OUR MIDDLE NAME
By Leo Melamed

Federal Reserve Bank
Roundtable on the Institutional Structure
of Financial Markets

Chicago, Illinois
February 15, 2002

Carl Sandburg gave us definition:

“Hog Butcher for the World,

Tool maker, Stacker of Wheat,

Player with Railroads and the Nation’s Freight Handler;

Stormy, husky, brawling,

City of the Big Shoulders.”

And this is how it evoloved:

In the 60's we were called hustlers---

Bamboozling the last dime from widows and orphans;

Proprietors in a stacked game of corner the market;

And yet we grew!

In the 70's we were called arrogant impostors---

Pretending to be relations to the holy temples of finance;

Stealing the rightful markets of New York and London;

And yet we grew!

In the 80's we were called lucky---

Beneficiaries of the inflationary aberrations of the 1970s;

Catering to speculators, volatility and index arbitrage;

And yet we grew!

In the 90's we were called obsolete---

Archaic mechanisms of a bygone era;

Inefficient relics that could not compete with ECN technology;

And yet we grew!

For necessity had recast Sandburg’s definition:

Risk Capital for the World,

Innovator, Conceiver of Markets,

Player with Concepts and the Nation’s Futures,

Stormy, husky, brawling,

City of the Big Shoulders.

Carl Sandburg’s recast definition became our new heritage, our new legacy. It brought us new fame, new image, new industries, new jobs, new banks, new strength, a new future. It protected us, rebuffing our competitors and rejecting our antagonists decade after decade. But our legacy is as tenuous as it is precious. Evolution is an unceasing taskmaster and the imperatives of the twenty-first century make new demands: modern technologies, demutualization, efficiency. So the old question resurfaces: Can we again meet the challenge of change and yet protect our hard-earned franchise?

The answer lies in understanding the three pillars of our legacy: financial integrity, liquidity, and innovation. Lose any one of them and you lose everything. It is a risky business.

Financial Integrity

Let me be blunt: Metaphorically speaking, Enron would not have happened in Chicago. Neither would Long Term Capital Markets, nor the most recent fiasco at the Allied Irish Bank. Of course, I am referring to their trading in over-the-counter (OTC) derivatives. For in the structures of Chicago exchanges, or, for that matter, at any centralized traditional exchange—whether in their boisterous open-outcry pits or in the cyberspace of their electronic screens—where trillions of dollars are transacted daily then cleared and settled by their clearinghouses, futures markets flourish within as safe a financial design as the human mind can devise.

At the core of these mechanisms lie some meticulously fashioned and highly sophisticated operations. Mechanisms that represent the very essence of their default-free success. Unlike Enron—a darling of the so-called “New Economy”—the combination of these interwoven components represent a marvel of human thought and time-tested experience. Call it the old-fashioned way, if you will. To be specific:

The neutrality of their clearinghouses

Their system of multilateral clearing and settlement

—providing a central counterparty guarantee to every transaction

—eliminating counterparty credit risk

Their daily mark-to-market disciplines

—eliminating accumulation of debt

Their daily margining demands

Their full disclosure standards

Their transaction transparency

Their audit trail regimen

Their financial surveillance procedures

Their regulatory requirements

I have no hesitation in saying that these components epitomize financial safety and transaction transparency—Enron represented their opposite. Gretchen Morgenson of the New York Times correctly called Enron “a master of obfuscation.” Even more damning was Jerry Taylor, the director of the Cato Institute: “Enron,” he said, “was an enemy, not an ally, of free markets. Enron was more interested in rigging the marketplace with rules and regulations to advantage itself at the expense of competitors and consumers than in making money the old fashioned way.” To put it another way, while Enron correctly believed that energy could and should be traded like stocks, bonds, and futures, it wanted to conduct its transactions in an opaque manner, devoid of disclosure, conducive to conflicts of interest, and driven primarily by greed, ambition and arrogance.

No bilateral system, no matter the parties involved, can hope to match the financial integrity and transparency of a multilateral counterparty clearing facility composed of the above-enumerated strictures—safer yet if the facility is integrated with its trading engine so that at all times it has the pulse of the entire marketplace. For instance, at the Chicago Mercantile Exchange, the number-one U.S. futures exchange, about $1.5 billion in settlement payments are made daily. We manage $30 billion in collateral deposits. On September 17, we had pays and collects of $6 billion—without a hiccup. Instead, Enron was a counterparty to every transaction it executed—no trade intermediation occurred. In other words, every trade on EnronOnline depended on Enron’s creditworthiness. If you don’t understand what that means, ask the people who are left holding the bag.

Liquidity

Let me be brief: Without it there is no market. It represents the constant flow of bids and offers to the market, thereby liquefying the price-discovery process. It allows every participant to assume or eliminate market exposure quickly and at a fair cost. But liquidity is as elusive as it is vital. Examples of failed systems by virtue of a lack of liquidity are legion.

On the other hand, “If you got it, flaunt it.” That motto is nowhere more applicable than to the liquidity at traditional futures exchanges. It is their hallmark—their genetic code. While everything about them changed—while detractors and demagogues accused them of everything from the Black Plague to the 1987 Stock Crash, one thing remained constant: Futures exchanges are by far the best in providing liquid pools of buyers and sellers for the management of risk. During world upheavals, this becomes their most coveted asset.

Look at the hundreds of millions of annual transactions at the CBOE. Look at the CBOT’s 30-year bond contract with its $23 billion in daily notional value or its note contract averaging nearly $11 billion a day in turnover value. Look at the NYMEX with its average daily volume of 466,000 contracts. Look at the CME Eurodollar market. Consider, the average daily volume in that instrument alone (futures and options) is about 1,200,000 contracts, or $1.2 trillion every day. And unlike at Enron, our traders never have to pretend that they are busy.

Innovation

Let me be explicit: If financial integrity is the heart of our futures exchanges, if liquidity is the blood that flows through its veins, then innovation is its soul—its middle name.

Innovation, the willingness to try something new, the genius to invent, the nerve to confront what Milton Friedman calls the “Tyranny of the Status Quo,” the audacity to take a risk, the courage to fail is what separates the commonplace from the phenomenal, the mundane from the divine, the past from the future. In markets it is the difference between failure and success. Without a soul, the market, like with every human endeavor, will soon expire.

That Chicago is the risk capital of the world is predominantly the result of its middle name. Other market forums can and have achieved financial integrity, other market arenas can and have achieved liquidity, but what sets this city’s futures markets apart from everyone else is an abundance of all three components. Indeed, emulating the Chicago Nobel laureate tradition of Milton Friedman, George J. Stigler, Merton M. Miller, Gary Becker, Myron Scholes, and a host of others, Chicago’s innovative soul is quite unique. Beginning in the 1850s with the inauguration of futures markets in the U.S., to the 1960s break from storable products, to the 1970s revolutionary introduction of financial instruments and the development of security options contracts, to the 1980s debut of cash settlement and the conceptualization of Globex, to the 1990s inception of electronic mini-contracts, Chicago markets have consistently been the incubator of innovation.

Indeed, Chicago’s innovations in foreign exchange, interest rates, security options, and equity index futures were not only the model copied by every center of trade the world over, it served as a mechanism that in the words of Alan Greenspan “has undoubtedly improved national productivity growth and standards of living.”

But past accomplishments do not by themselves guarantee future success. My fear is that in the process of modernizing and demutualizing, which we must, we neglect the principles on which we are founded—especially our middle name. As we become like corporate America, as we worry about quarterly results, as we concern ourselves with shareholder values, as we rush to give our clients what they seek, will our past continue to be prelude? Will we remain the risk capital for the world? The innovator, conceiver of markets? Or will we fail because we forgot that our legacy depended not on one or another of its embedded components but on all three? There is a real and present danger that we become transaction processing plants without a soul. It is a model with an immediate allure, but one that spells eventual ruin.

As our own history has proven, the inventor owns the market. A postulate easy to grasp but very hard to achieve. It is a goal that must resonate through every fiber of the institution—a most ephemeral ambition. And, lest we forget, the marrow of our past innovative success has been our floor community. As we prepare to meet current competition, as we evolve to become efficient, can we preserve the resource they constitute? Can we retain the intrinsic shareholder value they represent? While it is certain that an electronic future is our destiny, have we charted the correct course for its evolution? Let me be clear: While it is mandatory to create the best electronic system that can be devised, while we must advance its use and effectiveness, the market, and only the market, can dictate the timing of floor transference.

Innovation is also costly and includes risk of failure. Failure is counterproductive to the bottom line. Innovation is often also counterintuitive to what clients seek. Indeed, clients do not always know what they need. Were futures in foreign exchange, or Eurodollars, or bonds invented because of client demand? Were the energy contracts launched by the NYMEX in response to a demand from the energy industry? Not even close! By definition, innovation means to give birth to something of which clients know nothing. It means to prepare for contingencies not always visible. It means to create new clientele. It means to predict what our clients will need some day in the future.

The Business of Risk

To succeed, not only must we resist the temptation to serve solely immediate demands, we must be wary of what our competition wants us to become. There is a current philosophy in some competitive quarters that exchanges and clearinghouses should not be vertically integrated. That they should be run as separate entities—and operate as utilities. Were that to happen, it could prove fatal.

Who are these competitive quarters and what is their motivation? Mostly they are large intermediaries. Their avowed purpose in promoting the idea of transaction and clearing utilities is to lower costs to their customers. It is no more than a ruse. Werner Seifert, chair of Management Board of the Deutsche Terminbörse AG, the world’s largest futures exchange, calls it a “red herring.” Seifert understands as we do that their real motivation is to control their customers’ order flow. They want to internalize their dealings, take the markets upstairs, and exploit the profit from the bid/ask spreads. In doing so, they will no doubt make lots of money, but there will be at least two fundamental casualties in their wake.

The first will be in the transparency implicit in the exchange-transaction process, one that is vital to the world and its regulators. Need we explain the inherent dangers in the loss of transparency in financial transactions? Need we revisit the causes of the Enron debacle? If you want a glimpse of where lack of full disclosure can lead, you need look no further than current reports of ambiguous accounting procedures—reaching levels of abuse that often bordered on fraud. As a trio of erudite Wall Street Journal reporters (John R. Emshwiller, Anita Raghavan, and Jathon Sapsford) recently pointed out, “Some of the world’s leading banks and brokerage firms provided Enron with crucial help in creating the intricate and misleading financial structure that fueled the energy trader’s impressive rise.” Forgive me for underscoring that some of these same folks are the ones advocating that we become utilities, and have organized their own exchange where the transaction process has little if any transparency. Now, that’s what I call Chutzpah!

The second casualty will be that of innovation. Does anyone here remember the last innovation produced by a utility? Hardly, unless you count pre-demutualized futures exchanges—but we were unusual under any definition. Again, Werner Seifert states the proposition well: “The entire value-added chain of securities processing from the initial matching of trades and the determination of prices to the final steps in clearing and settlement has to work with extremely high reliability....[O]nly vertically integrated organizations can combine innovation with the level of reliability that customers require.”

To a degree, of course, this debate is an offshoot of the ongoing competitive conflict between centralized exchanges and ECNs. The fact that exchanges are regulated is only part of the issue. Who provides the most efficient forum, the highest liquidity, the best price at the cheapest cost, are the critical considerations? Well, the winner of that debate can be determined only by the ultimate arbiter—the marketplace itself. And although the jury is still out, there has already been some indication which way the verdict is leaning. Countless of would-be-competitive ECNs that were launched with great hoopla during the B2B bubble now find themselves in the historical scrap heap. Indeed, long before the terrorist attacks, there was growing recognition by participants that centralized exchanges provided the best combination of the ingredients necessary for safety and liquidity—just check our volume statistics. Since September 11, there is even less tolerance for experimentation. “Stick with the tried and true” is the message we are hearing. That theme is amplified—by an order of magnitude—with the Enron experience.

So call us hustlers or arrogant imposters; call us lucky or even obsolete; call us what you like. We will remain the risk capital for the world, the innovator and conceiver of markets, so long as we remember the principles upon which our legacy was built.

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