Wake Up Call¹

Presented at the International Association of Financial Engineers
November 9, 1995
New York, New York

Reprinted in the December 1995 issue of
The Journal of Financial Engineering

We are at an unprecedented moment in the evolution of finance and markets. We find ourselves at the vortex of three primary crosscurrents that have converged to create some turbulent waters and whose resolve is still uncertain. The rush of these currents has been extremely rapid and has advanced upon the world at nearly the same time. Their remarkable history is quite recent and still very fresh in our memory.

First came globalization. Walter Wriston, the former chairman of Citicorp, sensed it early. In 1985 he told us we were witnessing a “galloping new system of international finance,” one that was not built by politicians, economists, central bankers or finance ministers, but by men and women who interconnected the planet with telecommunications and computers. As a result, Wriston stated, the world had replaced the gold standard with the information standard.

Indeed it had. Our separate financial existence was transformed into one interrelated, interdependent world economy. Geographical borders that once could limit the flow of capital are history. Internal national mechanisms that once could insulate a population from external price influences are increasingly impotent. Financial markets have become virtually unencumbered, continuous, and worldwide. A company located anywhere in the world can use resources located anywhere in the world, to produce a product anywhere in the world, to be sold anywhere in the world.

Second: political. As Nobel laureate Milton Friedman predicted, the free economic precepts of Adam Smith combined with the principles of political freedom espoused by Thomas Jefferson have resulted in an unmitigated triumph of market-driven economic order over central planning, of capitalism over communism, of democracy over dictatorship. The world experienced the incredible might of these two ideals as together they seemingly overnight forced the unification of Germany, the liberalization of Eastern Europe, the fall of communism, the collapse of the Soviet Union, and the dissolution of apartheid.

This political/economic transformation has propelled virtually every nation in the world to move to a market-driven economic order. It is a unique historical happenstance. For the past 20 years when we spoke of a global economy, we were only talking about 25 percent of mankind—mostly North America, Western Europe, and Japan. As recently as 1988, almost 70 percent of mankind was living under Marxist or socialist economic systems. Suddenly, there are 3 billion more participants in the capitalist system. Suddenly, every country on the planet is a competitor in the global marketplace.

Third: microdynamism. This is a word I made up to explain that the world has moved from the big to the little. In physics we traveled from General Relativity to quantum mechanics. We went from contemplating atoms to inspecting their nuclei and discovering quarks and leptons. Particle physics was upon us. Similarly, in biology scientists migrated from examining individual cells to peering within their structure and ushering in the era of gene engineering. Molecular biology was born.

This microdynamism and downsizing can be seen in every aspect of our lives. Today’s personal computer, small enough to be stored in a briefcase, can do much, much more than the UNIVAC, the world’s first computer, which required an entire room to be housed. We wear much lighter material that is warmer and stronger than the bulky clothing of previous eras. Fiber optic cables are replacing mountains of copper wire. Transistors transformed the radio and a myriad of other electrical appliances into handheld devices. Microprocessors miniaturized the entire technological world and keep getting smaller and smaller. And on and on.

In markets, the evolution was strikingly similar. When advancements in computer technology were applied to established investment strategies, the result was remarkable. Just as it did in the sciences, market applications went from macro to micro. Intricate calculations and state-of-the-art analytical systems ensued, offering financial engineers the ability to divide financial risk into its separate components. Derivatives—the financial equivalents to particle physics and molecular biology—were born. Investment methodologies were transformed from all-encompassing traditional strategies to finely tuned modern portfolio theories. Long-term hedging evolved into continuous online risk management.

The foregoing three primary crosscurrents, coupled with a swarm of secondary flows, have converged to create our present financial market environment. It is unique to history. It is still undefined and not understood. It is volatile and dangerous. At times the whirlpool is smooth and easy to anticipate. Suddenly it is vicious and unpredictable. Markets go up with unrelenting force, only to turn without warning and collapse without end. Participants find inventive ways to cash in, only to be caught in unsuspecting savage traps. Rogue traders unearth ingenious techniques to deceive or cheat as traditional controls are found antiquated or woefully inadequate. Market regulators, along with business managers, seem helpless and off guard.

What shall the world do? Condemn the events that produced the turbulence? Curse the reality of the present? Outlaw the markets? Restrict price movement? Ban futures? All of the above?

We can neither expunge the history that brought us to this fate nor prevent its ultimate resolve. We are in the midst of a great transformation. We are negotiating an unknown expanse between a world we knew and the one we know not. We are on a gigantic bridge between past political arrangements, past economic orders, past technical capabilities, past market applications, past internal controls, and a new reality.

We are yet insufficiently conversant with the new order, its dimension, its demands, its potential, to write the rules. If we act in haste to severely harness the currents, rigorously restrict its flow, or sternly direct its course, we take the risk of creating conditions far, far more dangerous than what is naturally in store for us. If we so fear the computer that we adopt a Luddite philosophy, if we so recoil from Procter & Gamble, Orange County, Metallgesellschaft, Barings Bank, Daiwa Bank, or similar debacles yet unknown that we enact Draconian rules to prevent their occurrence, if corporate boards shrink from the use of futures because of fears of consequential losses to their corporate bottom line, civil actions by shareholders, or sanctions by regulators, then at best corporate profits are headed south, and at worst Western civilization has hit its top.

At this juncture in the transformation, while we dare not ignore the dangers it has engendered, we must not cower in its presence. Just as we found it impossible to curtail the developments in gene engineering, so we will discover that financial engineering also cannot be stopped. Instead, we must be prudent and vigilant. We must set standards, benchmarks, and especially internal controls. We must heed the lessons we have learned and adopt the prescriptions that are warranted. We must enforce the recommendations of such forums as the Group of Thirty, the Windsor Declaration, and the FIA Global Task Force on Financial Integrity. We must observe and learn and intensify our education process. Risk management implicitly must include risk enlightenment.

And, above all, we must be realistic. There are but two certainties. Neither is surprising. First, that the metamorphoses I described are unending—by definition evolution is a continuing process, whether in physics, biology, or markets. Second, that the unmistakable common denominator of recent crosscurrents has been technology. Indeed, throughout the ages, technology has consistently been the foremost force in dictating fundamental and revolutionary change in the political and economic landscape of our planet. In the past decade, the technology of telecommunications forced a stark, uncompromising examination of political and economic systems, bringing down state-controlled economics and racial inequalities, while the technology of computers enabled physicists, biologists, and financial engineers to peer into the smallest detail of our structure and manipulate its makeup.

Clearly, the introduction of fire brought about a profound change in the life of our species, as did the invention of the wheel, electricity, the printing press, and the industrial revolution. But events speeded up. The technological revolution of recent years was of a larger magnitude and came upon the world in a shorter time span than ever before experienced. At an unprecedented pace that continues to accelerate, technology has produced, and continues to produce, fundamental changes that reverberate through every facet of our civilization, but nowhere more than in financial markets, where the transformations have been spectacular, global, and absolute.

There are still within our markets those who would ignore these realities. These souls are simply following historian Barbara Tuchman’s prediction that “Men will not believe what does not fit in with their plans or suit their prearrangements.” Pity! For no longer is there a valid debate on the subject. Anyone who is still skeptical about the direction we are headed is simply deaf to the thundering maelstrom of the technological avalanche around us. Anyone who had not seen the handwriting on the wall is blind to the reality of our times.

One can no more deny the fact that technology has and will continue to engulf every aspect of financial markets than one can restrict the use of derivatives in the management of risk. The markets of the future will be automated. The traders of the future will trade by way of the screen. Those who dare ignore this reality face extinction. Round-the-clock electronic information in stocks, futures, options, and mutual funds is now commonplace. Real-time spreadsheet capabilities which display, analyze, and monitor current financial data with electronic online data feeds are old hat. Portfolio information management systems designed to document and control transactions, provide real-time positions, P&L, and credit limit updates are routine. Electronic alerts, predetermined target prices, complex option spreads, currency conversions, and volatility cones are now standard trading applications. Software products providing a host of complex analytical calculations, multidimensional charts of theoretical pre-expiration curves, historical comparisons, projections, regressions, and exponential smoothing from single or multiple databases are abundant. Risk analysis modules providing a snapshot of the portfolio under varying market circumstances are standard. Support programs for exotics such as average rate, chooser, corridor, digital, double digital, dual, lookback, quanto, and trigger/barrier options are available. There are even computer trading systems that anticipate and incorporate the human thought process of traders, so-called artificial intelligence. And there are much, much more. For the information standard has become the information superhighway. There are 37 million users of the Internet on the North American continent alone.

In the 1970s and 1980s, futures markets led the way. We recognized that to survive competitive pressures, we had to embrace new technologies and integrate them with open outcry. To compete globally, we recognized that telecommunications was fashioning a global marketplace that would necessitate electronic trading mechanisms. Proudly, in 1987 the Chicago Mercantile Exchange membership overwhelmingly approved Globex. It was the first embrace of an electronic screen-based system for futures anywhere in the world. And almost on cue, the Globex pronouncement resulted in a virtual torrent of electronic systems devised either to extend existing trading hours or to conduct the entire transaction process.

The following year, the Chicago Board of Trade, the Tokyo Stock Exchange, the Osaka Securities Exchange, the Copenhagen Stock Exchange, the Danish Options & Futures Exchange, the Swiss Options & Financial Futures Exchange (SOFFEX), and the Tokyo Grain Exchange all launched automated electronic systems. The next year, the Irish Futures and Options Exchange, the Tokyo International Financial Futures Exchange (TIFFE), the London International Financial Futures Exchange (LIFFE), and the Sydney Futures Exchange (SFE) initiated similar systems. By the end of 1991, ten more exchanges followed suit, including the Deutsche Terminbörse (DTB), the London Futures and Options Exchange, the Swedish Options Market, the Finnish Options Market, and the Mercado Español de Futuros Financieros (MEFF). Indeed, except for Brazil’s BM&F and the MATIF in Paris, all new futures exchanges built since 1986 are fully automated.

Alas, in recent years, the process toward technology in futures markets seems to have come to a screeching halt. Suddenly, our market establishment reverted to establishment ways. The evidence to support this conclusion is overwhelming. While Globex volume statistics are growing, they are still pitifully small and the system itself has become enveloped in politics. It still accounts for only 1 percent of the Merc’s annual volume. That is about the same percentage as the ACCESS system of the NYMEX. The LIFFE APT system does a little better with about 3 percent of its annual volume, and the MATIF has done much better. Its Globex volume has grown from 5.5 percent in 1993 to 8.7 percent in 1995, proving that technologically the system is sound. Similarly, Sidney’s SYCOM system has grown from a 5.1 percent of its volume in 1993, to a 1995 total of 8.9 percent. In contrast, the evening session of the CBOT is losing volume, from 1.6 percent in 1993 to a projected 1.1 percent in 1995.

The low level of screen-based transaction volume on after-hours exchange systems gives testimony to a lack of understanding by many futures exchanges that—like it or not—a screen-based transaction process is in their members’ future. While it is comforting to know that the mass of futures liquidity is still on the floor today, it represents a false security blanket. Foreign exchange, a market institutionalized by futures exchanges, offers a stark and sobering comparison between electronic-driven volume and open outcry. The average daily FX turnover measured in U.S. dollars was approximately 200 billion in 1986 compared to 1 trillion in 1995, a 500 percent increase. In the last several years, the world experienced the wildest swings in FX prices ever recorded, accompanied by huge increases in transaction volume. According to figures recently released by the Bank for International Settlements (BIS), the turnover figures for major forex centers in cash markets between 1992 and 1995 (on a net basis, with data adjusted for double counting) shows a whopping increase of 60 percent in London, 46 percent in New York, 34 percent in Tokyo, 43 percent in Singapore, 30 percent in Switzerland, 49 percent in Hong Kong, and 40 percent in Germany. However, CME foreign exchange contracts did not benefit from this growth. It registered a mere 9.5 percent increase in volume in 1993 and another 6-plus percent increase in 1994. While admittedly some of this OTC volume can be attributed to exotics not traded on the exchange, one must accept the fact that OTC screen-based technology is an extremely attractive medium for FX market transactions.

Indeed, it is estimated that overall electronic order matching in foreign exchange has grown from virtually nothing in 1992 to over one-half of FX transactions in 1995. Reuters Holdings revenue from electronic transaction products in both equities and FX experienced an increase of 165 percent from 1990 to 1994. Its Instinet Corporation—whose affiliates are members of 15 exchanges and trade equities in 30 countries^—did 20 percent of the Nasdaq’s daily volume in 1994. Its 1995 volume shows transactions of 1 billion shares per month. Meanwhile, Reuters Dealing 2000–2 averaged as much as 20,000 FX trades per day in 1995, double its volume over the last four months. And Reuters is no longer alone. Electronic Broking Services (EBS), the consortium made up of some of the world’s largest banks and FX dealing institutions—ABN-AMRO, Bank of America, Barclays, Chemical, Citibank, Citicorp, Commerzbank, Credit Suisse, Lehman Brothers, Midland, J.P. Morgan, NatWest, Swiss Bankcorp, and Union Bank of Switzerland—has also come of age. EBS reported that daily volume has risen from 2,000 a year ago to 10,000 recently. Third in line is Minex, a two-year-old Asian consortium backed by Dow Jones/Telerate, Tokyo Forex, and KDD among others, which already accounts for 20 percent of all FX brokering in Tokyo and is doing well in Hong Kong and Singapore.

The global trading day begins in Tokyo and Sydney and is virtually unbroken 24 hours a day, as it moves around through Singapore and Hong Kong to Europe and finally the United States before starting again in Japan. How can the open-outcry hours of any single exchange hope to capture a significant portion of such business without a continuous screen-based system? Not to mention the fact that the fraud perpetrated on Barings and Daiwa Banks would have been near impossible in any automated trading system or within an electronic data management environment.

While I do not advocate turning off the lights on existing trading floors—that would be unforgivably stupid—it is equally suicidal not to seriously prepare for a technological tomorrow. Whatever progress there has been in recent years was at a snail’s pace. In almost every critical area of advanced technological competence, exchanges with trading floors have fallen behind. For instance, LIFFE is the only exchange with real-time clearing capabilities. Futures exchanges are far behind securities exchanges in automatic order routing. No futures exchanges have advanced capabilities for floor communications with brokers and have limited capabilities for handheld price reporting. Only the CBOE has developed a system for handheld terminals. No futures exchanges are developing automatic small-order execution systems. Use of electronic books in the transaction process can be found only at securities exchanges.

And everything within the technological revolution of the last two decades—which produced the present information standard and transformed the world into what we know today—is about to become old if not obsolete. For technology is poised once again to take a quantum leap. The computers that Walter Wriston wrote about and that wired the world in the mid-1980s are about to go wireless in the mid-1990s. Satellites will soon allow wireless communication from anywhere on the planet. When this wireless transformation goes into high gear—over the latter half of this decade—we will literally transfer information over thin air.

Today’s cyberwizards have combined the sorcery of electrical and electromagnetic waves, and propelled them at the incredible speed of 300 million meters per second, about three-quarters of the way to the moon with every second. In doing so, they have produced an invisible wave of energy that can carry a computer command, the human voice, or virtually any program including market information, quotations, analysis, and orders from anywhere to anywhere. The new technology will create a world in which applications impossible with wires will result in not just a series of new technological marvels but a spectacular lifestyle emancipation.

By unplugging us from existing infrastructures, networks of information, and communication hookups, we will suddenly have many more choices about where we live, work, or how we trade. This new freedom of wireless communications can be best illustrated with how the simple pager is already transforming our lives. So-called alphanumeric pagers with small LCD screens can show not only a phone number but a complete message. By the end of this year, a so-called bidirectional pager will enable us not only to receive e-mail but to acknowledge these messages by choosing one of the 100 set responses. Think of the possibilities for trading, if the response is buy or sell and is linked into an automated trading system.

Millions of people in African countries are sidestepping their backward infrastructures with cellular phones. Many millions more in China are already using pagers to communicate in places where no wired telephone network exists. Nor will we be limited to the telephone boundaries of today’s cellular capabilities. New phone networks, operating by way of satellites, will begin providing round-the-globe service later in this decade. Without the limitation of land-based antennas, everyone on the planet, and especially market traders, will be able to trade from places never before thought possible. Are today’s exchanges preparing for this world?

Futures markets take heed! Complacency is the enemy. Tomorrow’s futures traders grew up with Nintendo and Sega. They were given a keyboard for their fifth birthdays; their homework was done on a computer; their recreation time was spent in video centers; the World Wide Web was their playground; Cyberspeak is their language.

When the current transformation process has been completed, when we have crossed the bridge to the new reality, when the new set of rules has been written, futures will still be a primary way to manage financial risk, but it will be carried out on the information superhighway. Tomorrow’s traders will likely execute a complex set of trades from an interactive multidimensional wireless communication system representing the coalescence of key communications technologies: television, telephone, personal computer, and laser storage systems. The only question remaining is whether those trades will still be transacted on our futures exchanges.

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