China Must Continue to Grow its Futures Markets
International Finance Forum
Chairman Emeritus, CME Group
September 1, 2016
The futures industry is regarded not only as a bastion of free markets; it is also known as the cradle of innovation. To find its origin would require us to go back to ancient times. Just as we often go back to Confucius to find original words of wisdom, we must go back to the dawn of mankind itself, to find the precise moment when the idea of establishing futures markets was born. Clearly the first official act of forward hedging occurred in Biblical times when it is said that Joseph outlined his plan to the Pharaoh for protecting the land of Egypt from the coming seven years of famine. Or maybe even as far back as the Garden of Eden in Hebrew Lore, when the serpent convinced Eve to take a bite of the forbidden fruit in order to gain worldly knowledge.
From those ancient times the technique of future pricing knew of no national boundaries and, in one form or another, became utilized in every corner of the globe. Its evolutionary flow was dramatic and innovative as any event in the history of mankind.
The foregoing is particularly true of the CME Group. Early in the 1960s, the CME developed a futures contract with delivery of live "on the hoof" cattle. While it may not have been the most striking departure from the norm, it was the first time that something still alive became a deliverable product. The CME's image as an innovator was fully authenticated in the early 1970s when as chairman of the Chicago Mercantile Exchange I introduced the concept of finance in futures markets. That was a revolutionary departure from the centuries old tradition for commodities --- mostly in agriculture --- to be venue of futures markets. The idea for financial futures brought about phenomenal growth in every conceivable direction and dimension --- from foreign exchange to interest rates, to stock indexes, to credit default swaps and beyond. It also brought success to the City of Chicago.
The underlying reason for its success was that financial futures afforded the business world the same opportunity to hedge their financial risks and capture financial opportunities, as the agricultural world had been doing for centuries. With the advent of computer technology, financial futures were the gateway to Over the Counter (OTC) financial instruments. The combination of these financial tools, referred to as derivatives, provided the world with an extraordinary ability to institute investment strategies more efficiently and more cost-effectively than had ever been possible. Former Chairman of the U.S. Federal Reserve system Alan Greenspan explains that "these instruments allowed users to unbundle risks and allocate them to the investors most willing and able to assume them." Robert C. Merton, the Nobel Prize winner in economics and professor of finance at MIT recently stated: "The costs of implementing financial strategies for institutions using derivatives can be one tenth to one twentieth of the cost of using underlying cash market securities." That represents a most powerful reason for their incredible growth.
This is not to infer that derivatives do not include inherent risk. They are highly sophisticated financial tools. If used unwisely or without proper safeguards they can be dangerous and produce negative results---witness the 2008 financial meltdown. Nevertheless, their positive rewards far, far outweighed their risks and derivatives continue to be applied throughout the world.
The success of financial futures however was not based simply on an idea whose time had come. While this is very true, there was another dynamic at work. As previously noted the technological revolution during the second half of the 20th Century changed everything. In 1956, John Bardeen, William Shockley, and Walter Brattain of Bell Labs received the Nobel Prize in Physics. Their invention was the transistor, arguably the most important invention of the 20th Century. As we all know, a transistor is a semiconductor device that regulates the flow of an electric current. It was the pathway for the technical revolution that followed which ultimately led to the invention of the modern computer. This ushered in the digital age.
The CME's innovative image was again evident when it was first to recognize that the new technologies provided mankind with communications capabilities that could advance these markets to every corner of the globe. In the 1990s the CME led the world in creating an electronic transaction system called Globex. Today it is the world's premier futures electronic transaction system. While transaction volume is only one way to measure acceptance of an innovation, it is the quickest way to recognize success. CME's average daily volume grew from less than 100,000 in 1972 at the introduction of financial futures, to the incredible ADV of 18 million currently.
More than any other Exchange, the CME embraced the technology of the digital age by spurring new instruments of finance which provided cover for the business world in an ever risk-expanding global marketplace. Nations around the globe have embraced the idea and followed the Chicago blueprint. Today there are developed financial futures markets aside from the US, in Australia, Brazil, Canada, France, Germany, India, Japan, S. Korea, Mexico, Singapore, United Kingdom, Argentina, Columbia, New Zealand, and of course China.
China's futures entry into finance did not occur until 2006 with the launch of the China Financial Futures Exchange, (CFFEX) to trade in the popular Shanghai Stock Index, the CSI 300. The CFFEX was an enormous innovation for China and an instant success with an overwhelming volume from the very first day. However, while successful, it suffered from the same flaw that many of the Chinese futures markets do. They are primarily domestic and nearly without any global participation. More than 80% of CFFEX volume was from retail participation and dominated by speculation. That is not a constructive ratio of commercial versus speculative participation. It would be beneficial for China to encourage the development of a broader, more diverse set of participants in its capital markets, e.g. pension plans, life and casualty insurance companies, etc. Such industries approach trading and investment in a much more calculated and measured manner with much longer investment objectives.
In 2015, global markets in securities and commodities experienced extreme turbulence. This turbulence was driven by a variety of fundamental factors that span across geographic regions, economies and industries. Because China is a significant part of the global economy it could not escape the consequential results. Given the global financial conditions worldwide, and especially because of the unrealistic high levels the Chinese equity markets had reached, it should be no surprise that Chinese markets experienced extreme volatility. Price-to-earnings ratios for some Chinese stocks reached an average of 70-to-1 ratio, compared with a worldwide average of 18.5-to-1. It was an accident waiting to happen. To be specific, the Chinese stock market turbulence began with the popping of their stock market bubble on June 12, 2015. A third of the value of A-shares on the Shanghai Stock Exchange was lost within one month. Values of Chinese stock markets continued to drop despite efforts by the government to reduce the fall. More than half of the listed companies filed for a trading halt in an attempt to prevent further losses.
Allow me to state the obvious: Any market that rises to the extent in the rapid fashion as did the Chinese stock market, becomes a certain candidate for some form of a precipitous and rapid decline—in other words, a crash. It is easy enough to blame the futures market for what happened. Using futures as a scapegoat is not unusual. Futures markets are usually first to detect economic problems and first to react, making them look like the cause. But such blame is unwarranted. Indeed, I would place very little blame on the Shanghai Stock Exchange or China Financial Futures Exchange. They were not responsible for the underlying world economic environment nor the bubble conditions in China. The CSI 300 index is an instrument of finance; it too cannot be viewed as the cause.
If proof is needed, it can be found in the fact that 18 out of the G20 nations maintain equity index futures. As do an additional 14 major countries.
And allow me to put things in perspective. In the midst of great turbulence, it is perhaps difficult to remember that virtually all markets periodically suffer from episodes of volatility. In the last 30 years, for example, in 1987, in 2000, and 2007-09, the U.S. equity market suffered market meltdowns. But the fault did not lie with the exchanges, their procedures, or trading programs such as index arbitrage; rather the cause was related either to a major change in economic expectations, the bursting of a technology stock bubble or the similar bursting of a housing bubble. Indeed, the respected Tsinghua University, under the guiding hands of former PBOC vice president Wu Xiao Ling and Li Jiange, the former deputy director of the research center of the state council, published its conclusion directly after the Chinese market crash, stating "the equity index market is not the cause of the stock market turmoil" and encouraged to make the index markets stronger.
To say the least, the economics in China are complex. The government has correctly instituted a transformation from an export dependent manufacturing economy to a consumption-driven economy, one powered by internal growth. But such a monumental transformation is not without pain even during normal times. Unfortunately, this transformation encountered a time-frame when most of the major global economies were themselves on the defensive. It helped cause a slowdown. Still, China continues to grow about 6%.
Frankly, it is my opinion China's economy had become too reliant on loose monetary policy and credit expansion. Bubbles were the result. Going forward, I endorse President Xi Jinping's emphasis on reforms that reduce overcapacity in heavy industry and deflate asset bubbles. This is the correct path for China at this juncture in its economic development. I also totally support proactive measures taken by Governor Zhou Xiaochuan of the PBOC to internationalize the RMB. This course follows the commitments achieved at the recently concluded Strategic & Economic Dialogue (S&ED) for continued market-oriented exchange rate reform, allowing for two-way flexibility of the RMB with restraints on sustained depreciation of the currency. It also encouraged cooperation between China Foreign Exchange Trade System (SAFE) and the CME to achieve PBOC objectives.
I have continuously recommended that China must open its economic borders to cross-market application. Adding diversity means the inclusion of more offshore participants in Chinese markets. Global participation will lead to a more balanced market. It will strengthen the domestic markets, deepen the liquidity of underlying cash markets, and enhance the price discovery process of its commodity products to benefit the Chinese real economy. Toward this goal, in 2014 I applauded China's premier Li Keqiang directive with HKEx's chief executive, Charles Li, to institute the Shanghai-Hong Kong Stock Connection. I similarly applaud the recent State Council approval linking the Shenzhen and Hong Kong Stock Market. More of this is needed. Indeed, I am encouraged by current discussions between the CSRC and the CME aimed at expanding such programs with China to an international level.
The CME has an outstanding history in this respect. Our mission is no secret and its results are no mystery. Clearly, our international efforts helped make the CME stronger, but they equally made stronger the foreign economies involved. We have no ambition to take away market share from foreign exchanges. Quite to the contrary! Our mission is to collaborate and partner with foreign markets. It is a win-win strategy and a CME tradition. We actually helped the creation of the LIFFE exchange in London back in 1981, the SIMEX of Singapore in 1984, and the Japanese Exchange in Osaka in 1986. This tradition continues to this very day. We currently host the Malaysian derivatives exchange, the Dubai Mercantile exchange, the Minneapolis Grain Exchange, and the overnight Korean, KRX, futures marketplace. Allow me to emphasize, our purpose and motivation for collaboration and partnership is no different in China. Simply stated, we want to grow together.
Finally, I wish to underscore that Tsinghua University is correct in its analysis. As history has demonstrated, futures and options markets are of undeniable value in the management of complex business risk. It is therefore imperative that the Chinese government adopt policies that remove drastic restrictions on equity markets instituted during the market crash, restore the viability of CFFEX, institute more cross-border equity trading programs, establish permanent procedures required for rule-making or changes, and promulgate new economic policies as suggested by President Xi which are aimed at preventing the conditions that caused the crash in the first place.
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