THE NEED FOR RISK MANAGEMENT

Presented at the Mid-America Institute's Conference Series of Risk Management,
Chicago, Illinois,
May 30, 1990.

Risk management, as an orthodox discipline of business, is a relatively new concept. It came into being during the last two decades in concert with the development of a vast array of innovative financial instruments, techniques, information technologies, and the development of financial futures and options.

In great measure financial futures and options owe their phenomenal success to the recognition and acceptance by the commercial world of the concept of risk management. That this process occurred as quickly and successfully as it did is primarily due to the profound efforts and influence of the U.S. academic community.

Of particular note in this intellectual endeavor is Merton H. Miller, the Robert R. McCormick Distinguished Service Professor of the Graduate School of Business, University of Chicago. His contribution to the genre of risk management was partially responsible for his selection in 1990, together with Harry Markowitz and William Sharpe, as the Nobel Laureate in Economics.

Walter B. Wriston, referring to the revolutionary changes in our civilization brought about the marriage between computer technology and telecommunications, described it as the information revolution. Information— and to some degree, knowledge—is today transmitted at lightening speed to every corner of the planet. Consequently, the velocity of social and political change has greatly accelerated, the sanctity of every political power structure is in question, separate economies are being forged into one global marketplace, and the traditional regime of financial management is in transformation. Indeed, the consequences are dramatic, draconian, and global. Dr. Carver Mead of the California Institute of Technology said it this way: "The entire Industrial Revolution enhanced productivity by a factor of about a hundred, but the microelectronic revolution has already enhanced productivity in information-based technology by a factor of more than a million—and the end isn't in sight yet."

Two decades ago, financial risk was apt to be defined as the possibility of suffering financial loss. At that time, it was doubtful many thought of risk management as a discipline, nor was it likely that many outside of academia or the actuarial business spent much time tinkering with mathematical models in order to weigh different strains of strategic exposure; i.e., a firm's sensitivity to changes in tax rates, interest rates, exchange rates, the price of oil, etc. Two decades ago, the identifiable risks were the rough equivalent of what Claude Rains in the final scenes of Casablanca told his lackeys: "round up the usual suspects." Farmers, for example, have always been at the mercy of the weather. Beyond that, there were all the usual insurable risks: fire, theft, natural disasters, etc. And while recessions came and went, it was an era in which Treasury instruments yielded about 5 percent and foreign exchange rates were fixed.

Today, by virtue of Mr. Wriston's information revolution, "we are witnessing a galloping new system of international finance" . . .one that differs radically from its precursors" in that, as he notes, it "was not built by politicians, economists, central bankers or finance ministers. . .it was built by technology. . .by men and women who interconnected the planet with telecommunications and computers. . .and assembled a global financial marketplace that would. . .as a first step. . .replace the Bretton Woods agreements. . .with a new international monetary system governed by the Information Standard." Defined in the context of the world of commerce as we know it in the 1990s, risk is not merely a potential drought, earthquake, gas leak or even oil spill. In today's interdependent world: Where two contaminated grapes are found in Philadelphia and, a hemisphere away, Chilean farmers suffer $100 million in losses as a result; Where Europeans worry about growth hormones fed to cattle and American beef growers suffer the consequences; Where Bundesbank monetary policy must be weighed right along with that of the Fed; Where a head tax imposed in London can affect the corporate bottom line every bit as readily as a value-added tax levied by Washington; Where a drop in the Nikkei average can trigger a decline in every other stock market in the world; Where the U.S. budget and trade deficits impact not just the American economy, but the economies of all nations and all those who are business participants; Where the coming of Europe 1992 is not just a national or even a pan-European issue, but one that has profound investment and trade implications to every businessman; Where the revolutionary events in Eastern-Europe and Russia structurally change the strategy of all commerce and commercial enterprise; and, Where every action in any part of the world is immediately known by everyone else.

In such a world, risk is radically more complicated, intensely more concentrated and devastatingly swift. Risk, today, is any one of a myriad of contingencies that could negatively impact an enterprise, thereby altering either its value, its cash flow, or its future. More globalization, greater interdependence, immediate access to markets of choice, more sophisticated techniques, intensified competition—these are clearly the trends of the future. In a word, the management of risk has became integral to our well being. However, while risk management as a discipline may be new, the idea of managing risk is anything but new. Nor did the idea originate in Chicago.

The European trade fairs in the 1100s became the commercial marketplaces of medieval Europe and established Lettres de faire as the early mechanism for forward contracting. A couple of hundred years later, Lloyd's Coffee House became a central meeting place in London for individuals involved in marine insurance—and incidentally insurance against "house-breaking and death by gin-drinking." In the late 1600s, in Osaka, Japan, the feudal clans that had established warehouses to store and sell rice collected as land tax realized they needed protection from wide harvest-to-harvest price fluctuations. These feudal lord merchants did the sensible thing and established the first organized futures exchange—the Dojima Rice Market. As a consequence, Osaka became the leading commercial Japanese city of that era. However, to find the real source of risk management, one must regress some 5000 years in history to when Joseph convinced the Pharaoh to arrange for the first long grain hedge in order to protect against the coming seven years of lean.

American futures history, on the other hand, extends back to the mid-nineteenth century. Indeed, by time of the Great Fire of 1871, Chicago had already become this country's hub of transportation. As a consequence, merchants who dealt in raw commodities gathered in Chicago to contract for them—buying and selling in both a spot and forward fashion. It was inevitable that these merchants would soon think along the same lines as their earlier counterparts in London or Osaka.

The first centralized trading facility to serve part of this market was the Chicago Board of Trade (CBOT) established in 1848. Initially its membership was comprised of the actual grain merchants; but soon it was clear that commodity trading presented attractive opportunities to speculators as well. Indeed, just as Adam Smith explained, speculators—in pursuing their own interests—were making the markets more liquid and stable.

The second Chicago exchange, founded on South Water Street in 1874, traded butter, eggs, poultry and other farm products. By the end of World War I, the Butter and Egg Board (as it was then called), had evolved into the Chicago Mercantile Exchange (CME). Seventy years later, annual trading volume at the CME would exceed 100 million contracts. But on December 1, 1919, the first day of trading at the new CME, volume was a bit more modest. Only three cars of eggs were traded.

In the early 1970s, the Bretton Woods Agreement—the post-world war pact that instituted a fixed-exchange rate regime for the major world nations— had begun to show its structural flaw. Finance ministers were finding it increasingly difficult to dictate the value of currencies relative the dollar in a world where value changes were constant and information and capital free flowing. On August 15, 1971, President Nixon announced an emergency economic package that sent a seismic shock through the entire financial world. On that day, the United States suspended the dollar's convertibility into gold thereby ending fixed exchange rates between currencies.

The Chicago Mercantile Exchange was the first major futures exchange to recognize the market potential of the upheavals unleashed by this event. Supported by Nobel laureate Milton Friedman, the CME was the first exchange to assert that the principles of agricultural commodities futures could be applied successfully to financial instruments. Thus, currency futures—which began trading on the CME's International Monetary Market (IMM) on May 16, 1972—ushered in the era of financial futures, thereby forever changing the scope and utility of futures markets. One year later, the Chicago Board of Trade launched the Chicago Board Options Exchange (CBOE) and added a new dimension to the repertoire of risk management instruments. Three years later, Treasury bond futures at the Chicago Board of Trade made their debut and became the most actively-traded financial instrument. Within a decade, a vibrant new industry was born that subsequently opened the curtain on the index markets of the 1980s. The successes of these markets propelled the futures and options industry to unparalleled greatness. In the last decade alone, the volume in U.S. futures and options skyrocketed from 76 million contracts in 1979 to a record of 323 million contracts in 1989. These successes also prompted University of Chicago Professor Merton H. Miller, 1990 Nobel laureate in Economics, to nominate financial futures as "the most significant financial innovation of the last twenty years."

Chicago, with its rich history and tradition of forward marketing, insurers and reinsurers, with its innovative banks, and its robust futures and options exchanges will remain the risk management capital of the world. However, aside from providing Chicago with an enviable local economic engine, there are three additional direct consequences that resulted from the need the Chicago markets demonstrated: it provided an impetus for the development of futures markets worldwide; it spawned the introduction of risk management as a discipline; and it spurred the devolvement of secondary off-exchange products. All three consequences were predictable.

Clearly, our Chicago successes could not go unnoticed. Indeed, our very markets themselves began to be replicated all over the world. During this past decade, new financial futures exchanges have opened or been announced in London, Paris, Hong Kong, Sydney, Toronto, Singapore, New Zealand, Brazil, Osaka, Zurich, Dublin, Frankfurt and Tokyo. Four years ago, there were fifty-two exchanges worldwide, now there are seventy-two. Non-U.S. futures and options volume increased from virtually zero just five years ago to a record volume of 180 million contracts last year. During the same five years, U.S. market share fell from nearly 100% of total world volume to 64% in 1989.

By becoming integral to the financial landscape of the U.S. and the international establishment, futures and options markets gained an ever-increasing universe of users. Consequently, these markets are today utilized by investment bankers and broker-dealers, by foreign exchange traders and government securities dealers, by banks and insurance companies, by pension funds and mutual funds, and by corporations and financial institutions of every sort. Indeed, futures and options markets became a common denominator for professional money managers worldwide, providing impetus for expanded utilization of these markets generally and acting as catalyst for the development of the risk management regime.

The liquid markets of the established futures and options exchanges became a crucible of ideas for off-exchange products. Banks, in particular, became key players in an expanding off-exchange market for hybrid products such as interest-rate swaps and caps, forward rate agreements, floors and collars, etc.; not to speak of off-exchange trading systems and techniques for exchange products, the Exchange For Physicals (EFPs). While these hybrids represent somewhat of a threat and a liquidity drain to the exchange markets, in the final analysis, off-exchange products result in producing more business for the broad underlying exchange-traded instruments. For instance, both in swaps as well as in caps, a bank will shed its assumed interest rate exposure by hedging in the indicated futures market. In the future, we can expect innovation to intensify, and the demand for tailored risk management strategies to increase. This may tend to blur the lines between exchange-traded and off-exchange-traded products. It is important to note, however, that exchange-traded products have one additional important advantage for the financial community to consider, they provide a built-in mechanism for risk assessment. The financial risk of recent innovative instruments applied in an off-exchange environment makes them nearly impossible to be measured and poses a great unknown financial risk to the banking community.

The Chicago exchanges were never laggards in innovation or intimidated by competition. Indeed, in 1984, the CME recognized that the financial world was at the threshold of Wriston's technological revolution—one that would increase international competition for our markets—and became the first futures exchange to establish a mutual-offset trading link with a foreign exchange—the Singapore International Monetary Exchange (SIMEX). Similarly, the CBOT, instituted a successful evening session for its U.S. Treasury bond futures contract.

The CME ultimately concluded that the futures industry must make the giant leap toward automated technology if it is to respond to the demands of globalization. Thus, in 1986, in conjunction with Reuters Holdings PLC, the CME set about developing GLOBEX. GLOBEX represents the logical extension of the financial futures revolution that began in 1972 with the IMM. It is the only realistic response to the information revolution which demands there be an efficient and cost-effective capability for managing risk around-the-clock. In conjunction with the open outcry sessions of the American business hours, GLOBEX will provide investors around the world with a single, 24-hour futures and options trading system.

Our goal is to make GLOBEX the premier international futures and options trading system and the standard for the world. Toward that goal, MATIF, the Paris-based Marche a Terme International de France, was the first exchange to become a GLOBEX partner. Most importantly, however, last week, on May 23, 1990, the Chicago Board of Trade and the Chicago Mercantile Exchange successfully completed their extensive discussions pertaining to a unified after-hours electronic trading system, and announced a plan whereby both exchanges would utilize the GLOBEX network and technology. This agreement followed the announcement by the Japanese Ministry of Finance that GLOBEX was approved for Japan. Thus, subject to final agreement by Reuters Holdings PLC, GLOBEX will some day become the electronic trading system for over 75% of the world's financial futures and options when it becomes operational.

The agreement between the two Chicago exchanges proved once again that Chicago's "I can" tradition is alive and well. Indeed, we have helped transform this city from Carl Sandburg's Hog Butcher for the World to today's capital of risk management. But much more than that. The futures and options exchanges of Chicago—light years ahead of their counterparts in securities—have led the capital markets of this nation into the next century. In doing so, we have exemplified the innovative genius of the American people and created the tools with which risk—a permanent fixture of modern business—can better be managed. The rest is up to you.

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