DERIVATIVES AND THE ASIAN MARKET

International Futures Seminar
Seoul, South Korea
December 15, 1994

In their book, Free to Choose, the authors, Nobel Laureate Milton Friedman and his wife Rose, assert that the success of the United States is the combined consequence of two basic ideals: economic freedom coupled with political freedom.

There can be no doubt about the wisdom of this truth. Indeed, in recent years the world experienced first-hand the incredible might of these two ideals as together they propelled the disintegration of world Communism and the collapse of the Soviet empire. Clearly, the economic freedom precepts of Adam Smith, when combined with the principles of political freedom espoused by Thomas Jefferson, were fundamental to the unmitigated triumph of market-driven economic order over central planning, of Capitalism over Communism, of democracy over dictatorship.

However, there is more to this story. There was yet another dimension to the revolution that began in the last decade and spread like wildfire across most of the world: the inexorable march of science and technology. Indeed, the common denominator of all recent world upheavals—the unification of Germany, the liberalization of Eastern Europe, the fall of Communism, the collapse of the Soviet Union, the dissolution of apartheid—has simply been modern global communications capabilities.

More than any other single factor, the telecommunications revolution offered a stark, uncompromising comparison of political and economic systems. It made it impossible to hide the unmitigated bankruptcy of the Communist order or continue the unconscionable enslavement of people. It provided people with the unprecedented ability to judge their government, compare their living standards, evaluate their individual rights, examine their freedoms, and weigh them against that of their neighbors. The truth could no longer be concealed from the people.

The Globalization of Markets

Thus technology, as it has throughout the history of man, has dictated once again the fundamental and revolutionary change in our social structure and reshaped both the political and economic landscape of our planet. Its consequences reverberate through every facet of civilization and influence every aspect of daily life. Although it is impossible to completely perceive the ultimate consequences of this technological march around us, we know with certainty that its influence to date has been felt nowhere more than in financial markets. The results have been global, spectacular, and absolute. Our separate financial existence has been transformed into one inter-related, inter-dependent world economy. Distinct business divisions based on time zones have vanished. Geographical borders that once could limit the flow of capital are history. Internal national mechanisms that once could insulate a population from external price influences are increasingly impotent. NAFTA and GATT epitomize the world's new direction. Financial markets are virtually unencumbered, continuous, and worldwide.

This globalization of markets did not happen overnight. The first decisive action by financial markets occurred two and a-half decades ago with the suspension of dollar convertibility into gold and an abandonment of the system of fixed exchange rates known as Bretton Woods. As a direct consequence of this momentous eventuality, financial markets sought instruments of trade that were responsive to a shrinking world and modern telecommunications capabilities. In other words, innovations and products were necessary to protect financial exposure as well as to capitalize on opportunities resulting from rapid informational flows of the new world order.

The process was initiated by the financial futures revolution of the early 1970s when the International Monetary Market (IMM) was launched at the Chicago Mercantile Exchange with the express intent of developing futures trade in financial products. The creation of the IMM led to the introduction of the first broad-based risk management instruments and ushered in the Era of Financial Futures. What followed was an unprecedented age of innovation in corporate and international finance.

Evolutionary forces in business, global markets, and world economies—coupled with advancements in computer technology—transformed the first relatively simple IMM financial tools into the present genre of complex derivatives. The academic world introduced the concept of risk management and financial engineering became a commercial necessity. Acceptance of this philosophy served not only to legitimize derivative markets and bring them into the infrastructure of established finance, it acted as a catalyst for the use of indexes as instruments of trade and for the creation of a multitude of other financial products traded both on exchanges and over-the-counter (OTC).

Globalization, Competition, and SIMEX

In 1982, I began to be concerned about the globalization effect on markets and realized our Chicago markets were vulnerable to market centers in other time zones that could duplicate or mimic the contracts we had devised and invented. This led me to search for a "partner market" in the Asian region. There were three potential Asian candidates: Hong Kong, Tokyo, and Singapore. Tokyo was eliminated from the very start since it did not appear to have the legal and regulatory framework to create a futures exchange at that time. Of the remaining two locales, Hong Kong would have seemed the logical choice since it had a larger capital market and was known as a free market center. However, at the time, there was strife between the British governing group and the native Chinese group.

Singapore, on the other hand, had what might be called a "unification of purpose." The government, the industry, and the people were all joined in unison to actively promote the futures business. We, at the Chicago Mercantile Exchange, were very encouraged to find this and helped the Monetary Authority of Singapore (MAS) in the creation of the Singapore International Monetary Exchange (SIMEX) and establishing the first international linkage between exchanges—the Mutual Offset System (MOS). It is noteworthy to add that mutual offset had never before been tried and had the potential to be quite dangerous. However, my belief in the Singapore people and government, their willingness to work together, and their responsible attitude served to mitigate my concern about the MOS and made the effort worth the risk.

History has proved me correct in the decision to select Singapore. SIMEX grew to be one of the largest futures market in Asia and has contributed significantly in many tangible and intangible ways to the advancement of the Singapore economy. If there is a lesson to be learned from this, it is that government should work in conjunction with the needs of its financial community.

Of course, the SIMEX launch was prior to the technological tidal wive. By 1986, I knew that technology provided a much better answer to the competitive demands of globalization. Technology now enabled us to consider an electronic exchange for international trade whereby our markets could be traded for virtually 24 hours. It was this thought that gave birth to GLOBEX.

GLOBEX could potentially do for the world what the SIMEX was able to do for one contract and one region. GLOBEX would enable us to list all our contracts around the clock, around the world. Since all major exchanges have the same competitive concerns, we also invited the world exchanges onto the GLOBEX system.

The Benefits of Financial Futures to Emerging Markets

Recognition of the global economic need for financial futures and other financial derivative markets can be of particular importance to all emerging financial arenas and is of special relevance to Asia—the geographical region with the potential of becoming the world's leading market force in the 21st Century. Indeed, the Pacific Century is about to dawn. With a population ten times greater than North America and six times greater than Europe, and with a faster growth rate than either region, Asia has the potential to overtake the other two regions economically before very long. Last year, for instance, Trans-Pacific trade exceeded trade across the Atlantic by 50%; in five years, the ratio could be two-to-one in favor of the Pacific.

The development of a strong, resilient, broad-based cash market that can support both exchange-traded futures contracts as well as OTC derivatives is vital to this process. How quickly this will happen will depend largely on how quickly Asian governments learn to relax their tight monetary controls and permit the deregulation of their financial markets.

It is also most important to recognize that today is no ordinary moment in financial history. It is the first time in modern history that virtually every country on the planet has a market-oriented economic system and is attempting to be a competitor in the global marketplace. For the past 20 years we spoke of a global economy. However, we were only talking about 25% of mankind—mostly North America, Western Europe, and Japan. As recently as 1988, almost 70% of mankind was living under Marxist or socialist economic systems. Suddenly, there are three billion more participants in the Capitalist system.

Today, even developing nations have become major players in demanding capital. In 1993, emerging countries had capital inflows of almost $110 billion, whereas as recently as 1989 they were capital exporters. At the same time, many major industrial countries have current growing capital needs as well.(1) Clearly, to compete in this new financial order—both in terms of investments as well as capital—it will be mandatory for Asian nations to provide their institutions with access to the tools of modern finance and portfolio theory. Liquid and efficient derivatives markets are a primary prerequisite.

The Establishment of Futures Markets in South Korea

I have learned that South Korean President Mr. Kim Young Sam has recently urged the Koreans to embrace globalization. I applaud this course of action. The introduction of futures markets in South Korea is a significant step in that direction. In preparing for this historical event, your nation has experienced the same pains and wrestled with some of the same questions as other nations before you, such as:

What instruments of finance should be created as futures markets?

What government agency should regulate these markets?

Should there be more than one market?

Should there be more than one similar instrument?

What should be the role of foreign nationals?

What type of education and training is necessary for the Korean financial community?

These and many other issues related to these new futures markets have been discussed. Fortunately, you have a great deal of historical precedent. You can learn from the mistakes of others and emulate the successful solutions. But in the final analysis, the decisions are yours to make and you will learn from your own experience.

However, as one who has been intimately involved with the creation and launching of futures markets for over 25 years, allow me to offer some insights. It has been our experience that the listing of a futures contract on more than one market has the potential to be detrimental to the development of that contract. For example, while the listing of the same futures contract at more than one market may provide for arbitrage activity, it will do so at the expense of liquidity since order flow between the two markets will be diluted. And for a futures contract to succeed, it requires liquidity.

In addition, we have found that futures markets should be governed by a regulator who understands both the cash and futures markets, the benefits of these markets, and the impact of its regulations on that market. For if these markets are not governed in a coordinated and responsible fashion, or if the regulations are too onerous, you may find that the business will flow outside your nation to other markets who can develop a competing product. And, if your futures product is traded on other markets outside of Korea, it is important to note that business flow will favor the contract with the lower costs and the less burdensome trading requirements.

In preparation for the opening of a futures market in Korea, I urge you to continue educating prospective participants in the use of these important risk management tools. For these markets—with their ability to identify, price, and transfer existing risks—are complex mechanisms that require special expertise. Education is the key ingredient and the only answer. Building an army of well-trained and knowledgeable professionals is an indispensable element in the future health and growth of the Korean futures markets.

I congratulate you on the development of the Korea Stock Price Index 200 (KOSPI 200). I am pleased to learn that the KOSPI 200, is a capitalization-weighted index. As you know, most successful stock index futures products in the world are capitalization-weighted and are comprised of a broad range of actively-traded stocks that are representative of the overall stock market. It is my understanding that the KOSPI 200 meets all this criteria. Accordingly, I believe you will have a successful stock index product.

In addition, allow me to congratulate you on your decision to move forward with an electronic trading system. Since the Chicago Mercantile Exchange announced GLOBEX in 1987, the result was a virtual torrent of other electronic systems devised either to extend existing trading hours or for the entire transaction process. While most of these electronic systems were launched for use within a limited local area, the specifications of the systems devised often contemplate larger geographic competence. My prediction is that in the coming decades we will see a number of electronic systems for futures and options trade on a global 24-hour basis. In my opinion, this represents the future of futures markets.

Conclusion

As Merton Miller, the 1990 Nobel Laureate in Economics, proclaimed, financial futures are "the most significant financial innovation of the last twenty years." Financial futures have become an integral component of the world's financial system. Today, there are established futures exchanges in London, Paris, Hong Kong, Zurich, Kuala Lumpur, Barcelona, Sydney, Vienna, Toronto, Singapore, Sao Paulo, Madrid, Osaka, Brussels, Zurich, Frankfurt, Buenos Aires, and Tokyo. Soon Seoul will be added to this prestigious list. Futures markets have became symbolic of the economic order that demonstrated its supremacy over an economic system whose structure and function was dependent on central economic controls.

Make no mistake about it: The value of financial futures is not an imaginary notion. These instruments are not a selective luxury that can be done without. Indeed, if the use of financial derivatives as a hedge mechanism is excessively restricted, the consequences to the world's financial fabric may be much harsher than anyone realizes. It is this reality that is imperative for Asian governments to recognize. In our global market environment, driven by constant and changing market risks, instantaneous information flows, and sophisticated technology, financial derivatives are an essential instrument of finance, indispensable in the management of risk, and of immense benefit to a nation's economy.

Thank you.

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     (1) David Hale, "Rethinking the World," Barron's, 22 August 1994.

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