TOMORROW'S TECHNOLOGICAL TIDAL WAVE

Presented at the Seventh Annual London International Finance Symposium Conducted Jointly by the Chicago Board of Trade and the Chicago Mercantile Exchange,
London, England,
November 7, 1991.

Barbara Tuchman said it well, "Men will not believe what does not fit in with their plans or suit their prearrangements." Thus, throughout history, industries have failed simply because they resisted change. There were many within the futures industry who loathed or opposed the integration of our futures transaction process with technology. They were fighting a losing battle from the start.

The impact of technology on the human race during the past two decades is impossible to fathom or quantify. Its inexorable march materially affected every aspect and nuance of civilization and the lives of the inhabitants of this planet. It would have been impossible to stand in its way or ignore its demands.

The next twenty years may prove even more dramatic. It is now quite clear that the technological world is on the threshold of a quantum leap in the application of capabilities that will once again materially change the face of civilization. Nowhere will this change be more dramatic or more consequential than in world markets. Futures markets must not stand in opposition or they will be left in the historical heap of industries that failed to embrace reality. Rather, they must anticipate and stand ready to apply the demands of this unceasing evolution.

Futures markets, as their name implies, should provide a glimpse into the future. However, in truth, they often don't. The future is habitually too clouded and burdened with too many imponderables to be seen clearly.

At the end of the Twentieth Century, we are in the midst of a global rebirth, one that should offer an unequivocal picture of a bright tomorrow—Communism was slain, the tyrannical order of the Soviet Union dismantled, East European nations freed, market economic order embraced by all, apartheid in retreat, emerging nations in the Pacific Rim, and the European Economic Union about to commence. But something prevents an unguarded optimistic prediction for the world. Perhaps because we know of the contradictory and uncertain nature of mankind, or because we know the steep price tag of all that lies before us, or because we are concerned that the global credit spree of the 1980s will demand payment in the 1990s.

Instead, allow us to stay clear of the unknown, to discuss the inevitable, and to predict that whatever ensues, the role of futures and options will be significant and that these markets are about to be engulfed by a technological tidal wave.

***

Robin Maxwell settled back and buckled the safety-belt around her as the British Airways 787 taxied out to the runway at Kennedy. She pulls from her briefcase an IBM IAM-Port, her interactive multimedia portable system, and turns it on. After the screen in front of her comes to life, she executes a few directions using the system's electronic mouse and is instantly connected to the Equity Information Center at her Goldman Sachs office in New York. A few more clicks on the mouse gives her the information she requested as well as an on-line data-feed to various markets around the world. Robin studies the information, then calls up a trader friend in Chicago, who appears on her on-line video screen for a brief discussion of her market theory.

As the airplane levels off at 55,000 feet, Robin checks the time in London, calls up for a GLOBEX connection on the screen, and initiates orders to buy December S&P 500 contracts on the CME, sell March FTSE contracts at the LIFFE and CAC-40 contracts on MATIF, a complex DAX/Nikkei options spread on the Deutsche Terminborse and Osaka exchanges, and to buy February U.S. Bond puts at the CBOT.

When she is finished with the transaction, Robin watches the market for a while, sends a fax to her London office, takes a sip of the coffee the stewardess provided, and asks her IAM-Port to review the current crop of plays showing in London so that she can make reservations for that evening.

***

Science fiction? Don't bet against it. Interactive multimedia—a multidimensional vehicle of communication representing the coalescence of key communications technologies: television, telephone, personal computers and laser storage systems—is coming. And when these technologies merge, life as we know it will never be the same. While Robin Maxwell's Interactive Multimedia system is not yet available, what is available is quite amazing: Robin can easily install a calling card that provides her with 24-hour real-time market information in stocks, futures, options, and mutual funds, or install a real-time spreadsheet system that will display, analyze and monitor continuously current financial data with electronic on-line datafeeds, or install a portfolio information management system designed to document and control transactions and positions in actively managed portfolios or funds, or install a software product providing a host of analytical calculations, regression analysis and exponential smoothing from single or multiple databases, or install software that provides daily investment performance calculations by account, currency, group, sector and industry.

These are not the esoterica of a future tomorrow but just a small portion of present day avant garde technology. A dozen years ago, these systems were the product of someone's over-active imagination; a few years ago, they were on programmers drawing boards; and today they are reality.

In 1972, the markets of futures and options were among the very first to discern the meaning—as well as the potential—of the forthcoming new financial age. The new technological standard, while then still in its infancy, would instigate an information revolution that would dramatically change the scope, nature, and structure of financial markets forever. As Walter Wriston then predicted, by virtue of the information revolution, we would be witnessing a galloping new system of international finance, one that differed 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 results were spectacular. Today, as a consequence, we live in one inter-related, inter-dependent world economy. Distinct divisions based on time zones have vanished. Geographical borders that once could limit the flow of capital are history. Internal national mechanisms that once could insulate ones' population from external price influences are impotent. Financial markets are now virtually unencumbered, continuous, and worldwide in scope.

The markets of futures and options understood the consequences of the new technology. And because our markets embraced and adapted to its demands, they have blazed the trail for much of what has since followed in world capital markets. We established that there was a need for a new genre of risk management tools responsive to institutional money management and modern telecommunications; we introduced the idea of risk management as a regime; we fostered the concept of financial engineering as a commercial necessity; we became the catalyst for the invention of a multitude of new products—both on and off the exchange; we promoted the acceptance and integration of futures and options into the infrastructure of the financial establishment; and we engendered the development of futures markets worldwide.

That was just the first phase. And while exciting and highly successful, it was only the beginning. For our markets are continuously evolving and the breathtaking speed of technological innovation is not likely to abate. What technology will bring in the very near future will again completely transform our marketplace and make trading unrecognizable from what it is today. What is coming is a computerized trading competence undreamed of but a mere decade ago.

Some of it is structural. Computer-aided systems engineering—CASE— represents a new wave in programming. CASE moves systems development away from its traditional art form and into the realm of science by applying engineering discipline and computer support to systems building. CASE allows software development to focus on solving business problems. Its applicability is boundless. The Paris Bourse, for example, used CASE to overhaul and streamline its clearing system in order establish a competitive edge in Europe. Similarly, Paine Webber—by enlisting CASE—will become one of the first wire houses to attempt to retool itself for the 1990s with a state-of-the-art distributed computer system that will provide round-the-clock on-line availability for trading, marketing, and customer data.

Some of it is being developed by the exchanges. For instance, the Chicago Mercantile Exchange and the Chicago Board of Trade are jointly developing systems to accept trading instructions from market participants worldwide that will be delivered electronically directly into the trading pits. Orders will be routed through the CME's TOPS or the CBOT's EOS system for electronic switching to the proper pit broker who will then utilize a computerized broker's work station to organize and instantly report trade status back to the customer. Independent traders in the pits will utilize the latest innovations in hand-held technology with which to do their proprietary trading and to instantly report their trades for clearing. AUDIT terminals will use advances in pen-based hand-held computers including hand print recognition. But most of it is in software. Intelligent agents will reside in computers to create a world we can hardly envision. Craig Torres of the Wall Street Journal recently reported that during the past five years, major American market participants have spent millions of dollars to advance their computing potency. Indeed, one estimate says U.S. securities firms will spend some $7.5 billion on technology in 1991. Firms such as Morgan Stanley, First Boston, O'Conner & Associates, Salomon Brothers, Kidder Peabody, Goldman Sachs, and others are using automated development tools to build new software programs. They are venturing to achieve a new generation of analytics—sophisticated mathematical computer models that act as giant think-tanks to identify hundreds of never-before-imagined trading strategies in securities, futures, and options.

Though the trend is still in its infancy, its direction is unmistakable. Until now, computers were used mostly as spreadsheets, as fast calculators, to analyze risk, or to run accounting and other programs. In the coming age, computers will no longer act within the framework of their traditional competence, they will have gained artificial intelligence. The next generation of analytics—currently being developed at sophisticated research laboratories— seek to apply new financial theories that allow the trader to apply them to markets on an on-going basis. The evolving mathematical formulas will imitate the way in which traders think and look at markets—but at several thousand times faster than humans. A new supercomputer has just been unveiled that runs at a speed of one teraflop, a trillion floating point operations per second.

Computers are on the verge of generating a wave of pristine trading strategies that will offer heretofore unheard of opportunities. Computers are searching for price correlations and connections between markets that traders never thought possible—or never thought about at all. Computers will invent virgin tactics within a complex set of transactions inconceivable for the human mind to have perceived. Computers will create synthetic options and futures far beyond human imagination. Computers will find ways to blend these new analytical transactions with traditional strategies to produce even more complex possibilities. And while the bulk of the new wave of technological transactions will be utilized off-exchanges—within the cash markets—the markets of futures and options are bound to be substantial beneficiaries as well.

For example, computers recently created a synthetic option on the Nikkei Index by combining Nikkei stock index futures and exchange-traded stock index options. The synthetic Nikkei option cost less than the real option and allowed the traders who recently used it to make $500,000 on a single trade. In another example, a managing director of a major securities firm recently created a 2-year option that gives an investor the right to buy the S&P 500 stock index at its lowest point of 1991 in Swiss francs. Without analytics such products could not even be imagined.

IBM's mathematical sciences department—very much involved in the development of analytic market math—is working on a mathematical model that will allow investors to assemble hundreds of portfolios in seconds and have various shadings of investment risk and reward. Anticipating a constant 24-hour market, IBM has also been working on a mathematical model for the past two years that will scan the trading pattern of stocks or bonds around the world and around the clock. Says the department's director, "time shouldn't be measured by how the clock ticks, but by the level of trading activity." By creating a model that uses trading activity as a measure of time, IBM hopes to create a new vantage point for spotting price trends.

As one would expect, competition in this emerging field will be fierce. Every new analytic is a most closely guarded secret. The only proprietary component for the inventor is the mathematical formula he devises which offers unique profit opportunities in markets that are extremely efficient and extremely competitive. Consequently, while many of the major firms are working feverishly to develop analytic competence, most of it is behind secured doors. But the secret is out anyway. New computer-generated mathematical analytics are coming whether we like it or not. Says Myron Scholes of the coming new age in trading, "people who don't have analytics are going to be relatively obsolete."

Not only will analytics achieve a myriad of new trading opportunities, they will also result in a myriad of new regulatory concerns, issues, and problems. How will these new transactions be regulated? Will they be regulated? Can they be regulated? What dangers do they pose for the financial structure of the world? Can the financial risk of innovations applied to off-exchange instruments on a global scale be accurately measured or assessed? Does this not pose a great unknown financial risk to the international banking community? Those are legitimate and important issues yet to be recognized by the federal regulatory bodies of the world and the traditional exchanges. Very few understand the full scope and nature of the coming technological tidal wave.

The new technological trading competence will be structured to capitalize on the coming global 24-hour market. The revolutionary GLOBEX concept fostered by futures markets has now become part of the status quo even for the securities markets—and before our own international system is functional. Consequently, the New York Stock Exchange is moving in the desired direction with after-hour trading sessions, the Nasdaq International (a trading system for U.S. stocks on an electronic screen) has been launched, the Japanese Over-the-Counter market is launching a similar system, the Italian securities market is leaving the traditional open-outcry stock trading for computerized screens, and there are similar systems at LIFFE, MATIF, the Sydney Futures Exchange, TIFFE, SOFFEX, and the Deutsche Terminborse springing up all over the world.

The forthcoming technological age—when combined with greater globalization, instant informational flows, 24-hour trading, immediate access to markets of choice, and intensified competition—offers immense opportunities for the markets of futures and options. In such a world—where financial risk is constant, financial volatility is commonplace, innovation is rewarded, financial engineering is prized, opportunities rapidly appear and disappear on a constantly changing financial horizon, demand for unique risk management strategies will increase, and professional management will continue to demand efficient instruments of trade—the role of futures and options is fundamental.

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

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