CME CENTER OF INNOVATION
Remarks by Leo Melamed

Inaugural Event
CME Center of Innovation
Fred Arditti Innovation Award
June 19, 2003
Chicago

Allow me to begin by expressing my pride on the Merc’s inaugural of this center as well as its establishment of the Fred Arditti Innovation Award. The center will serve as a fertile forum from which will sprout ideas and ideals. The Arditti Innovation Award is a just tribute to someone within our family who served this institution with intellect, love, and integrity. Someone who is my close personal friend and colleague and with whom I have had the privilege to work in joy these many past years. Congratulations on both events.

“Without innovation art is a corpse,” the great Winston Churchill once said. He might have been talking about almost everything—especially in matters of business—especially in matters of financial markets—especially in matters of futures exchanges.

According to Nobel laureate William Sharpe, “More than most sciences, economics not only analyzes reality, it also alters it. Theory leads to empiricism which changes behavior. Nowhere is this more evident than in financial economics.”

Clearly, the past three decades were marked by unprecedented innovation in financial markets—their cumulative result represented in every real sense a financial revolution. The Chicago Mercantile Exchange, more than any other futures market, was both at the forefront of this revolution as well as able to capitalize on its rewards. The Chicago Mercantile Exchange, once the house that pork bellies built, is today the house that innovation built.

I will not belabor these proceedings to repeat the well-known history of the great innovations ushered forth or adopted by our exchange. They have been well documented and are the currency which gives us, more than most, the legitimacy to launch a Center of Innovation. Rather, at this celebration, allow me to make two observations about innovation that relate to the state of our industry, to our exchange, and to this evening: One is obvious, the other, maybe not.

First, the obvious: Simply stated, the motivation to innovate is inexorably intertwined with an incentive to receive a reward, monetary or otherwise. Ask any company in business. Ask Intel, or Allstate, or Pfizer, or General Motors, or Wal-Mart, and you will get the same emphatic response: We innovate to create new avenues of business, to gain an edge on competition, to achieve a greater share of a given market, in other words, to enhance shareholder value. Even in the academic world, where one might argue that motivation to innovate stems from a compulsion based on pure intellectual pursuit rather than tangible consequence, the reward of being in the forefront is as much the imperative as is accretion to the bottom line in business. Ask any aspiring theorist whether the prize of being first is not among the most driving forces in his or her intellectual quest.

Although this truth is axiomatic, unexpectedly, it has recently generated a bit of nonsensical controversy in our industry. There are some within our industry who question this obvious maxim. They suggest that futures exchanges give up the fruit of their innovations in favor of a rather discredited precept—one that smacks of socialism: To share our wealth by giving up the exclusivity prize of clearing.

Let me be explicit: The transactions the CME clears are a direct consequence of the innovations our exchange undertook, the intellectual capital we invested, the time we devoted, and the money we spent on research, development, education, and marketing. All of which begot us the crown jewel of the marketplace—liquidity. Without liquidity there is no market. Liquidity is that illusive Holy Grail that is awarded in those rare instances when an idea hits pay dirt. It is the market’s way, if you will, of awarding the innovator a patent. And while this liquidity patent is limited—because little prevents anyone else from copying the idea—it nevertheless becomes nearly impossible to replicate. The monetary consequence of liquidity is of course clearing of the resulting transactions. At the CME, 80 percent of its revenue is generated from the clearing of transactions. Simply stated, removal of the exclusivity of clearing will result in the death knell to the motivation to innovate. And without innovation there will be no Chicago Mercantile Exchange.

Which brings me to the second point. During the past decades, at the zenith of our innovative process, the Merc operated within what Henry Chesbrough of the Harvard Business School identifies as the paradigm of “closed innovation.” We were not alone. Indeed, it was the standard approach in business everywhere. Companies generated their ideas internally, financed them, marketed them, and supported them. It was an architecture that counseled a self-reliant approach to innovation. You hire the most talented people, you set in motion a race to be first to devise new products, you sponsor the internal research and development, then you market them before anyone else, and when possible you own the resulting intellectual property. It was a successful architecture for most of the twentieth century. It was an approach particularly well suited for futures markets, given the fact that we had spawned a brand-new market vista, given that it offered a vast range of virgin territory with untried product possibilities, given the intense competition requiring the utmost secrecy, given the race to be first, and given the fact that whoever was first “owned” the market.

But what was true for most of the twentieth century is not necessarily the case for the twenty-first. Indeed, in many industries, the very innovations successfully fostered through the closed innovation architecture resulted in fundamental changes which made the old way of doing things problematic. As Chesbrough points out, in the last century many leading companies held knowledge monopolies; they led their industry and indeed the world in the critical discoveries that supported their industry. Bell Labs was the premier example of such a research laboratory. Other examples of research-based companies include DuPont, Merck, IBM, GE, AT&T, and others that performed most of the research in their respective industries and did it internally.

Today these knowledge monopolies have been broken up. The distribution of knowledge has spilled out. The genie, so to speak, is out of the bottle. Information technology, a consequential innovation of closed innovation, was a primary force in changing the innovation architecture. The growing mobility of experienced personnel made ideas nearly impossible to maintain in secret. Important pools of knowledge began to be distributed among many avenues, companies, customers, universities, industry consortia, and start-ups. But while innovation could no longer be supported by the old closed model, the maxim that companies that don’t innovate die remained intact. Newcomers like Microsoft, Sun, Oracle, Cisco, and others grew up and succeeded by conducting little or no basic research of their own, yet found the means to garner the innovative fuel with which to succeed. The newcomers simply adopted what Chesbrough called open innovation. The new architecture invited and created avenues for ideas to flow from external sources. The newcomers used these external ideas to combine with internal ones in order to advance their innovative result. It worked. Existing companies that adapted to open innovation processes continued to survive; those that didn’t perished.

Sometime during the latter part of the twentieth century, we at the CME similarly sensed the need to adjust to the new reality. Competition from foreign and over-the-counter markets became intense. The globalized marketplace induced the incubation of new ideas in far-flung arenas to which the CME often had little access. Demands for new products sprang up in spheres with which the Merc had little direct relation. The pace of change and the consequential market alterations were often difficult to decipher—unless, that is, one maintained a standing army of idea detectives on guard around the world and around the clock. Still, for us the altered innovation architecture was fairly easy to accommodate. The Merc was fortunate to have an extended family, a large and diverse group of members and member firms that by themselves or through their customers represented a legion of users and potential users—in other words, an army of idea detectives. It only required the relatively simple task of establishing a channel for such information to readily flow to our data banks. We made such a channel available. Our members gained access to its board and management.

However, the new innovation architecture requires more, and the CME is prepared to respond. We recently initiated the creation of a Competitive Markets Advisory Council. Chaired by Nobel laureate Myron Scholes, and offering me the privilege of acting as vice chairman, CMAC will invite to its domain some outstanding academicians, market practitioners, thought leaders, and other professionals who will afford our exchange the precious opportunity to gain from their knowledge and insights in our quest to discuss competitive challenges and formulate new ideas for market implementation.

Finally, tonight we celebrate the inauguration of still another dimension of the new architecture. The CME Innovation Center and the Fred Arditti Innovation Award will invite and embrace ideas from which can spring new products, applications, and markets. While these consequences will not always be directly related to our industry, or always result in a revolutionary change, I predict they will more often than not stimulate our internal think-tank processes and either directly or indirectly bring us the coveted prize of innovation.

Thus, open architecture of innovation must become and remain the signal component of our existence. In that fashion, and only in that fashion, can we assure that innovation continues to thrive in the house that innovation built.

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