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Interesting
Times
By
Leo Melamed
Inauguration of the Singapore Mercantile Exchange (SMX)
July
9, 2008
Singapore
As everyone
knows, “May you live in interesting times," is
an ancient Chinese saying. But the saying is a bit superfluous.
I am here to tell you, mankind always lives in interesting times.
It is part of the human condition. We are always bringing forth,
new ideas, new inventions, new innovations.
Some twenty plus years ago, to be specific, in 1986, I came
to Singapore to advance the concept of financial futures. I chose
Singapore because here I found a people hungry to build a financial
center in Southeast Asia. With the help of many in this community,
especially Ng Kok Song and the Monetary Authority of Singapore
we launched the world’s first mutual offset link between two
continents. It was revolutionary. The Singapore International
Monetary Exchange (SIMEX) and the Chicago Mercantile Exchange
(CME), did something no one ever before dared to do. We fused
together two separate markets, utilizing the same fungible instrument
of trade, Eurodollars, and made possible the management of interest
rate risk in a most efficient manner. To be clear, before computer
technology made it easy to link every corner of the planet together,
we gave the world the first 24 hour trading mechanism. Were not
those, interesting times?
Since that time, financial futures have grown beyond anyone’s
imagination. Today, derivative markets provide risk management
capabilities on a round-the-clock basis on a vast array of products
that cover the gamut from finance to energy, from securities
to the environment, from banking to agriculture. Organized futures
exchanges provide alternative investments coverage, maintain
strategic alliances with other exchanges, serve as a global benchmark
for valuing and pricing risk, provide most transparent markets,
offer an array of mini products for individual investors, and
maintain educational facilities. Importantly, they manage efficient,
financially sophisticated clearing houses that guarantee, clear
and settle every trade along with a complement of banking services.
A few statistics
will illustrate the magnitude of the change: In 1971, the year
just prior to the launch of the IMM, the world’s first financial
futures market, there were 14.6 million contracts traded on
U.S. futures exchanges—there were no futures exchanges of consequence
anywhere else. There are today some futures exchanges in nearly
every corner of the planet. Last years’ exchange traded volume
reached nearly 10 billion contracts. On the CME last year’s
average daily volume was 11 million contracts. Overall, exchange
traded derivatives grew from $38 trillion in notional value in
1994 to $400 trillion in 2007.
But as I
always cautioned, these are complex and sophisticated financial
tools. They need expert understanding. Used improperly, they
can create unacceptable risk. Some world banks recently learned
this the hard way. Over the course of years, bankers found
ever more clever ways using some Over the Counter derivatives
to repackage trillions of dollars in loans and sell them off
in slivers to investors around the world. Most were mortgage
backed securities. Rating agencies failed to understand the risks
involved. Greed led to a lack of financial discipline with a
breakdown of proper risk management controls. As home prices
and mortgage lending boomed, a housing bubble was created. It
was grounded in the fallacious belief that housing values will
go up forever. It was a recipe for disaster.
As fate would have it, the foregoing conditions came after a
decade of enormous global growth. A decade during which the world
became awash with liquidity. Easy credit led to a global pyramid
of debt and an economic bubble. Risk became excessively underpriced.
When this pyramid of debt began to collapse it created the current
credit crunch. Added to this mix were inflationary pressures
based on the high price of oil and grains. It created a toxic
brew. It should be no news to anyone at this conference to learn
that all economic bubbles end in tears. There is no reason to
believe that current global conditions will cause an exception
to this rule. Don’t you agree that we live in interesting times?
When talking about the derivatives markets it is imperative
to understand the difference between futures on exchanges and
OTC traded derivatives which greatly overshadow exchange-traded
futures instruments.. In December 2007, The BIS Quarterly Report
explained some of the differences:
-
In the OTC
market the original contract remains in place, increasing the
total size of the market. Not so in futures where an offsetting
position eliminates the original contracts.
-
OTC markets
do not have the protective components of the futures exchanges,
namely: Daily mark-to-the-market value adjustments, margin
deposits, price and position limits, and most notably the guaranty
of a central clearing house.
-
While OTC
derivatives may take place on multilateral trading platforms,
clearing and settlement is by its very nature bi-lateral—this
means OTC derivatives are not assets that can be traded freely.
-
In the OTC,
contracts with different counterparties are usually not fungible
which makes it difficult for traders to close positions. Contracts
often have long maturities, and counterparty risk a much greater
concern than in securities markets or futures.
-
OTC derivatives
contracts may themselves be very complex, involving payments
that depend on prices of other assets.
-
OTC markets
generally lack the regulatory control of federal authorities
to which futures and options exchanges are subject.
These differences are dramatic. While nothing is perfect and
no one can foresee all eventualities, the structure and procedures
at regulated futures exchanges represent a time-tested mechanism—the
very essence of their default-free success. On regulated exchanges,
not only are disclosure and transparency the hallmarks of their
transaction and clearing mechanisms, there can be no doubt about
the integrity of their daily settlement procedures. Even in the
most distant Eurodollar contract at the CME—priced ten years
into the future—there exists a real price established every day
in a notoriously open forum—now primarily Globex. In futures
no artificial pricing can occur. There is no “mark to modeling.”
On the other hand, in the OTC derivatives market, values are
often measured on the basis of the original model when the instrument
was created. Rating agencies make a value determination at that
time. Over time, without some form of an updating mark to market
mechanism, these valuations become stale and sometime meaningless.
Consider: During the Baer Sterns collapse which required a Federal
Reserve bailout to stem the fallout in the greater credit market,
no such federal assistance was necessary or even considered in
the futures market. Consider: In stark contrast to the turmoil
of recent events, the CME clearinghouse has operated for more
than 100 years without failure. In 2007, the CME Clearing House
cleared more than 2.8 billion contracts traded on the CME/CBOT,
representing more than a quadrillion dollars in notional value
terms.
That is not
to say, that OTC derivatives are to be shunned or feared. That
would be unthinkable. For the vast majority of financial managers,
whether OTC or exchange traded, these risk management tools
work exceptionally well. It is estimated that over 90% of the
world's 500 largest companies—domestic and international banks,
public and private pension funds, investment companies, mutual
funds, hedge funds, energy providers, asset and liability managers,
mortgage companies, swap dealers, and insurance companies—use
derivatives on exchanges and OTC to help manage their business
exposure. Nor could it be different in today’s complex and interdependent
financial world. These market tools have improved national productivity,
growth, and standards of living across the globe. Indeed, if
OTC and exchange derivatives application were suddenly not available
in business today, they would have to be invented. Without them,
it would be like going back to the stone age. Now that would
be living in interesting time. Still, the lessons learned must
be applied. OTC derivatives require more sunshine. There must
be adequate disclosure of attendant risks. There must be a process
in which valuation of complex derivatives are made more current.
And finally, Rating Agencies must be made accountable.
The financial
instruments we are talking about are a modern invention, a
consequence of computer technology. I have often stated, computer
technology moved mankind from the big to the little, from macro
to micro—from looking at the universe in its entirety to discovering
the smallest forms of matter. Just as technology enabled mankind
to discover subatomic particles in physical science, just as
technology enabled us to discover the genetic code in biological
science, so technology enabled us to manipulate components of
risk in financial science. Derivatives are the financial counterparts
to particle physics and molecular biology. With computer technology,
financial engineers learned to divide risks inherent in stocks,
bonds, foreign exchange and commodities into their basic components.
In other words, to disaggregate, repackage, and redistribute
risks and their corresponding rewards, exchanging one set of
risks and rewards for another that responded better to an investors’
preferences.
Today, the
trading “pit” has been electronically transported to every
corner of the globe. Today, nobody of consequence can say anything
anywhere, without it instantly reduced into a buy or sell on
a screen—for instance, on Globex at an average rate of 20 milliseconds.
You can execute a complex spread, or do an entire panoply of
connected transactions that includes markets across multi-asset
classes as fast as your fingers press the keys—or you can let
the computer execute your algorithm. Don’t’ you agree we live
in interesting times?
I submit
that futures markets are still in their infancy. Indeed, the
Digital Age which seems already so pervasive just began. We
are just beginning to understand its potential. Compare the
history of electricity: Remember, Michael Faraday invented
the electric generator in 1831, but it took another 48 years
for Thomas Edison to apply it in an electronic bulb, and well
into the Twentieth Century to popularize its use—a trend that
is still ongoing. Sure, things move much quicker today but
the point is no less valid. The digital revolution will impact
the 21st Century just as the industrial revolution directed
much of the Nineteenth and Twentieth centuries.
I congratulate SMX for taking this step and designing an exchange
in this region that will be internationally accessible. Its product
portfolio and individual contract specification will serve the
needs of regional users of base and precious metals, agricultural
products, as well as a MCX commodity index to track the Indian
commodity market. The SMX has received the blessing of the Monetary
Authority of Singapore precisely because it will advance international
trade and contribute to the local economy as an economic engine
for Singapore. Financial Technologies of India, in its brief
history, has understood this. As a result it has had amazing
success as the leading financial transaction innovator on the
sub continent. And now, here in Singapore, it will create a world
class exchange.
It is thus my pleasure to return to Singapore, where I first
came over twenty years ago to innovate, and where I will continue
to push for innovation. While I cannot guarantee many things,
I can guarantee you we will continue to live in interesting times.
* * *
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