White Cats, Black Cats
By Leo Melamed

Keynote Address
China Seminar
Shanghai
September 26, 2005

Common Sense Innovations

The 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."

It 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.

By 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.

Chicago's 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.

Nobel 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 shocks."²

It All Began with FX

It 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.

The 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.

It 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:

Changes 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

The 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.

That 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.

We 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.

Capital Efficiency

Of 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.

Happily, 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.

Most 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.

The results of the survey were perhaps best summed up by Professor Michael Brandl, Lecturer, University of Texas at Austin:

"By 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."

In other words: financial derivatives in capital markets are the equivalent of Deng Xiaoping's good cats catching mice.

* * *

¹ Financial 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.

² From the congratulatory message by Federal Reserve Board Chairman Alan Greenspan on the 30th Anniversary of the International Monetary Market (IMM), May 16, 2002.

³ The Need for Futures Markets in Currencies, Milton Friedman, 1971.

⁴ Remarks by Chairman Alan Greenspan, before the Futures Industry Association, Boca Raton, Florida, March 19, 1999.

⁵Survey of Finance Professors' Views on Derivatives, conducted by The International Swaps and Derivatives Association, March 2004.

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