FINANCIAL MARKETS IN THE COMING DECADE

Essay published in Futures Magazine,
November 1990.

The cataclysmic upheavals in the Soviet Union spelled the end of the Cold War and the beginning of a new world order. While none of us are sage enough to know precisely the ultimate outcome of the foregoing events or the repercussions they yet portend, it is incumbent upon us to attempt to put those remarkable happenings in perspective, particularly as they relate to world markets.

Clearly, the market-driven economic order epitomized by the U.S. was the most important victor in the struggle between East and West. But at what cost to our own financial structure? What role did futures and options markets play in this drama and what will be their function in the new world order? Will the world now enter an era of economic equilibrium or are there new disorders to be faced? Will the debt accumulated during the 1980s result in trouble for the 1990s? What will the markets be like in the coming decade?

While predicting the future is dangerous at best, it is often imperative that we make the attempt.

It seemed like just another traditional May Day celebration in Moscow Red Square. As usual the government top brass were all present, as usual there were banners and marches and song, as usual there was all the expected pomp and circumstance. But something was drastically different. It was the banner! The colors were right—yellow letters on a red background—but the words were all wrong. "Communists: have no illusions—you are bankrupt," it blatantly proclaimed! Right there, in the middle of Moscow Red Square, on May Day 1990!

The occurrence of this incredible event—that it occurred without fear of retribution—is first and foremost vivid and commanding testimony of the failure of Communism. Or to state it in the affirmative, it represents a magnificent triumph of Capitalism, of Democracy, of market-driven economic order, of Adam Smith, Ayn Rand and Milton Friedman. As Alan Greenspan reflected, it is almost as if a great economic experiment had been undertaken some fifty years ago. "The world was divided into two," said the Chairman of the Fed, "on one side, there would be market-driven Capitalism, and on the other, a centrally planned economic order. Today we can compare the results."

The results are stunning. President Gorbachev himself admits the Soviet Union is suffering from "economic deadlock and stagnation." Or as reported by Irwin M. Stelzer, political columnist for the London Sunday Times, who succinctly sums up the situation in the USSR by quoting Nikolai Shmelev and Vladimir Popov, two prominent Soviet economic experts, "There is not enough of anything, anywhere, at any time." The inexorable result: An impending plan to dismantle central economic controls and move to free markets.

Tangentially, of course, the experiment was equally a triumph for the markets of futures and options. These markets are integral and indispensable to the economic order that demonstrated its supremacy over an inferior economic system whose structure and function is dependent on the edicts of government. Indeed, what markets better epitomize price determination by virtue of the free forces of supply and demand than do the markets of futures and options?

But the Red Square banner is testimony to still another truth, one that has even greater implications to the world of tomorrow. Let's face it, the failure of Communism is not news, it failed long before the autumn of 1989. What is news is that the populations that were hostage to this economic and political order suddenly had the temerity and courage to publicly denounce the system that had enslaved them. What is news is that the truth—officially kept secret within a world isolated by an iron curtain—was out.

Unquestionably, Andrei Sakharov, Mikhail Gorbachev, Lech Walesa and, no doubt, many others whose names historians will ultimately determine, deserve a substantial measure of the credit. These giants of human history forged a political environment that made the events of last autumn possible. However, with all due respect, their monumental achievement was not conceivable without the parallel consequence of yet another human endeavor: the inexorable march of technology. More than any other single factor, the telecommunications revolution—or what Walter Wriston dubbed the information revolution—made it impossible to continue the charade and hide the unmitigated bankruptcy of the Communist order. Modern communications techniques between people, coupled with massive media penetration in disregard of national boundaries, offered everyone a stark, uncompromising comparison of economic systems.

As journalist Mike O'Neil, years before the historic events of 1989, predicted: the consequences of the new telecommunications technology "is hurrying the collapse of old order, accelerating the velocity of social and political change, creating informed and politically active publics, and inciting conflict by publicizing the differences between people and nations." To put it another way, the technological revolution of the last decade made Perestroika inevitable.

Thus, as it has throughout the history of mankind, technology again is dictating fundamental change in our social structure and reshaping both the political and economic landscape of our planet. Its immediate impact on the populations of Eastern Europe is now an historical reality. However, the effects of the information revolution reach far beyond social and political change. As Dr. Carver Mead of the California Institute of Technology points out: "The entire Industrial Revolution enhanced productivity by a factor of about a hundred, but the microelectronic revolution has already enhanced productivity in information-based technology by a factor of more than a million—and the end isn't in sight yet."

Clearly, the consequences of the telecommunications revolution will be felt in every facet and niche of civilized life, and will dramatically change the nature and structure of financial markets. Already, what were once dozens of scattered national economies are inexorably becoming linked into one inter-related, inter-dependent world economy. It is, by now, a cliche to explain that sophisticated satellites, micro-chips and fiber optics have 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. Today's financial markets are worldwide in scope, ignoring geographic boundaries and time of day. Today, as Mr. Wriston stated, by virtue of the information revolution "we are witnessing a galloping new system of international finance "...one that differs radically from its precursors" in that, it "was not built by politicians, economists, central bankers or finance ministers...it was built by technology...by men and women who interconnected the planet with telecommunications and computers..." The consequences are global as well as regional and affect public as well as private financial policy objectives. That is good news for futures and options markets.

Indeed, the markets of futures and options were the first to read the handwriting on the wall and discern the meaning as well as potential of the new information standard. The financial futures revolution, launched in Chicago in 1972, blazed the trail for much of what has since followed in world capital markets. It established that there was a need for a new genre of risk management tools responsive to institutional money management and modern telecommunication technology, it led to the acceptance and integration of futures and options within the infrastructure of the financial establishment, it acted as the crucible of ideas for new off-exchange products, it became the catalyst for the development of futures markets worldwide, and it induced the introduction of risk management as a regime.

It is the latter consequence that will have the greatest impact on the use and expansion of futures and options markets during the coming years. Because more globalization, greater interdependence, instant informational flows, immediate access to markets of choice, more sophisticated techniques and intensified competition are the trends of the future, the management of risk is bound to be at the core of every prudent long-range financial strategy. Two decades ago, financial risk was apt to be defined by most in fairly simple terms as the possibility of suffering financial loss. At that time, it was doubtful that many thought of risk management as a discipline. Nor is it likely that many outside of academia or the actuarial business spent much time tinkering with mathematical models in order to weigh different strains of strategic exposure; that is, a firm's sensitivity to changes in tax rates, interest rates, exchange rates, the price of oil, and so forth.

Two decades ago, the identifiable risks were the rough equivalent of what Claude Rains in the final scenes of Casablanca told his lackeys: "round up the usual suspects." Farmers, for example, have always been at the mercy of the weather. Beyond that, there were all the usual insurable risks: fire, theft, natural disasters and so on. And recessions came and went. But at the end of the day, it was an era in which Treasury instruments yielded about 5 percent and foreign exchange rates were fixed.

Defined in the context of the world of commerce as we know it in the 1990s, risk is not merely a potential drought, earthquake, gas leak or even oil spill. In today's interdependent world—where two contaminated grapes are found in Philadelphia and, a hemisphere away, Chilean farmers suffer $100 million in losses as a result; where Europeans worry about growth hormones fed to cattle and American beef growers suffer the consequences; where Bundesbank monetary policy must be weighed right along with that of the Fed; where a head tax imposed in London can affect the corporate bottom line every bit as readily as a value-added tax levied by Washington; where a drop in the Nikkei average can trigger a decline in every other stock market in the world; where the U.S. budget and trade deficits impact not just the American economy, but the economies of all nations and all those who are business participants; where the third world debt is everyone's burden; and where every action in any part of the world is immediately known by everyone else, its impact swift, and sometimes (as in the case of Iraq's invasion of Kuwait) of critical significance—risk is radically more complicated, intensely more concentrated and devastatingly swift. Risk, today, is any one of a myriad of contingencies that could negatively impact an enterprise, thereby altering its value, its cash flow, or its future. And, since the implicit counterpart to risk is opportunity, the complexity of the world of tomorrow is good news for the markets of futures and options. Moreover, as Dr. Mead said, the end isn't in sight yet.

Futures and options markets are ideally suited for a world where innovation and competition will intensify, where demand for tailored risk management strategies will increase, and where opportunities will rapidly appear and disappear on a constantly changing financial horizon. Indeed, while in the coming years the lines between exchange-traded and off-exchange traded products may become somewhat blurred, no markets other than futures and options offer a blend of so many credible instruments to safeguard or enhance one's assets.

Consider for a moment the salient properties of futures and options markets—the widest array of agricultural and financial instruments, from beans to bonds, from cattle to crude, from stocks to silver, from euros to yen, from coffee to CPI; a measure of liquidity not available anywhere else; a cost-efficiency of incomparable narrow bid/ask spreads; an ability to swiftly institute a variety of strategies, programs, or fine-tuning techniques; the ability to cost-effectively adjust portfolio exposure by moving back and forth between securities and cash; a flexibility to choose between the most fairly priced alternative instrument at any time; a facility to preserve credit lines within a system offering the highest degree of credit-worthiness: a fluency to access all markets on a global basis; a speed and certainty of execution difficult to duplicate; and, soon, market coverage on a 24-hour basis—which represent a uniquely impressive array of components in the arsenal of tools imperative for the financial manager to possess.

There are at least two more profound consequences brought about by the technological revolution that have a material impact on the markets of futures and options as well as significant financial implications for the decade. First is the growth of institutional investment funds. Scientific and technological advancement have forced the world to become highly specialized, expertise-oriented, and professional—a trend that will not abate, but rather will accelerate, and is nowhere more obvious than in finance. In the United States, investment managers now represent over 23 million mutual fund shareholders and control a trillion dollars in assets for them. U.S. pension funds now total 60 million plan participants plus beneficiaries and hold $2 trillion for them, compared to only $400 billion a decade ago.

Investment and pension funds managed by professionals who apply complex strategies will increasingly dominate the markets. These managers will continue to invent investment techniques and demand instruments of trade—principally found in futures and options—that serve their needs. It is important to note that many trading activities will not be conducted relative to strict fundamental evaluations. With respect to equity investments in particular, portfolio management is likely to continue with the current trend of following index enhancement strategies—the 200 largest U.S. pension funds now have 30% of their assets committed to some form of indexation. These investment strategies may require adjustments to portfolios that sometimes cause price movements in individual stocks that bear little relationship to fundamental values. Thus, the debate between fundamental and technical investment philosophies will continue for the foreseeable future.

Moreover, financial management will continue to become increasingly more disciplined, professional and pre-programmed. To meet the demands of competition, financial engineering will become an exacting art form, and money managers will need to continuously refine and upgrade the process by which they make investment decisions. There will be no time to simply react during a moment of panic or pressure. To succeed in the coming decade, managers will have to employ precise blueprints and models for all eventualities. Investment strategies, protective hedging techniques, or decisions with respect to asset allocation will need to be in place long in advance of the time they are necessary. It goes without saying, professional management will need the most efficient tools, the know-how to use them, and the technology to apply them.

Second, the loss of dominance by American financial markets is striking and will continue to have a pivotal influence on money management. In the fixed income markets, the Japanese have become major participants. For instance, Tokyo's trading of Japanese government bond futures—which did not exist five years ago—is currently nearly twice as great in dollar value as Chicago's trading of U.S. Treasury bond futures. In 1988, Japanese investors accounted for 44% of the nearly $50 billion net foreign purchases of U.S. government notes and bonds. Similarly, the U.S. equity market is no longer the dominant force that it was years ago. In 1975, the U.S. accounted for 57% of the capitalization of world equity markets; today the figure is only 31%. Japanese investors alone represented nearly 30% of the $360 billion in U.S. stock transactions made by foreigners in 1988, while in 1983, Japanese investors accounted for less than 3% of the $135 billion in foreign transactions. And, bear in mind, the foregoing erosion of American market dominance occurred prior to the effects of "Europe 1992" and the revitalization of the emerging nations of the Pacific Rim, Eastern/Central Europe and the Soviet Union.

There are many significant national sovereignty consequences that will flow from this altered financial panorama, but one of the most profound effects on the U.S. will be that American businesses and their markets—no differently from foreign businesses and their markets—must adopt a global posture if they are to survive in the coming decade. "The multinational of the 1970s is obsolete," said Business Week in its May 14, 1990, issue. "Global companies must be more than just a bunch of overseas subsidiaries that execute decisions made at headquarters." Enter in its place: "the stateless corporation." A company that "does research wherever necessary, develops products in several countries, promotes key executives regardless of nationality, and even has shareholders on three continents."

And as Business Week might have added, enter also the risk management discipline. Because the international marketplace will no longer be dominated by a single nation as it was the last century, no international entity will continue to exist for very long unless it has mastered the ability to manage risk on a global scale. Market coverage will have to be world-wide as well as on a round-the-clock basis. As Business Week concluded, "in this world of transparent borders, governments and nations that fail to create the right climate will find their living standards and well-being short-changed. But those that can extract the benefits that stateless corporations can offer will emerge clear winners." Once again, this is highly constructive for the markets of futures and options. President Gorbachev knew this when he recently called for the establishment in the USSR of both securities and commodity exchanges.

Finally, one sobering caveat and one fascinating prospect: Obviously, crystal ball gazing is both difficult and dangerous. When one reflects that virtually nobody predicted the cataclysmic European events of autumn 1989 even days before they occurred—although they represented a happening that will totally reshape the world of the coming decades; when one considers that we ignored all warnings about Iraq's invasion of Kuwait until hours before it occurred—although the event portends financial upheavals reminiscent of the early 1970s with threatening consequences for all financial markets; one must make predictions only with a carefully defined set of qualifications and caveats. Indeed, in the volatile and rapidly changing world in which we live, there are few easy prognostications. Every prediction is subject to unforeseen events or forces over which we have no control.

Clearly, the international economic repercussions stemming from the upheavals in the Soviet Union and Eastern Europe cannot be underestimated. As Professor Joseph A. Grundfest, Stanford Law School, and former SEC Commissioner, recently wrote, "It is difficult to overstate the severity of the problems faced by the Soviet Union and its temporarily constituent republics, on either the political or economic front... As a practical matter, the economic condition of the USSR is indistinguishable from that which would exist had the USSR lost a conventional hot war—its economy has to be rebuilt from the bottom up and top down." The financial reverberations will undoubtedly be serious and global.

Even when focusing on only one segment of the revolution that swept over Europe—the reunification of Germany—we must conclude as did Professor Grundfest, that it "may well turn out to be the most significant single economic development over the short term economic horizon. Indeed, from a macroeconomic perspective, it can be compared to West Germany conducting a leveraged buy-out of East Germany, its physical plant, and its 16.6 million people." Can there be any doubt that such an LBO when coupled with the attempted emergence of neighboring economies will have profound ramifications to the financial future of all of Europe and beyond? Its economic consequences for the world at large cannot be estimated and must be viewed with extreme caution.

Aside from the foregoing, there are heavy clouds in the sky above us. "We enter the decade of the 1990s," writes Charles R. Hulten in May issue of The American Enterprise, "riding one of the longest economic expansions in our history. But far from being the source of great optimism, other economic trends are the cause of much gloom: America is no longer competitive, we save too little and are burying the future under a mountain of debt, the standard of living of many workers has not risen in a decade."

Indeed, the decade of the 1980s is often described as one of excesses. The world accumulated debt as if it was on a unlimited credit card. But as Milton Friedman taught us, there is no such thing as a free lunch. Debt must ultimately be paid and that process can be long and painful. When you add to the fragile and problem ridden state of the American economy the oil crisis which recently exploded in the Middle-East with its grave financial implications on the economies of the entire world, one cannot help but believe that a recession is certain, perhaps of a severity we fear to spell out. Even if the Iraqi-Kuwaiti oil crisis turns out to cause but temporary dislocations, more "fundamental financial forces are now inexorably pushing their way to the surface," says financial columnist John Liscio (Barron's, August 13, 1990). Fundamentals which are of a much more permanent and serious nature and a consequence of our decade long "unprecedented reliance on debt to fuel economic growth."

Alan Abelson, editor of Barron's, strikes an even more ominous tone (August 13, 1990) by suggesting that the coming recession will be "a credit-contraction recession," and quite different than the inventory recessions with which we are so familiar. "A credit recession", says Abelson, "is something there's no modern memory of, and hence one can only conjecture at its workings and its consequences. At worst, it would seem to encompass an unraveling of 30 years of debt abuse and entail, among other unpleasant things, an epidemic of bankruptcies. At least, it would be attended by more financial dislocation than we've experienced since the end of World War II."

Of course, not everyone subscribes to an America-in-Decline thesis or even to the gloomy picture portrayed by the global debt structure. States Herbert Stein, Senior Fellow, American Enterprise Institute, "The most important thing to know about the American economy is that it is very rich... in real terms, after allowing for inflation, the GNP now is six times as high as in 1929, and three time as high per capita...the GNP of the U.S. is probably two and one-half times that of Japan and five time that of Germany...Some people think that the U.S. is becoming poorer because Americans and their government borrow a good deal abroad. But actually Americans are becoming richer. The productive assets owned by Americans—at home and abroad—are rising much faster than their liabilities to foreigners."

The discussion continues, one that is of great relevance to us. The fortunes of futures markets, no differently from any other market sector, are highly dependent upon the state of national as well as global economic conditions. Should the U.S.—and thus the world—fall into a state of severe depressed economic activity, futures and options markets could very well suffer with the rest of the financial community. Of course, in the past somehow the world always seemed to muddle through, and, even if there are some rough years ahead, beyond them there is certainly a brighter tomorrow. Moreover, as in the case of Saddam Hussein's oil grab of Kuwait, world upheavals are often fuel for the fortunes of our markets and spell a continued and even greater demand for the features of futures and options.

As an unyielding consequence of the telecommunications revolution, the tomorrow we foresee will unquestionably include automated electronic systems for the execution of not only futures and options but every other financial medium including stocks, securities, options or cash market instruments. In this respect, true to their tradition, futures markets again blazed the trail.

Indeed, back in 1984, recognizing that the financial world was at the threshold of increased international competition as a consequence of Wriston's information revolution, the Chicago Mercantile Exchange (CME) became the first futures exchange to respond by establishing a mutual-offset arrangement with another exchange in another time zone—the Singapore International Monetary Exchange (SIMEX). And, not much later, the Chicago Board of Trade (CBOT), with the same purpose in mind, instituted an evening session for its U.S. Treasury bond futures.

Ultimately, however, both Chicago exchanges—as well as most of the others in the world—concluded that futures and options markets must make the giant leap toward automated technology if they are to respond to the demands of globalization. The breakthrough occurred in 1986 when the CME initiated its development of GLOBEX with Reuters Holdings PLC as a joint-venture partner. This revolutionary direction for our industry was irrevocably confirmed when the CBOT subsequently also set about to develop an electronic after-hours system. With the recent agreement between the CME and CBOT to unify their separate after-hours electronic trading systems, and with the Paris-based Marche a Terme International de France (MATIF) already a member of the same system, GLOBEX will become the premier international futures and options trading mechanism. Indeed, when GLOBEX becomes operational, it will automatically include over 50% of the world's financial futures and options business. Ultimately, GLOBEX envisions the linkage with a number of other world markets, affording these markets the capability to present their unique product lines on an international system.

GLOBEX represents the logical extension of the financial futures revolution that began in the early seventies. It is the only realistic response to the demands for an efficient and cost-effective capability for managing risk on a global basis. It will integrate the open outcry sessions of the regular business day with state-of-the-art computer-generated screen technology. It will offer the world a 24-hour risk management regime that includes all the vital features of futures and options markets—their products, liquidity, trade clearing capability and credit-worthiness. It will facilitate competitive prices, a centralized marketplace, access and a continuous flow of price information to the public. It represents the avant garde of the financial services arena and the precursor of market systems that will serve every segment of the financial world. In a word, 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.

Clearly then, as the old Chinese curse admonished, we live in interesting times. That is particularly true for those of us in markets, be they securities, options, or futures. Indeed, the markets developed in the United States over this century are at the epicenter of the cause which toppled the Communist order. They are at the heart of the reason why the American standard of living—its social structure, its potential for the future—are the envy of other nations and the quintessential component of any successful global economic system for the coming era.

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

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