EMBRACING REALITY

Chicago Mercantile Exchange 1987 Annual Report.

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The 1987 stock market crash was a shocking event. It unleashed an unparalleled torrent of unfavorable accusations, sentiment, and publicity aimed at futures markets. For a time, it became so bad that it was unclear whether our markets could survive the negativism that was hurled at us. The assault took form both in legislative proposals that would cripple our existence as well as in a highly adverse national image. It required all our courage, skill, intellect, and careful strategy to repel the onslaught and keep our markets viable.

Our strategy was fourfold: Meet the attack head on, bring out the truth (the facts were highly favorable to our markets), explain the underlying fundamentals that caused the crash, and point to the solution of the problem. Thus, we wrote and published a host of material, testified before many Congressional committees, and gave innumerable speeches. Particularly important was the understanding and assistance of our own membership. As in many prior instances, I used the Annual Report as an avenue to educate our members and establish the "party" line. Afterwards, the theme was amplified and carried forward to the outside world.

The conflict was anything but easy and lasted almost two years. In the end, our strategy not only proved successful, it resulted in catapulting futures markets to the forefront of the financial arena. The Chicago Mercantile Exchange, in many ways, became equated to the New York Stock Exchange—a measure of stature and respectability unimaginable a few years ago.

The unwelcome episode unwittingly served as the constructive beginning of a new growth era for futures markets and initiated our epoch of globalization.

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When the United States Congress began an investigatory process to determine the cause of the October 19 stock market crash, I suspected what would happen. I was not disappointed.

The Congressional hearings, the regulatory inquiries, the media pressures, the multitude of studies (official and private), focused the attention of Congress and our nation on how the stock market crashed and diverted its consideration from why it crashed. Clearly, why the market crashed is the more fundamental issue, albeit harder to resolve. Clearly, the concerns stemming from underlying economic conditions and factors that ultimately determine values of investments ought not be relegated to second place. And an investigation to determine these conditions and factors was not necessary. There was a plethora of legitimate candidates.

At one end of the spectrum were the momentous and complex twin problems of the record budget and trade deficits, the mounting pressure from their dire consequences overshadowing all else. At the other end of the continuum was the simple explanation that after a five-year uninterrupted bull market, a correction was long overdue. There were an overabundance of bulls and price-earnings ratios were at historically high levels.

Then, of course, there were the concerns over the tightening of monetary policy by the Fed; some loss of confidence in American leadership; federal legislation that would—among other things—disallow interest deductions for any significant takeover borrowing, thereby directly affecting a market activity that had acted as the major fueling force for the U.S. stock market; the dangerous specter of protectionist trade legislation; and the increasing unfavorable disparity between the return on stocks versus the return on fixed income investments.

Beyond this backdrop of fundamentals, there were some psychological concerns: an unsettling Persian Gulf situation with stepped-up Iranian hostilities; some dire predictions about inflation as well as a recession; a falling dollar; an open policy disagreement between the U.S. Treasury and the German Bundesbank spelling an end to the Louvre Agreement (targeting exchange rates) and thus exploding the myth that foreign exchange values can be ordained by government edict; falling prices on foreign stock markets; and finally, a raft of articles comparing October 1987 to October 1929. Surely, the combination of these factors was more than ample cause, both real as well as psychological, for a market collapse.

Perhaps Alan Greenspan, Chairman of the Federal Reserve Board, summed it up best in his report to the U.S. Senate Banking Committee on February 2, 1988:

Stock prices finally reached levels which stretched to incredulity expectations of rising real earnings and falling discount factors. Something had to snap. If it didn't happen in October, it would have happened soon thereafter. The immediate cause of the break was incidental. The market plunge was an accident waiting to happen.

Thus, in our haste to look responsible and explain the crash, in our need to find a villain, in our ambition to prevent a recurrence, we have not only diverted our attention from the obvious, we have also focused our concerns in the wrong direction. Indeed the answer to why the market fell so quickly fast is no mystery. Overvalued markets can become very painful; when everyone wants to sell, there are never enough buyers. In other words, perhaps there is nothing one can do about this reality.

However, there is something to be learned from the October crash. The event provided us with a very fundamental insight, one that we dare not ignore. We learned to what extent our technological competence had out-distanced our market mechanics. To put it bluntly, most of our traditional markets were operating on a technological standard equivalent to the steamboat, while those who make market decisions were using the jet plane. Allow me to elaborate.

The disparity between markets and their participants is growing and is the result of two interconnected causes. First, the decision-making power in matters of finance has become compressed. Scientific and technological advancement has forced the world to become highly specialized and professional —a trend that will not abate and is nowhere more obvious than in finance. In the United States, investment managers now represent over 33 million mutual fund shareholders and over 60 million pension plan participants and their beneficiaries. These funds equal nearly $2 trillion in assets compared with only $400 billion a mere decade ago. The reason is obvious. Large pools of capital offer access to professional management, enabling even small investors to equal the profit capabilities of institutional participants. As a result, a myriad of specialists, techniques and strategies have evolved. Moreover, technological sophistication has enabled these professionals to apply their strategies with lightening speed. Unfortunately, traditional market mechanisms, particularly in stocks, are simply not structured to accommodate the massive and sudden money flows these managers command.

Second, the effects of globalization. The marriage between the computer chip, the communication satellite, and fiber optics changed the world from a confederation of autonomous financial markets into one continuous marketplace. No longer is there a distinct division of the three major time zones— Europe, North America and the Far East. No longer are there three separate markets operating independently of external pressures by maintaining their own unique market centers, product lines, trading hours, and clientele. Today, news is distributed instantaneously across all time zones. When these informational flows demand market action, financial managers no longer must wait for local markets to open before responding. They have the capacity to initiate immediate market positions.

As Walter Wriston, the former chairman of Citicorp, the largest U.S. bank, recently wrote (Forbes, Dec. 14, 1987):

Today there are more than 200,000 computer screens in hundreds of trading rooms, in dozens of countries, which light up to display an unending flow of news. It takes about two minutes between the time the President or prime minister reads a statement and the time traders buy or sell currency, stocks or bonds based on their evaluation of the effect of that policy on the market.

While Mr. Wriston's assessment of the number of computer terminals is far too low and his estimate for the reaction time too high, his point is precisely on target. The technological revolution has given us what he calls the information standard which he states is far more draconian than the gold standard or the Bretton Woods standard. With the information standard, it does not matter what market legislation we attempt. The screens will continue to light up with information, and the market participants will continue to act on the information as they deem fit. As Wriston puts it, "the new global electronic infrastructure has doomed the effectiveness of a cosmetic political fix." I agree and would go further: the new global reality has placed demands on our markets which cannot be met by current transaction mechanisms.

The solutions to October 19 do not lie in new federal regulations, new federal authority, nor a ban on program trading or other market strategies. Such cosmetic or political fixes may serve perceptional needs, but will delay us from applying the real solutions. Indeed, they are fraught with danger and point in the wrong direction. Nor will the answers be found in better coordination between the markets or the federal agencies, although that is clearly welcome and necessary. Rather, the solutions that are possible lie in structuring the world marketplaces, both internally and externally, so that their procedures and transaction mechanisms are more efficient and more reflective of the realities of specialization, globalization and the technological revolution. It is with a measure of pride that the CME can boast of having recognized the realities of the information standard and accepted the technological challenges it represented long before the events of last October. Indeed, we had been struggling with these issues for a long time. And, in the same revolutionary spirit with which we introduced the IMM and spawned the financial futures revolution, in the same innovative mode with which we created the CME/SIMEX Mutual Offset System, we prepared to embrace the technology of the present era and respond to the demands of globalization.

We had company. As everyone in our industry is aware, many exchanges have attempted to meet the globalization challenge by searching for solutions to preserve local business flows and attract business generated on foreign shores. With varying degrees of success, these actions involved either electronic linkages with foreign exchanges or, more recently, extended trading hours. While it is still too early to fully evaluate the long-term effectiveness of these alternatives, it seemed to us that neither represents an adequate response to the demands of the 24-hour trading day.

Electronic linkage proved that markets in separate time zones can be linked to allow safe access to each other's open interest, giving both markets the advantage of the other's non-regular trading hour business flows. However, while we deem our link-up experiment with SIMEX successful, as do those who followed with similar linkages of their own, all of them have identified certain limitations to their effectiveness.

Similarly, the extended trading solution of a night market in the U.S. also has inherent limitations and thus a limited potential. While, undoubtedly, it will be a window of opportunity for the next several years, ultimately it can only hope to attain a secondary market niche by way of arbitrage and minor business flows.

The CME chose to meet the challenges head on. As our members well know, in September of last year, in a bold and far-reaching joint undertaking, the Chicago Mercantile Exchange and Reuters Holdings PLC entered into a long-range agreement to create an after-hours global electronic automated transaction system for the trading of futures and futures-options. CME members overwhelmingly approved the proposal on October 6, 1987.

The concept embodied in P-M-T (Post Market Trade—its working designation) is clearly an historic milestone in the development of futures trading. It embraces the realities brought about by technological advancements of recent years and takes a giant step toward unification of the world's separate financial centers. P-M-T combines elements of electronic linkage with those of extended trading and integrates them with the open-outcry system. In effect, it draws the best from the present and marries it to the technology of the future. In all modesty, it puts the CME light-years ahead of its competition.

The ingredients of the new trading system will include all the critical elements of a viable trading environment: The liquidity and open interest of the CME financial markets—representing a comprehensive spectrum of instruments in world finance—to which will be added selected foreign instruments; Reuters, the communications organization with the largest international network of communications hardware as well as the technological capability to create and conduct an automated transaction system; and, The capability, credit-worthiness and established financial integrity of the CME clearing system.

P-M-T will mean that the financial markets of the Chicago Mercantile Exchange, with their operational capabilities, liquidity and safeguards, will be open—not just during the regular trading hours of the CME trading floor— around the clock. It will also mean that financial markets from foreign shores will become readily available to the American investor.

This is our response to the demands brought about by the technological revolution as well as to the challenges of globalization. We believe it will translate into opportunity and cost-efficiency whether you are a banker in Tokyo, a risk manager in London, an investor in the United States. It is a solution in sync with the markets of the future. Thus, the CME has led the way once again. While P-M-T was not devised as a consequence of the October stock market collapse, it represents the correct direction for the solutions to that episode.

Markets subject to the flows of institutional capital demand a transaction system responsive to the needs, uses and strategies of professional managers. Markets subject to the flows of global information demand a market mechanism responsive to the 24-hour trading day. Markets subject to the consequences and strains of modern technology demand systems and procedures of equivalent competence. Nothing less will suffice. Simply stated, the solutions to October 19 will be found in embracing reality.

Reprinted by permission. Excerpted from Melamed on the Markets, by Leo Melamed. John Wiley & Sons, 1993

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