki has recently opened the Finnish Options Exchange, and Dublin has big plans to open one or more futures exchanges. In Germany, there are plans to open a futures market in Frankfurt. Elsewhere in North America is the Toronto Futures Exchange where activity in the Toronto 35 index is thriving. In South America, there is the Bolsa Brasileira de Futuros in Rio de Janeiro and the Bolsa de Mercadorias in Sao Paulo.

Finally, since it is obvious that the most momentous influence on our markets is globalization, it is safe to assume that its effects will dramatically direct the destiny of our markets. Indeed, a recent Coopers & Lybrand study Opportunity and Risk in the 24-Hour Global Marketplace concluded:

The global financial marketplace is a reality for many of the world's leading banks, insurers, money managers and securities firms—and 24-hour-a-day access to this marketplace is believed to be inevitable. Prompted by a growing economic need for enhanced access to capital sources and supported by deregulation and advances in technology, the global market has been irrevocably established.

The Chicago Mercantile Exchange understood this reality when four years ago it instituted the mutual-offset trading link with SIMEX. It was the first successful attempt to link the trading capability of two different markets in two different time-zones and served as a model for other exchanges to follow. This experiment brought the world one step closer to the 24-hour trading day and proved that world markets can be safely and efficiently linked. Other market links followed. In December 1984, the Boston Stock Exchange and the Montreal Exchange established a computerized linkage enabling Canadian users to direct trading orders to the Boston floor. In September 1985, the American Stock Exchange and the Toronto Stock Exchange instituted a two-way trading link for dually-listed securities. Recently, NASDAQ has forged a link with the International Stock Exchange's SEAQ quotation system. An additional NASDAQ link is now operational with Singapore's stock exchange.

Beyond linkage, the question of how best to respond to the demands of globalization has resulted in a tug-of-war between traditional transaction methodologies and automation. Some exchanges—such as SOFFEX—have opted for full automation—all trading, clearing, margining and settlement transpire entirely through links between the SOFFEX computer, back-office computers of each member and the existing electronic settlement network for Swiss equities. And the West German banks planning the Frankfurt exchange are currently contemplating a trading network modeled on SOFFEX. On the other hand, the New Zealand Futures Exchange combines automation with extended trading. Increased interest from the U.S., Europe and Japan has resulted in a two hour extension in trading on the NZFE; in the near future, the NZFE may again opt to extend trading to a 12-hour schedule.

Conversely, the Chicago Board of Trade (CBOT) response to globalization has excluded automation and exclusively embraced open outcry for its extended trading session. While the experiment has had some success, it has been applied chiefly to one instrument and for only a small portion of the American night. Thus the CBOT response begs these questions: Can extended open outcry trading be successfully devised to encompass the remaining 16 non-business hours of the North American time zone? Will such a night market develop sufficient liquidity for a multitude of complex financial instruments? Can it sufficiently respond to the needs of all world participants from every center of finance? One must consider these questions with some degree of skepticism. Moreover, while the open outcry system has been the most successful means for achieving liquid markets in North America, it is not the only means, nor is it the methodology preferred in other world centers. Indeed, most other centers of finance—including Japan—have chosen technology and automation as the foundation for their trading systems. Therefore it is unrealistic to suggest that in this advanced technological age one can ignore automation in favor of a night-time open outcry market.

The Chicago Mercantile Exchange has chosen a dramatically different response to the demands of globalization. Indeed, our response has been described as a revolutionary milestone in the development of futures trading. We have entered into a joint venture with Reuters Holdings PLC—the world's foremost communications organization—to develop GLOBEX, a global automated electronic transaction system. GLOBEX embraces the realities brought about by the technological revolution and represents a giant step toward unification of the separate world's financial centers. GLOBEX will allow transactions in futures and futures-options contracts to be executed from anywhere in the world on an electronic terminal, representing the ultimate in efficiency and opportunity. It will provide 24-hour coverage and equal access to the market for all participants. Whether you are a banker in Tokyo, a stock trader in Osaka, a financial manager in London, or an investor in Chicago, you will be able to trade directly from your place of business in an integrated global marketplace.

The CME is convinced this concept embodies the manner in which the world of tomorrow will function and that GLOBEX is destined to become the accepted global transaction standard for the 24-hour trading day. We have invited every center of finance to participate. We particularly invite the Japanese financial community to join with us as partners in the development of this bold and comprehensive plan for the future. In the spirit of friendship and kinship, we welcome you to our global community of futures. And while the ultimate benefits of futures markets for Japan can be measured only over the span of many years, there is an immediate cause for celebration: What began here in the 17th Century has returned home.

Reprinted by permission. Excerpted from Melamed on the Markets, by Leo Melamed. John Wiley & Sons, 1993

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