FUTURES MARKETS IN AN E-COMMERCE WORLD
Canadian Annual Derivatives Conference
October 15-17, 2000
It is no secret that the combined onslaught of globalization,
Over-the-Counter (OTC) competition, and technological advancement, have put enormous
pressure on traditional futures exchanges. Indeed, in some quarters, there is a growing
belief that the good days for traditional exchanges is behind them. It is thus imperative
to examine the state of affairs and attempt a look ahead. Allow me to begin with a brief
As history buffs know, organized futures exchanges had their
origin in Japan. It was during the Edo period (1600-1867) that centralized futures markets
were born. In Osaka, the "Kitchen of the Nation", feudal lords established
warehouses to store and sell rice that was paid to them as land-tax by their villagers. To
protect themselves from wide price fluctuations between harvests, these merchants did the
sensible thing. In 1730 they established the first organized futures exchange, the Dojima
Rice Market. Prices were protected by futures contracts and Osaka became the leading
commercial city of that era.
The fundamental principle of futures markets, however, that they
can be applied exclusively to agricultural products, remained unchanged for the next two
centuries. It was not until 1972 in Chicago that futures markets were applied to financial
instruments. This revolutionary experiment worked beyond anyones imagination. In the
words of the late Merton Miller, the 1990 Nobel Laureate in Economics, the launch of
financial futures represented "the most significant financial innovation of the last
twenty years." Today we know that these instruments of finance, in currency, treasury
bills, gold, eurodollars, US bonds, federal funds, oil and gas, stock indexes and so on
changed the nature of risk management in business and ushered in the modern era of
finance. With the advancement of computer technology beginning in the mid-1980s, these
futures contracts served as the cradle from which sprang todays giant financial
derivatives marketa market that is currently estimated at $80 trillion in
Alan Greenspan subscribes to the importance of financial
derivatives. "By far the most significant event in finance during the past
decade," said the chairman of the Fed a few years ago, "has been the
extraordinary development and expansion of financial derivatives....These instruments
enhance the ability to differentiate risk and allocate it to those investors most able and
willing to take it.....a process that has undoubtedly improved national productivity
growth and standards of living."
Clearly, the chairman of the Fed believes that the need for risk
management in business will not diminish in an e-commerce world. Indeed, as globalization
and technological efficiencies increase competition and lower per-transaction profits, the
necessity to reduce risk exposure by hedging activities in interest rates, currency,
equity or commodities will increase. But as previously noted, the world is in a major
transformation. With a growing demand for efficiency and speed of executions, with an
expanding universe of electronic communication networks, the so-called ECNs, and with the
advent of ever-bigger institutions of inordinate financial strength, whose OTC
capabilities and global reach is awesome, is there a role for traditional futures
exchanges? In other words, can the old fashioned resources of futures markets viably
compete in a world where the Internet has removed all borders from global transactions?
Tough question. Surprisingly, as you will soon see, the answer is clearly in the
affirmative, but just as clearly, it is qualified. To remain viable will require dramatic
and speedy changes in the makeup of traditional exchanges.
I make the following three assumptions: First, that hedging
activities in risk management will flow to the marketplace that is the most liquid. It is
axiomatic that market users tend to shun markets that do not provide certain entry and
exit. Second, that markets providing the widest distribution network together with the
most functional and efficient technology at the lowest cost will be the most attractive.
In other words, global electronic distribution of market instruments coupled with
technological competence will rule the day. Third, that market participants will gravitate
to the marketplace that provides efficient and financially secure clearing and settlement
procedures. The virtue for financial security in the clearinghouse needs no elaboration.
There you have it. While clearly there are other requirements for
success in the e-commerce world, the foregoing three principles will dominate in
determining which exchange, which marketplace, or which ECN will win the race in the
Twenty First Century. I submit that traditional futures exchanges have most of the
necessary elements in place to succeed if they act quickly and decisively, and if they can
overcome their inbred opposition to change by virtue of establishment influence. To begin
with--they already posses huge pools of liquidity. Whether it is with respect to short
term interest rates transactions such as Eurodollars rates at the Chicago Mercantile
Exchange (CME) and Singapore International Monetary Exchange (SIMEX), or the Euribor rates
at London International Financial Futures Exchange (LIFFE), or Euroyen rates at the Tokyo
International Financial Futures Exchange, (TIFFE), or with respect to long term rates such
as in U.S. bonds at the Chicago Board of Trade (CBOT), or in JGBs at the Tokyo Stock
Exchange (TSE), or in German Bunds at Eurex, or with respect to equity products such as
S&P and NASDAQ contracts at the CME or equity options at the Chicago Board of Options
Exchange (CBOE), or with respect to energy products at the New York Mercantile Exchange
(NYMEX), or other instruments in finance such as here at the Montreal Exchange, these
traditional exchanges are still the primary locale for immediate and certain liquidity.
They provide the user with a constant flow of bids and offers virtually any time of the
day or night.
But they are no longer alone. The Over-the-Counter sector has
come on strong, offering a wide range of derivative products to its natural customer base.
Better than two thirds of the $80 trillion outstanding derivative contracts were executed
in an OTC venue. Swaps are today the instrument of choice when it comes to hedging of
risk, and the worlds biggest financial firms or banks have captured the lions
share of this expanding market. Indeed, less than a dozen world banks, mostly U.S., hold
95% of all reported derivatives transactions. It is an open question whether this
concentration of risk poses any special problem. In truth, however, the OTC dealers have
been assisted by the fact that the futures markets are always available and act as a giant
security blanket for their own exposure. Bottom line, with respect to liquidity, while
traditional exchanges have a running start and still have much to offer, they no longer
have a monopoly in this regard.
The second requirementdistribution and technological
competencerepresents a highly complex subject. To do it justice would require much
more time than allotted here. I can provide but a brief summary of the state of
affairsit is not favorable to futures exchanges. In a nutshell, most of the
traditional exchanges are far behind modern-day technological demands. At the CME, for
instance, while its GLOBEX system was first in the world, and while its technology has
recently become much more viable, its Paris based NSC system has not yet completed its
goal to provide the functionality necessary in a global network. Eurex, on the other hand,
claims superior technology, but their recent launch of CBOT bonds without the ability to
stay open during much of the Asian time zone represents a major defect and casts a doubt
on this claim. LIFFE also claims technological superiority but that too is an open
question. LIFFE has a limited product-line and virtually no distribution outside Europe.
The Swedish OM Gruppen is also in the mix, but no major derivative exchange is using its
platform. At many other exchanges, like those in Japan, there still is no viable
electronic system that can compete on a global scale whatsoever.
So clearly, if traditional exchanges are to stay alive they will
have to quickly meet global technological demands. That requires huge sums of money, the
kind of money that is usually available only within very large financial entities or the
public sector. It is the very reason why nearly every traditional exchange is in the
process of or considering de-mutualizing. In other words, abandoning their membership
structure in favor of becoming a for-profit entity with an ability to go public or offer
equity to a potential partner in return for technology. LIFFE and Eurex are already there.
In the U.S. the CME is the first major exchange to take this step and is now awaiting
final governmental approval to proceed. The NYMEX and the CBOT are similarly following
The need for distribution is also the reason why many exchanges
have created alliances and continue to create alliances with other exchanges, be it in
equities or in derivatives. Global alliances, bilateral or multilateral, can theoretically
serve as a means of quickly achieving a distribution network for marketing of products.
Again the competition is brutal and the decision with whom to forge an alliance is
critical. For instance, the CME has achieved a measure of success with its GLOBEX alliance
which already includes derivative markets in Singapore, France, Spain, Canada (the
Montreal Exchange), and Brazil. The CME has also forged a separate special alliance with
LIFFE. The Eurex alliance includes the Swiss derivatives products as well as bonds at the
In European equities markets the definition of alliances is still
up in the air as a battle rages for dominance between a variety of national stock
exchanges. The proposed creation of iX was intended to create the first pan-European
equity market from a merger between the London Stock Exchange (LSE) and Deutsche Boerse.
That proposition recently blew up under the weight of opposition within Great Britain and
the hostile takeover bid made by OM. As a countervailing force, Euronext was opened in a
merger between the stock and derivatives exchanges of Paris, Amsterdam, and Brussels, and
Euronext too has its sights on the LSE. Meanwhile, some large securities houses (Merrill
Lynch, UBS Warburg, Morgan Stanley, etc.) created Tradepoint Financial Networks as an
electronic market based in London that is also intended to represent the first
pan-European share exchange. To add to the confusion, the NASD is trying to form its own
European alliance with the LSE and Deutsche Borse, while LIFFE proposes that LSE join
them. Not to be left out in the cold, there is the proposed Global Equity Market, the
so-called GEM alliance, that is led by the NYSE and includes ten world exchanges,
Australian, Euronext, HKSE, Bolsa Mexicana de Valores, Bolsa de Valores Sao Paulo, Toronto
and the TSE. In the meantime, in Asia, the NASD initiated a variety of bilateral alliances
including Nasdaq Japan which represents a partnership between NASD and Softbank.
Obviously, every derivatives and equity exchange has realized that in the Internet world
no exchange can afford to remain an island unto itself.
With respect to the third critical requirementclearing and
settlement capabilitythere is little doubt that traditional exchanges have the
dominant advantage. To begin with, there are but a handful of major credible derivatives
clearinghouses throughout the world. They are mostly tied to or owned by traditional
exchanges, each with some distinguishing features. In Europe, for instance, there is the
LCH, the clearing entity tied to LIFFE, Clearstream, the clearinghouse partially owned by
Deutsche Boerse, and Clearnet owned by the Paris Bourse. In the U.S. there is the CME,
BOTCC, OCC, NYMEX, and GSCC. There are of course other clearing entities which serve some
of the smaller equity and derivatives exchanges around the world. I may be somewhat
biased, but I would submit that the CME clearing system, with its so-called Clearing 21
technology that is fast becoming a global standard, with its ability to clear trillions of
dollars annuallylast year it cleared 201 million transactions totaling $138
trillionwith the fact that it is fully owned by the CME, and its 100 year history of
faultless clearing experience stands above its competition. But regardless of which is the
best, with respect to this most critical component, existing exchanges have a commanding
lead. More about this attribute in a moment.
From the foregoing brief overview, it should be evident that the
potential for traditional futures exchanges to succeed in the world of e-commerce while
daunting is quite real. Toward this goal, there is one additional evolutionary change that
is worth mentioning. That e-commerce has spawned and will continue to generate a great
number of new business models and opportunities is too obvious a fact to discuss. But
among these new market paradigms, the so-called B2B, business to business exchange, is
most prominent. Every major sector of the business arenabe it in chemicals, energy,
electricity, paper, or real estate, and so forthis striving to create the definitive
exchange on the Internet. In other words, aspiring to become the predominant space for its
industry and thereby attracting the majority of trade that deals in its product-line on a
global scale. To state that the prize is huge and that the competition is fierce is the
understatement of the new century. Some have estimated the total potential of B2B business
as high as $10 trillion. It is believed that those exchanges that succeed will dominate
their industry worldwide. Alas, while many will try, only a few will actually succeed.
How does this development impact traditional futures exchanges?
We believe it offers an enormous opportunity for them. To be successful, B2B exchanges
need precisely the capabilities futures exchanges possess. First, exchanges possess the
ability to create the instruments of trade that will bring traders and therefore liquidity
to a potential B2Bs space. After all, who better than a futures exchange is there
with established expertise in creating instruments of trade that are necessary in the
business of a particular market sector. That is precisely what these exchanges have been
doing for the last hundred years. More important, however, is the need of a B2B to offer
credible clearing and settlement procedure. Without competent clearing, the B2B will not
be able to attract a critical mass of liquidity and participation. And as I just pointed
out, the ability to clear and settle transactions is a specialty of futures exchanges. The
recent agreement between the CME and Chematch is a case in point. Thus, this evolutionary
developmenta singular result of e-commerce and the Internetopens up an unusual
opportunity for traditional futures exchanges.
But time is of the essence. The competition is not sitting still.
Traditional exchanges must act quickly to take advantage of their inherent capabilities.
They must achieve a level of financial strength, technological capability, and market
distribution for their products as demanded by the global marketplace. Those that
dont will be history. Those that do will achieve a secure place in the e-commerce
world of the Twenty First Century.
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