THE SHAPE OF THINGS TO COME

Presented at the Chicago Mercantile Exchange London Financial Symposium,
London, England,
November 10-11, 1988.

In 1977, I wrote an article for the Hofstra University Law Review on the mechanics of a commodity futures exchange. In it, I concluded that an automated transaction process cannot supplant the trading floor nor the open outcry system. That article was used by detractors of GLOBEX in their attempt to discredit my sanction and praise of an automated after-hour trading system.

The attempt failed. First, because the Hofstra article was written a decade before GLOBEX, for a world radically dissimilar to present market realities. Ten years ago, globalization was a mere theory, futures were but an American phenomena, their scope, volume and application rather limited, and technology—as we know it today—was in its infancy.

Second, the Hofstra article did not suggest that the futures industry would cease to evolve or stop its innovative processes. To suggest this would have been the antithesis of beliefs I hold sacred. Then as today, I recognized that the world of futures is dynamic, continuously evolving, and that innovation is its middle name. Our industry cannot ever stop inventing or ignore reality.

Third, GLOBEX does not propose to supplant the open outcry system, rather it will complement and protect it. While open outcry is the liquidity engine of futures markets—and will no doubt remain so for many years to come—it does not serve us in the current global competitive struggle. Financial futures cannot be patented; our contracts are being copied by foreign centers of trade. If we do not create a mechanism that can offer our markets to participants on a 24-hour basis, we stand to lose a substantial portion of our market share—business on which we thrive and which was invented on the American shore. To do so would be the height of folly.

During the late 1970s, a favorite question of financial reporters was whether financial futures could prosper in a non-inflationary environment. To them it was clear, futures markets were successful and our exchanges prosperous simply because the world was then experiencing record-breaking inflation accompanied by record-breaking interest rates. Ah, but since such financial turmoil cannot go on forever, what pray will happen to financial futures in more normal times? The implication was that futures markets were no more than a momentary blip in economic history, a fashionable craze that would go the way of the hoola-hoop as soon as sensible times returned. That represented the conventional media wisdom of the day.

In truth, of course, futures did indeed do rather well during the upheavals of the 1970s. U.S. futures volume rose from an overall 11 million transactions in 1969 to 76 million transactions at the end of the following decade, an increase of approximately 600%. Then came the 1980s and more normal times. U.S. inflation fell by 70%, and similarly interest rates were cut better than in half. The abnormalities of the previous decade were behind us. But guess what? Financial futures defied dire expectations. Rather than diminishing in importance, futures exchanges became coveted the world over. Financial futures became an indispensable risk management tool of money managers everywhere. U.S. transaction volume grew every year during the "non-inflationary" eighties, reaching 275 million transactions in 1987. Similar growth was experienced in every world center that futures are traded.

Then came the 1987 October crash. At first it again looked as if the days of these markets were numbered. At least that was again the conventional wisdom of many in the media. We were under attack as seldom before. Some used the moment because they viewed futures as a competitive threat; some, because they sought control over this arena of market activity; still others, because they feared what they could not understand; and finally, those who believed our markets to be inherently evil. It was a frightening process, more frightening than even the market's display of brutal power during the crash itself.

Demagoguery, ignorance, and misinformation are indeed powerful combinations. But the investigatory process led to a most unexpected result. For in the final analysis, as Alfred North Whitehead, the noted British mathematician and philosopher stated, facts are irreducible and stubborn. Indeed, the truth will out. After all the studies were in, after all the evidence was presented, after all the analysis was made, after all the misinformation was laid to rest, futures markets were not only exonerated from blame, they were vindicated by receiving the highest of praise from most academic studies and from most knowledgeable experts. The frightening process served to strengthen, rather than weaken, futures markets worldwide.

Indeed, one doesn't hear much these days about the imminent demise of financial futures. Quite the contrary, new financial futures markets have been instituted or are scheduled in every corner of the globe. It seems as if the pronouncement by Professor Merton Miller of the University of Chicago, that financial futures were "the most significant financial innovation of the last twenty years," has become accepted gospel.(1) Futures markets have become establishment. Ah, but therein lies a greater danger. One that, to me, is no less frightening than any of those we have vanquished. For within success lies the seeds of complacency. Worse yet, an overwhelming preference for status quo.

Financial futures, in my view, have occasioned two milestones in their short history, both of a revolutionary nature. 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. The second milestone was cash settlement. Once financial futures shed the requirement of physical delivery, they opened the curtain on instruments and concepts which were previously totally unthinkable. Cash settlement represented the gateway to index products and seemingly limitless potential. Proudly, both milestones occurred on the floor of the Chicago Mercantile Exchange: in 1972 when the IMM was launched with its first financial contracts, and in 1981 when the Merc's Eurodollar contract became the first to attempt cash settlement.

Today, financial futures are at the threshold of their third milestone. Not surprisingly it is again the CME that is leading the way. And as was the case with the first two milestones, the third one has generated a good deal of discussion and even controversy. For all the milestones have a single common denominator—they each represent a revolutionary departure from status quo.

GLOBEX, the automated global transaction system of the CME and Reuters Holdings PLC, represents a move toward automation in the transaction process. Consequently, 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 that involves automation or adoption of technological advancements. To them such reforms advance the black box and hasten the end of open outcry.

The world of futures is dynamic and continuously evolving. 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 they became the standard tools for risk management, the changes we engendered were dramatic and revolutionary. Today the futures industry is not in any way, shape or form the same industry that spawned the financial futures revolution in 1972. Nor does this industry bear much resemblance to the one that fought to prove its merit during the formative years of its existence. We are today but a distant cousin to that which gave us life. And while we must respect our heritage, we must not be held back by its limitations.

Throughout our dramatic metamorphosis and expansion, open outcry has been the liquidity engine for our success. This is still the case and it would be futile for anyone to argue otherwise. The Chicago Mercantile Exchange, like all other American exchanges, has a continuing commitment to the preservation of this transaction process. However, 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 is both foolish and dangerous and could lead to disaster.

In a 1977 Law Review article for Hofstra University(2) on the mechanics of a commodity futures exchange, I concluded that an automated transaction process cannot supplant the trading floor nor the open outcry system. I still wholeheartedly support this view. GLOBEX is not designed to replace the present transaction process, but rather to enhance and secure it. Nor did my conclusions of a decade ago intimate that our industry should ever, in any way, shape or form, be precluded from experimenting with change.

Indeed, in order to preserve open outcry, we should examine the state of our industry in light of current demands on our markets and in the context of those very competitive and technological pressures that attack the present system's viability. We must not only examine these issues, we must be willing to respond to them in a manner that is consistent with the findings. Open outcry is predominantly an 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 partial or total automated execution system. For example, the Japanese Government bond futures market—often cited as the most successful foreign futures market—was not established on an open outcry foundation and is destined to become fully automated within a year or so.

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 and provide a continuous flow of orders to the market. They represent a liquidity source virtually nonexistent a decade ago. Upstairs traders cannot, in the near future, replace the liquidity source of pit traders, there is no denying that the former is a growing universe with no visible limitation on its expansion.

It is, by now, a cliche to explain that sophisticated satellites, micro-chips and fiber optics changed the world from a confederation of autonomous financial markets into one continuous marketplace. We need no reminder that 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 by maintaining their own unique market centers, product lines, trading hours and clientele. Today's capital flows know no allegiance to time zones or geographical boundaries. Today, as we know too well, users of every market come from around the globe because news is distributed instantaneously across all time zones. When such informational flows demand market action, financial managers no longer wait for local markets to open before responding.

During the past several years, exchanges have attempted to meet the globalization challenge by searching for alternative solutions to preserve local business flows and attract business generated on foreign shores. With varying degrees of success, these actions involved either electronic linkages with foreign exchanges or, more recently, extended trading hours. While it is still too early to fully evaluate the long-term effectiveness of these alternatives, it is the CME's view that neither represent an adequate response to the opportunities and perils of the 24-hour trading day.

The Chicago Mercantile Exchange understood the globalization reality when four years ago it instituted the mutual offset link with SIMEX. 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 the global market. What's more, this experiment provided the CME with invaluable expertise and living proof for everyone that world markets can be safely and efficiently linked.

Beyond linkage, the question of how best to respond to the demands of globalization has resulted in an extension of trading hours. This concept is not new. From time-to-time, all exchanges have restructured and extended their regular trading hours (RTH) to accommodate new business flows. Such past trading extensions have more or less proved successful. However, extensions of RTH beyond the parameters of normal business hours, as was instituted by the Chicago Board of Trade and the Philadelphia Stock Exchange are far different in scope than RTH extensions in the past. The purpose of these new RTH extensions as well as the problems they pose are considerably different from past trading hours adjustments. To date, the CBOT experiment has met with some success, but it has been applied chiefly to one instrument and for only a small portion of the American night.

The extended trading response begs these questions: Can a night open outcry market be successfully devised to encompass the remaining sixteen non-business hours of the North American time zone? Can a night open outcry market develop sufficient liquidity for a multitude of complex financial instruments? Can a night open outcry market sufficiently respond to the needs of all world participants from every center of finance? Will non-U.S. financial centers be satisfied with a night market on the U.S. shore for their RTH financial needs? Will non-U.S. financial exchanges also respond to globalization by creating their version of night markets?

To say the least, one must consider the answers to these questions with some degree of skepticism. Beyond that, there is the larger question of reality. Is there not something inherently amiss if in this day and age there is no attempt made at unifying the global transaction process? And if such an attempt is made, can it ignore technological applicability? Technology and automation are the driving forces behind today's markets, its uses and users.

The Chicago Mercantile Exchange has embraced reality and chosen a dramatically different response to the demands of globalization. We believe GLOBEX combines elements of electronic linkage with those of extended trading 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. At the same time it represents a giant step toward unification of the separate world's financial centers. We are convinced GLOBEX correctly envisions the global marketplace whose time has come and embodies the manner in which the world of tomorrow will function. We have invited every center of finance to join us as partners in this endeavor.

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     (1) Merton H. Miller, Financial Innovation: The Last Twenty Years and the Next, Graduate School of Business, The University of Chicago, Selected Paper Number 63, May 1986.

     (2) Leo Melamed, "The Mechanics of a Commodity Futures Exchange: A Critique of Automation of the Transaction Process," Hofstra Law Review, Fall 1977, Volume 6, No. 1.

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

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