Preface to the Chinese Translation of ESCAPE TO THE FUTURES

By Leo Melamed

2003

"The Mediterranean is the ocean of the past, the Atlantic the ocean of the present and the Pacific the ocean of the future," so said John Hay, the American Secretary of State at the turn of the Twentieth Century.

John Hay, while early, was correct. At the dawn of the Twenty First Century, the future has arrived. Market oriented reforms that begun in 1978 under Deng Xiaoping have taken root and China has transformed itself from a centrally-planned economic order into one that increasingly embraces free market principles. Thus, China has again resumed its role as a world growth leader.

However, continued growth will not be without pain. China’s markets are still a long way from instituting all the tenants of the free market. 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 greater market liquidity. A liquid market reflects truer price values and gives investors confidence in the marketplace. As a consequence, capital markets are strengthened, capital cost is reduced, and capital is utilized more efficiently. Ultimately, social order is greatly benefitted.

A well developed futures and derivatives market can help immeasurably in achieving liquid markets. The economic function of derivatives instruments is to provide a safety-net based on benchmark groupings of inherent business exposures or to unbundle the risks involved into their basic components and transfer them to those most able and willing to assume and manage each component. Consequently, financial derivatives—both on centralized futures and options exchanges or customized in the OTC market—can be likened to a gigantic insurance company that allows financial market risks to be adjusted quickly, more precisely, and at lower cost than is possible with any other financial procedure. A process that has strengthened capital markets and improved national productively growth and standards of living.

Escape to the Futures, tells the story of the development of financial futures and derivatives in the United States where they were born—on the floor of the Chicago Mercantile Exchange (CME) on May 16, 1972. It was an invention that two decades later would be named by, Nobel economist, Merton Miller as the “the most significant financial innovation of the last twenty years.”

These instruments of finance provide three important economic functions: (1) risk management, (2) price discovery, and (3) transactional efficiency.

Risk management is often quoted and often misunderstood. Its primary purpose is to protect existing profits—not to create new profits. It is imperative to understand this purpose and function. Risk management involves the structuring of financial contracts to produce gains (or losses) that counterbalance the losses (or gains) arising from movements in financial prices.

Thus, by virtue of derivatives application, risks are reduced and profit is increased over a wide sphere of financial enterprise and in various ways.

Second, price discovery. This represents the ability to achieve and disseminate price information. Without price information, investors, consumers, and producers cannot make informed decisions. They are then inhibited and deterred from directing their capital to efficient uses. Derivatives are exceptionally well suited for the role of providing price information. They are the tools that assist everyone in the marketplace determine value. The wider the use of derivatives, the wider the distribution of price information.

Third, transactional efficiency. Transactional efficiency is the product of liquidity. Inadequate liquidity results in high transaction costs. This impedes investments and deters the accumulation of capital. Derivatives facilitate the opposite result. They significantly increase market liquidity. As a result, transaction costs are lowered, the efficiency in doing business is increased, the cost of raising capital is lowered, and the amount of capital available for productive investment is expanded.

Of course, one cannot speak about efficiency of markets without mentioning the role of the speculator. All modern analysis leads to the conclusion that competitive speculation serves an all-important role in improving price efficiency. Speculation enhances market liquidity by creating higher levels of trading and a tighter bid-ask spread. The more trading and smaller the spread, the more market prices will migrate toward their true values. The more investors are confident that market prices reflect a high level of accurate information, the more willing they are to commit capital with a smaller premium for uncertainty. Thus, where speculation is high, the cost of capital will be lower, and the efficient allocation of capital among competing investments more likely. In other words, just as Adam Smith suggested a long time ago, by performing his speculative function, the speculator serves the overall economy.

Still, a world of caution is in order: Derivatives represent sophisticated instruments of finance that require education and comprehension. There are four inherent risks in business—risks that exist with or without the use of derivatives. There is (1) Credit Risk. The exposure to the possibility of loss resulting from a counter party's failure to meet its financial obligation; (2) Market Risk. Adverse movements in the price of a financial asset or commodity; (3) Legal Risk. An action by a court or by a regulatory body that could invalidate a financial contract; and (4) Operations Risk. Inadequate controls, deficient procedures, human error, system failure, or fraud. These risks should be clearly understood before establishing positions in derivatives markets.

Three decades after financial futures were launched at the International Monetary Market (IMM) division of the CME, Alan Greenspan, Chairman of the Federal Reserve Board, sent the following congratulatory message to the CME:

The financial derivatives markets, which the IMM has played a critical role in developing, have significantly lowered the costs and expanded the opportunities for hedging risks that previously were not readily deflected. As a consequence, the financial system is more flexible and efficient than it was 30 years ago, and the economy itself may be more resilient to the real and financial shocks.

Make no mistake about it! In our global market environment --- driven by constant and changing market risks, instantaneous information flows, and sophisticated technology --- future markets and financial derivatives are essential instruments of finance. And for emerging economies who represent the ocean of the future, they are indispensable tools in the development of free and efficient capital markets.

Leo Melamed

Return to top of page | Return to Index | Home Page