Cats, Black Cats
September 26, 2005
great Deng Xiaoping is regarded as the primary architect of modern
China and its dramatic economic reform. The crux of Deng Xiaoping's
philosophy was based on pragmatism and embodied in his dictum
to seek truth from facts. The criteria for success, he believed,
are determined by common sense and flexibility rather than by
ideology. He dramatized this philosophy by insisting, "No
matter if it is a white cat or a black cat; as long as it can
catch mice, it is a good cat."
is clear that Deng Xiaoping's vision of common sense economics
produced today's economic miracle in China. Since the adoption
of his ideology, China pursued a pragmatic path towards a market-driven
economy. The results have been nothing short of astounding. His
vision of common sense economics lifted more people out of poverty
than did the efforts of any other world leader, anytime, anywhere.
China is today the world's fastest-growing large economy. The
country has grown around 9 percent a year for more than 25 years,
the fastest growth rate for a major economy in recorded history.
In that same period it has moved 300 million people out of poverty
and quadrupled the average Chinese personal income.
sheer coincidence, Deng's revolutionary economic philosophy espoused
in the late 1970s occurred during nearly the same time-frame
when half way across the world another revolutionary economic
concept was born: The idea that the mechanics in futures markets,
traditionally used in agriculture, could be similarly applied
in finance. The modern era of financial derivatives was born.
The idea began in 1972 with the launch of currency futures at
the International Monetary Market of the Chicago Mercantile Exchange.
derivatives innovation, while of an entirely different dimension
than Deng's economic reforms, also contributed greatly to the
improvement of national productivity and standards of living.
May I dare suggest that the ability of financial derivatives
to allocate capital efficiently is the market equivalent of good
cats catching mice.
economist, Merton Miller named financial futures as "the most
significant financial innovation of the last twenty years."1 Recently,
Alan Greenspan, Chairman of the US Federal Reserve stated that "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
All Began with FX
is interesting to note some other similarities between China's
markets of today and the financial markets in the United States
at the time FX futures were launched. The critical causation
at that time was the abandonment of the Bretton Woods system
of pegged exchange rates which lasted from 1945, after the
end of World War II, until 1970, when President Nixon closed
the gold window.
old system of fixed exchange rates at Bretton Woods was a solution
uniquely suited for post-World War II reconstruction. That purpose
was over. If applied much beyond that, as it was, then its basic
and fundamental flaw, its rigidity, was destined to become its
undoing. A fixed exchange rate system could not forever effectively
cope with the continual change in currency value resulting from
the daily flows of political and economic stresses between the
member nations of Bretton Woods.
was clear to us that the different external and internal interests
of the participants-their different rates of economic growth;
their different fiscal and monetary policies, beholden to different
forms of governments; their different work force considerations;
their different election timetables and political pressures-would
combine to destroy a system dependent upon a unified opinion
regarding respective exchange values. In that case, we believed
the world would need a futures market in foreign exchange. We
asked Nobel Laureate Milton Friedman what he thought about our
idea? His answer was emphatic:
in the international financial structure will create a great
expansion in the demand for foreign cover. It is highly desirable
that this demand be met by as broad, as deep, as resilient a
futures market in foreign currencies as possible in order to
facilitate foreign trade and investment.3
idea worked beyond our wildest imagination. The IMM market provided
commercial enterprises with a tool to hedge foreign currency
risk It catapulted the CME to the forefront of financial risk
management. Our idea became the model for every center of trade
and was extended into the OTC market. While central futures exchanges
concentrated on broad-based instruments for risk management,
the computer allowed OTC financial engineers to devise tailor
made applications. Combined it grew into today's $250 trillion
global derivatives market. Today, CME offers 36 individual FX
futures and 23 options on futures products. It is the largest
regulated marketplace for foreign exchange with a daily notional
trading value of approximately $45 billion. CME FX trading accounts
for about 7% of the overall $680 billion spot (cash) market.
More than 51 million FX contracts, representing $6.2 trillion
in notional value, traded at CME in 2004.
Chicago is the birthplace of modern financial derivatives markets
is no accident. Chicago has a long history of market innovation.
It began in the 1850s with the inauguration of futures markets
in the U.S. In the 1960s, CME introduced the idea of non-storable
products. In the 1970s, we revolutionized the futures industry
wit the introduction of financial instruments, while the CBOT
developed security options. In the 1980s the CME launched cash
settlement, and introduced the concept of electronic trading,
eventually named Globex. In the 1990s we conceived electronic-mini-contracts
in equities. Thus, from the beginning, Chicago markets and the
CME in particular have consistently been the incubator of innovation.
believe what was true for the CME is true for the exchanges in
China today. In our opinion, the effective development of financial
derivatives on futures exchanges should be the next step in China's
progression. Not only is this directive necessary for the uninterrupted
growth of Chinese capital markets, the Chinese futures exchanges, the
Shanghai Futures Exchange, the Zhengzhou Commodity Exchange,
and the Dalian Commodity Exchange have reached the level
of experience that make such a step feasible and desirable.
course these are sophisticated instruments which require expertise
and experience. There are inherent risks: 1) Credit, or so-called,
counter-party risk. Will the party to whom risk is transferred
be able to perform its contractual obligation? 2) Liquidity risk.
The ease with which the instrument can be traded, especially
during periods of high volatility. 3) Pricing risk. Pricing models
sometimes inadequately reflect market risk when it relates to
long-dated or exotic instruments infrequently traded. 4) Transparency.
Transparency in the transaction process assures participants
that competitive forces will determine the price for a product.
in all of the above areas of concern, derivatives traded at a
central exchange, so called (ETD), provide time-tested solutions
that are not readily available in over the counter (OTC) derivatives.
While OTC derivatives are typically transacted as bi-lateral
agreements between two counter-parties, thus creating a counter-party
risk, ETD utilize multi-lateral clearing facilities providing
a central counter-party guarantee to every transaction. The exchange
acts as the buyer to every seller, and the seller to every buyer.
As for liquidity, central exchanges offer the most liquid and
resilient markets possible, ones that have been time-tested during
the most volatile economic conditions. Of course, with respect
to transparency, the mechanism for transactions on exchanges
provides the most transparent, highly competitive forum ever
devised on a real-time basis. And finally, pricing risk, even
for exotic or long-dated instruments, is substantially minimized
because of the transparency nature of ETD trading, its daily
mark-to-market procedures, and its daily margining demands.
important, derivative application in business has been universally
endorsed by the financial experts of the academic community.
In a survey conducted last year by the International Swaps and
Derivatives Association (ISDA) of professors of finance at the
top 50 business schools worldwide, including some the worlds
most prestigious universities, the use of derivatives by companies
to manage risks was commonly cited as a contribution to the stability
of the global financial system.5 The respondents 1)
unanimously agreed that derivatives help companies manage financial
risk more effectively; 2) unanimously agreed that derivatives
will continue to grow in use and application; 3) eighty-one percent
agreed that the risks of using derivatives have been overstated;
4) over half agreed that derivatives have not created new types
of risk; 5) ninety-nine percent agreed that the impact of derivatives
on the global financial system is beneficial.
results of the survey were perhaps best summed up by Professor
Michael Brandl, Lecturer, University of Texas at Austin:
allowing for a more efficient management of risk derivatives
have resulted in a more efficient allocation of capital. An
efficient allocation of our resources, including capital, allows
for more rapid global economic growth. It is through economic
growth that each generation has the ability to live better
than past generations. Thus, an expanded efficient use of derivatives
is an important component for future economic growth."
other words: financial derivatives in capital markets are the
equivalent of Deng Xiaoping's good cats catching mice.
Innovation: The Last Twenty Years and the Next, Merton H. Miller,
Graduate School of Business, The University of Chicago, Selected
Paper Number 63, May 1986.
the congratulatory message by Federal Reserve Board Chairman
Alan Greenspan on the 30th Anniversary of the International Monetary
Market (IMM), May 16, 2002.
Need for Futures Markets in Currencies, Milton Friedman, 1971.
by Chairman Alan Greenspan, before the Futures Industry Association,
Boca Raton, Florida, March 19, 1999.
of Finance Professors' Views on Derivatives, conducted by The
International Swaps and Derivatives Association, March 2004.
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