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FUTURES
EXCHANGES IN A CHANGED WORLD ORDER
Fifth Annual Conference of Asian Capital Forum
Suzhou, China
October 26, 2002
Published
in the 4th Quarter, 2002 Derivatives Special Report:
Profit & Loss: Digital
FX
A
few months ago, on May 16, 2002, the Chicago Mercantile Exchange
celebrated the thirtieth anniversary of the International Monetary
Market, the IMM. It was a jubilant occasion, which included two
distinctive congratulatory messages, one from Nobel Laureate,
Milton Friedman, the other from the Chairman of the Federal Reserve,
Alan Greenspan. It also featured a keynote address by William
McDonough, President of the Federal Reserve Bank of New York.
The
fact that these world luminaries would take the time to honor
the IMM in this fashion, defines the significance of the events
that occurred in Chicago in 1972. Looking back, it is easy to
forget how revolutionary the concept of financial futures was
regarded. Not only did the world then still distrust free markets
in general, and futures markets in particular, the idea represented
an unprecedented departure from its agricultural tradition. Indeed,
the IMM endured a painful process of acceptance by the global
financial community, especially its banking establishment. Its
eventual approbation and phenomenal success came only as a result
of the stubborn determination of its market founders, early pioneers
and traders. But mostly its success flowed from the simple fact
that the idea was a good one. Its blueprint has since been copied
and extended to every financial center in the world. It made
the Chicago Mercantile Exchange the number one futures market
in America.
Praise
for futures and derivatives by these distinguished experts at
this moment in history—when economic woes and financial excesses
have caused a major downturn in world equity markets and when
U.S. corporate transgressions have shaken the credibility of
the American corporate landscape—is by itself highly significant.
For unlike past eras when any adverse financial event was reason
to place blame on our markets, no one—not even the thoroughly
uninformed—has pointed a finger at futures markets: Not for the
bubble that was created in equity markets during the late 1990s;
not for its inevitable bursting which began in March of 2000;
nor for the corrupt corporate practices and manipulative accounting
procedures which were employed at some firms with reckless abandon
prior to their public exposure.
The
causes of these corporate wrongs, while committed at but a limited
segment of corporate America, were of a sufficiently serious
nature to demand comprehensive reforms and were easily documented:
Corporate governing boards that were either in alliance with
or puppets of corporate management. Stock options to top executives
which induced them to inflate near-term share prices regardless
of long-term consequences. Accounting tricks to make certain
that profits met or exceeded Wall Street expectations. Insider
trading practices in violation of ethical standards and SEC regulations.
Inflated revenues by virtue of fraudulent transactions and financial
shams. Wildly overoptimistic price targets by analysts at many
brokerage firms. Forgiving loans to corporate executives and
ignoring their use of corporate money for personal acquisitions
such as yachts, mansions, jets and other expensive prizes. Distribution
of lucrative initial public offerings to company clients and
friends. And a multitude of other schemes or transgressions which
were camouflaged by the irrational exuberance of an unceasing
rising stock market. Until the Ponzi scheme burst as it always
does.
When
it did, the market exposed the truth: Enron Corp. structured
complex financial vehicles with which to fraudulently boost the
firm’s cash flow. Arthur Andersen, Enron’s Auditor, aided and
abetted accounting shams and later obstructed justice in an attempt
to hide their misdeeds. WorldCom disclosed $3.8 billion in accounting
misstatements and later uncovered an additional $3.2 billion
in accounting distortions. The CEO of Tyco International is accused
of evading taxes and conducting secret corporate deals. Cable
giant Adelphia inflated financial statements and made $3.1 billion
in undisclosed loans to its major shareholders. Global Crossing
sold its telecom capacity in a way that artificially boosted
its revenues. Dynegy and CMS Energy Corp. made fictitious transactions
in order to pump up its trading volumes. Xerox inflated revenue
and profits by including future payments on existing contracts.
Analysts employed by Merrill Lynch and Salomon allegedly mislead
investors for the purpose of furthering income to their firms.
All
the while, the markets of futures and options, while far from
perfect, continued to carry out their function as a mechanism
of risk management. Indeed, the performance of world futures
markets deserve the highest marks for their uninterrupted service
during recent financial upheavals: Eleven consecutive reductions
in the U.S. Federal Funds rate in the course of one year; market
disruptions unleashed by the terrorist act of September 11th;
a precipitous fall in equity prices; the ensuing war on terrorism,
the possibility of new terrorist acts, the potential action against
Iraq; and the mind boggling flood of corporate scandals of a
magnitude not witnessed since the years preceding the Great Depression.
Little
wonder Messrs. Friedman, Greenspan and McDonough saw fit to extol
the virtues of our markets. As the chairman of the Fed. recently
stated, "These (derivatives) transactions represent a new
paradigm of active credit management and are a major part of
the explanation of the banking system’s strength during a period
of stress." Indeed, one has to wonder how the financial world
would have fared were there not the markets of futures, options
and financial derivatives to absorb the shock engendered by the
afore-described upheavals. I dare say, not nearly as well. Not
only did our markets act as a font of information, continuously
disseminating price intelligence with which consumers and producers
could make informed decisions across a wide spectrum of business
demands; not only did our markets provide easy and efficient
access to everyone who sought their application; not only did
our markets provide financially secure clearing and settlement
procedures; but our markets served as a security blanket, offering
deep pools of liquidity with a constant flow of bids and offers
with which investors and money managers could interact to reduce
their risks, diminish their losses, or institute positions with
a potential for profit.
For
it is axiomatic: The management of risk is the bedrock of futures
exchanges. The prospect of any economic dislocation, the potential
for any change in value or price, the expectation of any alteration
in national economic policies, whether it be the result of international
turmoil or the consequence of domestic business disruptions,
whether it be in finance or agriculture are the natural drivers
of futures business flows. Proof of the value placed in our markets
by the international business community during recent stresses
can be seen in the surge of transaction volume at the world’s
major futures markets: At the CME a 78% gain in the year of 2001,
at LIFFE over a 64% increase, at Eurex a 48% increase, and at
the CBOT a gain of over 12%. 2001 increases in open interest
were commensurately impressive with the CME leading the majors
with a whopping increase of 87%. In 2002 the trend of volume
increases continues to date: At the CME 33%, at the CBOT 23%,
at Eurex 14%, and at LIFFE nearly 10%.
We
live in a highly complex and hazardous economic environment.
Where geographical borders and time zones that once could limit
the flow of capital are but history; where traditional internal
protections that insulate ones' citizenry from external price
influences are no longer valid. We live in a world in which competition
is global, financial volatility is commonplace, and opportunities
rapidly appear and disappear on a constantly changing financial
horizon. We live in a world that demands products to protect
against inherent risks, that demands cost-efficient instruments
to adjust portfolio exposure between securities and cash, and
that pays a premium for credit-worthy mechanisms which preserve
credit lines. In such a world, futures and options markets are
critical components of the financial establishment.
Today,
the largest difference between rich and poor countries__between
economic hope and economic despair for its people__is
the freedom and efficiency with which they can utilize their
resources. Free and efficient capital markets ensure that resources
are allocated wisely. The more efficient the system, the better
the allocation of these resources. Efficient markets lead to
tighter bid-ask spreads, higher volumes of trading, and greater
market liquidity. A liquid market reflects truer price values
and gives investors confidence in the marketplace. As a consequence,
the cost of capital is reduced, the standard of living is enhanced,
and social order is greatly benefitted.
Futures,
options and derivatives markets are among the tools to achieve
this national benefit. They epitomize the fundamental principles
of free market processes. While these processes may not be without
fault, they represent the best economic order ever devised by
mankind. Consider, even as we lament the market excesses which
produced the recent American equity bubble, even as we cringe
and denounce the American corporate misdeeds of recent years,
we must recognize and applaud the fact that the market worked. Unlike
economic systems that are controlled by the heavy hand of government,
the American free market system acted quickly to right the wrong.
It exposed the truth and unmercifully punished both the corporate
entity and corporate executives that violated the rules.
China’s
markets are still a long way from embracing all the tenants of
the free market. However, the country has made giant strides
in this direction and is a nation in transition. Not only have
China’s capital market grown dramatically over the past decade,
after 15 years of negotiations, its recent entry into the World
Trade Organization is a monumental milestone. It will mark a
dramatic departure from the past insulated, centrally-planned,
economic order into one that will be defined by market forces
and global trade. The WTO entry will thus set in motion sweeping
changes across the entire Chinese economy.
Among
those effected will be the Chinese agricultural community. This
nation’s 500 million farmers will have to negotiate the combination
of new obligations and new opportunities that will confront them.
Protective tariffs must be lowered. Foreign products must be
allowed to compete with local produce. Many of these transformations
will require patience, engender pain, and take years to institute.
Toward this purpose, expansion of China’s futures markets should
be given the highest priority. Chinese enterprises, both in agriculture
as well as in finance, will find that WTO entry dramatically
increases their need for sophisticated futures market tools with
which to protect against inherent economic risks.
China’s
history in futures markets has admittedly been problematic. Its
past experience was the consequence of an inadequate regulatory
framework and unprofessional trading practices. These past errors
have been corrected. Beginning in 1994 the Chinese government
instituted an effort to close illegal futures operations and
consolidate many others. Under the direction of the China Securities
Regulatory Commission from over 60 futures markets only three
remain: The Shanghai Futures Exchange (SFE) which specializes
in trading of aluminum, copper and natural rubber, the Zhengzhou
Commodity Exchange (CZCE), primarily trading in wheat and mung
bean, and the Dalian Commodity Exchange (DCE) trading in soybeans,
soybean meal and beer barley. The DCE is today the second largest
soybean futures market behind the CBOT.
We
applaud the National People’s Congress recent acknowledgment
for the need for additional futures instruments. We urge the
government to open China’s futures markets to foreign investors
and brokerage firms. And we encourage the China Securities Regulatory
Commission to look favorably on the application by the SFE to
enter into the arena of financial futures. The SFE goal to become
the major futures market in the Asia Pacific region is predicated
on its ability to launch stock index futures, as well as contracts
in interest rates and foreign exchange. We advocate this development.
The
people of China are resourceful, determined and resilient. This
conference is clear proof of their desire to improve their market
efficiencies and expand their market structures. We have no doubt
that this nation can achieve these results. The people in America,
in turn, stand ready to help. The Chicago Mercantile Exchange
is specifically here to extend its hand and provide expertise.
Our common goal is to strengthen your capital market, smooth
out the difficulties posed by WTO entry, attract foreign participation
and foreign investors, and raise the standard of living of the
Chinese people.
Looking
forward, I would make the following observations about futures
markets: What remains unalterable is that hedging activities
in risk management will flow to the marketplace that is the most
liquid. Second, the world today demands disclosure and transparency,
whether in the execution process or in its book-keeping. Third,
market participants will gravitate to the market that provides
financially secure clearing and settlement procedures. Finally,
the market providing the widest distribution network together
with the most functional and efficient technology at the lowest
cost will be the most attractive. In other words, global electronic
distribution of market instruments coupled with technological
competence will rule the day.
However,
technology alone will not be enough to persevere in the 21st Century.
Innovation is the key. Finance is after all a dynamic science.
The pace of change has accelerated exponentially and the distinctions
between types of markets are vanishing. Strategies pertaining
to equity, debt, indexing, foreign exchange, futures, forwards,
options, swaps, and cash, are all interdependent and interchangeable.
The digital age has unbundled all manner of risk and is capable
of repackaging it in any form the customer wants at the moment
he wants it. Customized strategies and customized instruments
of trade are today’s soup du jour. Thus, the days of narrow-based
niche market capabilities are limited. The futures exchange of
tomorrow must be able to provide comprehensive risk management
in every sense of the word.
Some
exchanges and many electronic communication networks, so-called
ECN’s who were not up to the above requirements have already
vanished, others are being thrust to the side-lines. For those
who survive there is bound to be massive consolidation. While
there may always be regional exchanges serving a local clientele,
they will be irrelevant unless they are tied to a global network.
There is also little doubt that the ongoing trend of blurring
distinctions between the instruments of futures and securities
is continuing. The recent Joint Venture in single stock futures
between the CME, CBOT and CBOE is a giant step in that direction.
It
cannot be over-emphasized: Transformation in information technology
created a world economy. It will continue to foster more globalization,
greater interdependence, instantaneous informational flows, immediate
recognition of financial risks and opportunities, continuous
access to markets of choice, more sophisticated techniques, new
innovations, and intensified competition. These are the unalterable
trends of the future. As a consequence, the management of risk
will remain at the core of every prudent financial strategy__a
reality that will continue to have the greatest impact on the
use and expansion of futures, options and derivatives markets,
global and around-the-clock.
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