THE THIRD MILESTONE

Chicago Mercantile Exchange
1988 Annual Report.

It was axiomatic that a trading system that utilized automated electronic capabilities epitomized the ultimate threat for members of the futures industry. It erroneously represented the proverbial Darth Vader who would destroy their coveted open outcry world and eliminate the trading pit in favor of the "black box"—a computer-driven marketplace. But it was equally axiomatic that automation, electronic competence, and technological advancements were inexorable forces that would overwhelm anything that stood in their way. Those who ignored the march of technology were soon banished to the historical scrap heap of failures. In other words, use it or lose it.

The foregoing ideological conflict seemed to represent a dilemma of Hobson's choice proportions for many within our industry. It caused many to simply shun the issue, for to contemplate technological automation in the transaction process was suicidal. Still, for some of us, the challenge was inevitable. To bow to the demands of status quo simply because of fear of change was unacceptable. To me, innovation was no idle concept to be admired from afar. Indeed, market innovation was as essential to me as the very oxygen we need to stay alive—it was the critical trait that made us different and empowered us to bring the Chicago Mercantile Exchange to the forefront of financial markets worldwide.

Thus, the concept of GLOBEX was born. Because we could not ignore the reality of competitive demands engendered by modern technology, because we realized that without automated electronic competence, our futures contracts would be limited to the regular business hours of the American time-zone, because our market share was threatened by foreign competitors, we chose to meet the challenge with a computer-based electronic after-hours trading system. The trick was to convince our members to embrace this reality.

In a referendum held on October 6, 1987, the members of the Chicago Mercantile Exchange voted overwhelmingly in favor of the GLOBEX concept by a vote of 3,939 to 526. The following was the rationale behind our victory.

Financial futures have occasioned two milestones in their short history. These milestones, both of a revolutionary nature, occurred on the floor of the Chicago Mercantile Exchange. The first milestone was their creation itself. The departure by traditional futures from their century old agricultural base and entrance into the world of finance dramatically changed their direction and history. By definition, no financial futures history could have ensued without its conceptual inception. It is clear today that the revolutionary concept sponsored by the CME seventeen years ago, was destined to change the world of finance and become an indispensable risk management tool the world over. Indeed, the invention of financial futures has been hailed by Merton H. Miller, PhD., Professor of Banking and Finance, University of Chicago, as "the most significant financial innovation of the last twenty years."

Alas, hardly anyone recognized that event as significant back in 1972. Indeed, hardly anyone believed it to be of any consequence at all, and few gave it any chance of success. Pundits and critics mocked the idea, regarding it as no more than a joke or, at best, a quixotic impossible dream. Some simply thought it ludicrous that a "bunch of pork belly crapshooters" would dare to contemplate treading on the hallowed ground of foreign exchange. But succeed we did. The reason? Quite simple! Victor Hugo explained it when he told us that no general was smart enough and no army strong enough to suppress an idea whose time had come.

The second milestone—cash settlement—came nine years later. In 1981, the Merc's Eurodollar contract became the first to settle by way of payment in cash rather than by delivery of the instrument itself. Once financial futures shed the requirement of physical delivery, the curtain was opened to instruments and concepts previously unthinkable. Cash settlement represented the gateway to index products and seemingly limitless potential.

Today, financial futures are poised at the threshold of their third milestone. Not surprisingly, the CME is again leading the way. As was the case in the with the first two instances, the third has generated a good deal of discussion and even controversy. For all the landmarks have a single common denominator; each represent a dramatic departure from status quo. GLOBEX—the third milestone—the automated global transaction system being developed by the CME and Reuters Holdings PLC—represents a move toward automation in the transaction process. It touches the very nerve center of status quo in our industry and has incurred the criticism of those who would oppose any movement toward change in automation or adoption of technological advancements. To them, such reforms advance the black box and hasten the end of open outcry.

The unequivocal truth is that the world of futures is dynamic and continuously evolving. Complacency is the enemy; innovation and change are at the very heart of our success. As our markets' applicability extended to new products, new techniques and new users, as our markets became the standard tools for risk management, the changes we engendered were dramatic and revolutionary.

In 1977, I wrote an article on the mechanics of a commodity futures exchange for the Hofstra University Law Review. The article concluded that an automated transaction process cannot supplant the trading floor nor the open outcry system. While that assertion was made with respect to a world quite different from today, GLOBEX does not run contrary to this view. GLOBEX is not designed to replace but rather to enhance the present transaction process. Nor did my conclusions of a decade ago intimate that our industry should ever be precluded from experimenting with change. Indeed, we must continually evaluate the state of our industry in light of current demands and competitive pressures on our markets, and in recognition of the effects of scientific and technological changes in the world around us.

There is no doubt that throughout our dramatic metamorphosis and expansion, one thing has remained constant. In the United States, open outcry has been the liquidity engine for our success. This remains the case. The CME, like all other American exchanges, has a continuing commitment to the preservation of this transaction process. However, the CME also believes that to blindly assume that open outcry is the perfect system for all time is to be lulled into a false sense of security and forgo any opportunities to strengthen or advance our way of doing business. Such a policy would be both foolish and dangerous and could lead to disaster. While we must always respect our heritage, we must never let ourselves be held back by its limitations. We must recognize the greater truth—that those who ignore or fear to embrace reality will quickly become history. Therein, of course, lies the rub.

Historian Barbara Tuchman succinctly told us that "men will not believe what does not fit in with their plans or suit their prearrangements." Walter Wriston, the former Chairman of Citicorp, is more explicit: "When major tides of change wash over the world," he tells us, "power structures almost inevitably reject the notion that the world really is changing, and they cling to their old beliefs."

The change that has washed over our end of the world is the telecommunications revolution: sophisticated satellites, micro-chips and fiber optics changed the world from a confederation of autonomous financial markets into one continuous marketplace. There is no longer a distinct division of the three major time zones—Europe, North America and the Far East. No longer are there three separate markets operating independently of external pressures, maintaining their own unique market centers, product lines, trading hours and clientele. Today, news is distributed instantaneously across all time zones and when such informational flows dictate market action, financial managers no longer wait for local markets to open before responding. The old order offered our financial markets a geographical security blanket that kept them relatively free from the dangers of international competition. That order is history. Globalization, caused by the telecommunications revolution, has ushered in the information standard. Every financial market is now a potential competitor of the other. GLOBEX recognizes and embodies that change. GLOBEX symbolizes the technological revolution that has engulfed every walk of life—and none more than ours. GLOBEX embraces reality and shakes the very foundations of complacency about us. GLOBEX will change our industry forever. And what's more, GLOBEX will extend its life.

Two additional observations. First, successful open outcry is a predominantly American phenomenon. With few exceptions, other world centers have not long had this tradition nor much success with its application. As a consequence, many non-U.S. centers have, from the outset, opted for either a partially or totally automated execution system. Second, while the futures market pits remain the single most important source of present-day liquidity, they are no longer the only source. Today, there exists an army of upstairs traders whose trading methodology is not dependent upon eye-to-eye pit contact, but rather on two technological instruments: the computer-screen and the telephone. Using these instruments, upstairs traders buy and sell in rapid fashion throughout the day—similar to pit traders—and provide a continuous flow of orders to the market. These traders represent a liquidity source virtually nonexistent a decade ago. While they will not, in the near future, replace the liquidity source of pit traders, there is no denying that they represent a growing universe with no visible limitation on its expansion. GLOBEX should present no problem for the upstairs trader.

The CME perceived the globalization reality when it instituted the mutual offset link with the Singapore International Monetary Exchange (SIMEX) in 1984. It was the first successful attempt to link the trading capability of two different markets in two different time zones. It served as a model for others to follow and took the world one step closer to a global market. This experiment provided the CME with invaluable expertise and living proof that world markets can be safely and efficiently linked. It also led us to the next logical evolutionary step.

GLOBEX combines elements of electronic linkage and integrates them with the open outcry system. In effect, it draws the best from the present and marries it to the technology of the future. It is critical to understand this point. We did not set out to re-create open outcry. We sought a way to secure it—a way to marry it to the technology of the future, a way to extend its market day—but not to re-create it. While we recognized the value of open outcry and the liquidity it generates, we sought to do better. We recognized the inadequacies of open outcry—its inherent unfairness. We knew that an automated system provided us an opportunity to do away with those inadequacies, an opportunity to make the system more fair.

At the same time, GLOBEX represents a giant step toward unification of the separate world financial centers. GLOBEX will offer the world a transaction capability that is as advanced as the imagination will allow and as far-reaching as the future itself; a transaction capability that will allow the products of all the world's great exchanges on the same system—on the same screen—to be utilized by everyone around-the-clock. The very words are breathtaking.

We envisioned a global, interactive, shared system for futures and options. A system whereby no partner exchange will relinquish its autonomy; whereby every partner exchange will continue to clear and guarantee its own products; and whereby the rules of the respective governments will continue in force, as before. Yes, we envisioned a transaction structure for the ultimate unification of the world's separate marketplaces. That is the essence of GLOBEX.

GLOBEX is a major departure from status quo. Consequently, it has drawn heavy criticism from those who fear change, as well as those who recognize the competitive edge the new system will offer our institution. Those are some of the very reasons the CME conceived GLOBEX. Of course, there are no guarantees. There are many hurdles to overcome, some in the government domain. Unfortunately, our own government officials often fail to appreciate the prophet in their own backyard. All too often, American innovations are ignored or repressed by virtue of shallow reasoning or bureaucratic red tape. Such examples are too numerous to mention. We trust, however, that will not be the case with GLOBEX. We trust U.S. federal officials will recognize that GLOBEX is the trail-blazer, the model for all to follow; and, that it is a product of American ingenuity to be assisted and encouraged.

Again Wriston says it well. "If today's leaders in government and business fail to recognize that the world has changed" because what they see, in Tuchman's words, `does not fit in with their plans or suit their prearrangements' they will follow into oblivion a long list of leaders who have made similar mistakes. Those who can understand and master change will be tomorrow's winners."

The first two milestones the CME engendered offer unequivocal proof that our institution does understand change; that we are both willing and capable of embracing the realities it represents. The third milestone carries forward this tradition in a grand fashion.

Reprinted by permission. Excerpted from Melamed on the Markets, by Leo Melamed. John Wiley & Sons, 1993

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