Canadian Annual Derivatives Conference
Montreal Exchange
Montreal, Canada
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 glance back.

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 anyone’s 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 today’s giant financial derivatives market—a market that is currently estimated at $80 trillion in outstanding contracts.

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 world’s biggest financial firms or banks have captured the lion’s 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 requirement—distribution and technological competence—represents 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 affairs—it 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 suit.

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 CBOT.

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 requirement—clearing and settlement capability—there 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 annually—last year it cleared 201 million transactions totaling $138 trillion—with 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 arena—be it in chemicals, energy, electricity, paper, or real estate, and so forth—is 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 B2B’s 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 development—a singular result of e-commerce and the Internet—opens 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 don’t 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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