MARKETS IN AN E-COMMERCE WORLD
Annual Derivatives Conference
October 15-17, 2000
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.
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.
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 outstanding contracts.
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."
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.
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.
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.
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.
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.
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.
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
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
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.
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.
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.
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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