IN THE EVOLUTION OF AN EXCHANGE
at Focus Europe
International Conference for Managed Futures and Derivatives
September 11-14, 1995
as "Dance Hall Daze" in the January 1996 issue of Futures & Options
Fourth Earl of Chesterfield counseled the world that "whatever
is worth doing at all is worth doing well." Few axioms are more
dear to my heart. The more complex the endeavor, the more appropriate
Lord Chesterfield's advice. Clearly, his words are most applicable
with respect to the complexities in the evolution of an exchange—the
topic of my remarks at this conference.
timeliness of this topic is self evident. Not only are futures,
options, and other derivatives very much in the news, many governments
in this part of the world, and throughout the world, have recently
completed such an undertaking, or are contemplating the creation
of a futures exchange. The list of prospective exchanges is impressive
and covers the entire globe:
only is Lower Saxony here in Germany planning a new agricultural
exchange, Mexico's central bank has plans for an interest rate
market, Costa Rica's stock exchange is planning a financial futures
exchange, and India's finance ministry has requested a study
with respect to a futures and options exchange. Similarly, plans
have been announced for prospective futures markets in Hungary,
Indonesia, Israel, South Korea, Malaysia, Nigeria, Panama, Peru,
Poland, Portugal, Slovenia, Thailand, Turkey, Venezuela, and
Vietnam. This list is probably incomplete. My remarks here today
are directed to these new and would-be exchanges. For those who
are familiar with the creation of an exchange, my thoughts will
be of little value, except perhaps to validate what you already
all these markets necessary? Will all of them succeed? My personal
view is that in all probability, all these markets are not necessary
and that most will not succeed. Nor is it my opinion that every
town, territory, or hamlet needs a futures exchange of its own.
One should not, as a general rule, consider the establishment
of an exchange from a mere philosophical point of view—let's
establish an exchange in Xanadu. Because it sounds right?
Because your neighbor has one? Because it is fashionable to have
one? All of those are the wrong reasons.
will speak of some of the right reasons for a futures market
a bit further in these remarks, but allow me to explode one popular
misconception at the outset. Contrary to what some may believe,
a futures exchange alone will not create economic prosperity.
Such thoughts are naive. Indeed, the contrary is more the case.
Before a nation can contemplate a futures market, it must first
reach a sufficient degree of maturity in its free market experience
and capabilities. A hospital with the latest medical equipment
is of no value to a region unless there are doctors and technicians
with the knowledge to apply the science involved. Similarly,
a nation's cash market and institutional participants must have
reached a level of sophistication, experience, and liquidity
that will successfully support a futures exchange. To proceed
before the demands for a futures market have developed is putting
the cart before the horse. Derivative markets cannot function
without efficient cash markets. It is one of the reasons that
historically there have been more failed attempts at the creation
of an exchange than there have been successes. Which exchanges
will or will not succeed depend to the greatest degree on Lord
Chesterfield's admonition—and how closely the prospective exchanges
pay attention to these remarks.
the basics, what is an exchange? The great U.S. Supreme
Court Justice Louis Brandeis, in the early part of this century,
defined an exchange as a set of rules that assure open access
to many sizes and kinds of buyers and sellers. When I took over
the Chicago Mercantile Exchange as a young man back in 1967,
the President of the Exchange, Everette B. Harris, sat me down
and explained what Judge Brandeis meant in simple language, "The
exchange is a dance hall," Mr. Harris said, "the administration
provides the music and the traders do the dancing."
but adequate. Basically an exchange has two fundamental purposes:
First, to furnish the dance hall, the facilities for buyers and
sellers to conduct business; second, to provide the music, the
rules by which buyers and sellers conduct their business. If
you take the foregoing definition literally, then the fairs in
medieval Europe qualify as an exchange. So do the Sunday morning
flea markets one finds throughout the world today. Unfortunately,
once we look beneath the surface similarities, we find that fairs,
flea markets, and exchanges, while performing similar functions,
are vastly different. Among the distinguishing characteristics
is the fact that at fairs and flea markets the seller can bring
to the market any product he chooses, of any quality, and of
any specification. At exchanges, the seller can only offer the
products established by the exchange, of a certain quality and
specification. In other words, since 1650 when the first organized
exchange was created in Osaka Japan, the music to which the traders
can dance is pre-ordained.
even before inception of a new exchange, we come to the first
essential issue of every would-be exchange: What shall be
our initial product line? This is the most critical of all
the questions an exchange will face. The initial product line
will in most instances determine success or failure—there is
often no second chance. Indeed, the issue of product line is,
in my opinion, so decisive that in practice it is the driving
force—or should be—behind the decision to establish a new exchange.
Consequently, the only valid motivation for the creation of a
new futures exchange is that the business community of a given
region or sovereignty has reached the level of maturity and sophistication
to know that a certain product line will most likely be successfully
traded on a futures exchange. Every other reason pales by comparison.
the product issue is resolved, there follow an array of other
issues that must be correctly resolved, but in no particular
shall be the membership structure? For example, at the
CME, only individuals can purchase memberships, while at the
TIFFE and DTB, only institutional memberships are available.
Or shall there be no distinction made, with memberships available
for everyone, individual and institutional alike, or shall
there be several categories. The decision will often depend
on the size and cultural history of the sovereignty where the
would-be exchange is contemplated, the infra-structure of its
business community, and the manner in which business flows
are expected to be generated. It also will depend on the number
of products that are listed at the outset. And whether memberships
have restricted rights and privileges. While the foregoing
are important issues in determining who will best serve the
interests of the would-be exchange, the issue of membership
structure is insignificant compared to the next question: Electronic
or pit transaction system.
can be no surprise to anyone in this room that this issue, screen
vs. open outcry is perhaps the most debated topic within
academia, as well as a heated topic of discussion in virtually
every board room of exchanges around the world. Clearly a would-be
exchange must make this determination before it can contemplate
opening its doors. Much that follows will depend on the answer
to this query. However, it represents an issue that deserves
its own seminar and certainly more than one viewpoint. I cannot
attempt to do it justice in this overview. Still, I feel compelled
to offer some brief thoughts.
1977, I wrote an article for the Hofstra University Law Review
in which I categorically concluded that the only futures exchange
that can succeed is one that operates within an open outcry transaction
environment. I based that opinion on my frame of reference and
the knowledge available at that time. In 1977 there was no such
thing as personal computers; windows were something from which
you looked out at the street; Bill Gates was still in college;
and the apple was no more than a delightful fruit. Things change.
Ten years later I had no trouble recognizing the revolution that
technology had engendered.
there are still some in the audience who are skeptical about
the road ahead for the world, they are simply deaf to the thundering
maelstrom of the technological avalanche around us. It is a human
frailty. As historian Barbara Tuchman said, Men will not
believe what does not fit in with their plans or suit their prearrangements. However,
such skeptics are no different than those who scoffed at the
idea of financial futures back in 1972. Technology has revolutionized
the transaction process. This is not a theoretical observation
of some ivory tower academic. It is pure fact. Moreover, telecommunications
has fashioned a global marketplace that will encompass global
trading mechanisms—either now or someday. This truth will not
change or disappear. Those who dare ignore these realities, at
best, flirt with the danger of being relegated to a secondary
position in world markets; at worst, their fate can be extinction.
does not mean that open outcry exchanges should close their doors—it
would be heresy and stupid to suggest this, or to deny the enormous
success they represent. Nor does the foregoing intend to ignore
the fact that open outcry has attributes that are still difficult
to match on screen-based systems and that for some products it
is the best system. But what it does mean is that the electronic
transaction process has made enormous strides in recent years
and will continue to do so. What it does mean is that electronic
trade contains enormous benefits and cost efficiencies for the
marketplace. What it does mean is that in the long run, technology
will most likely overtake those exchanges that are exclusively
pit-based. The MATIF and the BM&F were the last pit-based
exchanges to be successfully formed.
additional word about technology as it relates to GLOBEX. I know
this global electronic transaction system has not been the success
that we had hoped for when the idea was unveiled in 1987. There
are many reasons for that which I will not discuss today. But
GLOBEX correctly recognized that globalization was upon us. It
was the first official endorsement by the futures market establishment
that automation was a necessary adjunct to its infrastructure.
Indeed, the GLOBEX pronouncement resulted in a virtual torrent
of electronic systems, devised either to extend existing trading
hours or to conduct the entire transaction process. These exchanges,
to one degree or another, emulated GLOBEX by recognizing the
realities of the technological revolution. Today no exchange
contemplates opening its doors without considering screen-based
trading or an electronic connection of one sort or another. The
fact GLOBEX has not yet achieved its potential proves nothing.
Revolutions take time. In the long run, either GLOBEX or the
cousin or grandson of GLOBEX will be the way the world will trade.
the issue of pit or screen has been determined, the prospective
exchange must create a body of rules and regulations that will
provide two essentials: 1) a fair and equitable transaction process,
one that does not favor either buyer or seller, and 2) a financially
sound clearinghouse. This means that issues such as margin and
capital requirements must be addressed. At its core, by-laws
must provide unquestionable assurance to public and private participants
that the price established has been achieved in a fair, open,
and business-like fashion, that the funds utilized will be secure,
and that the contracts executed will be satisfied. In today's
world, the financial integrity of the exchange and its participants
is perhaps the most overriding concern and will be a primary
determinant in the success of the undertaking. It is axiomatic
that an exchange attracts trade because its clearinghouse eliminates
counterparty credit risk.
by now there are a host of such rules and by-laws to choose from
and to follow. When, I led the launching of the IMM in 1972,
we did a lot of innovating, inventing, and praying. The rules
and practices of trade we inherited at that time were generally
archaic, often from a legacy that was dominated by cut-throat
competition and robber baron influence. Today that is far from
the case. While there are still important differences within
rules from exchange to exchange, there are fairly standard principles
around the globe. The world exchanges have learned from each
other. Our best teacher has been the emergencies we have faced.
Each financial disaster, each commercial failure, each corner,
squeeze and default has provided the world a wealth of experience.
We have indeed been most fortunate to have had so many misfortunes.
most recent Barings PLC bank collapse, is a case in point. As
a direct consequence of its occurrence, representatives of the
futures industry under the leadership of the Futures Industry
Association (FIA), formed a Global Task Force to examine what
went wrong and how to prevent a recurrence of the problems. This
task force included more than 60 participants from 17 jurisdictions
which included Australia, Belgium, Canada, France, Germany, Hong
Kong, Italy, Japan, the Netherlands, New Zealand, Norway, Singapore,
South Africa, Spain, Sweden, the United Kingdom, and the United
States. It resulted in the issuance of Financial Integrity
Recommendations. This work product, which contains some
60 recommendations, will become the fundamental benchmark of
futures markets in the years ahead, and is clearly of the greatest
benefit to new exchanges.
foregoing, of course, brings us to the fact that exchanges today
cannot be organized or launched without the direct and sometimes
heavy-handed involvement of government. There exists no exchange
today that is not subject to oversight or regulation by a governmental
agency that in some cases has been created for this specific
purpose. Often the question is how many governmental agencies
will be involved. As a consequence, a would-be exchange is well
served if it works hand in hand with government at the outset
in establishing its rules. Since this, at best, is a mixed blessing
of modern society, the prospective exchange should consider what
it can obtain in return from government. Favorable tax treatment
for the traders is a good place to start. A free trade zone where
the exchange is situated is another.
to opening its doors for business, the last prerequisite for
a new exchange—but far from the least—is to educate. I have stressed
education in the development of markets from the day I launched
my first instrument in currency futures. Education of the traders,
education of the institutional intermediaries, education of the
end users, education of the regulators, and even education of
the general public is fundamental to the success of an exchange.
Education in every conceivable form, whether under the auspices
of the exchange itself, or its members, or private sector institutions,
or colleges and universities. All should be encouraged and utilized.
This theme cannot be stressed sufficiently. First, because only
through education will market participants learn how to correctly
and profitably use the products offered for trade. This will
immensely increase the chances of success of the instrument traded
as well as the exchange hosting the product. In other words,
education goes a long way in creating liquidity—and liquidity
is the fuel that runs the exchange.
second reason for education is equally important: for defensive
purposes. No futures market is free from detractors. It is as
natural for the marketplace to have both protagonists and antagonists,
as it is to have buyers and sellers, as well as hedgers and speculators.
Unfortunately, speculation—what Lord Keynes defined as the way "to
anticipate what average opinion expects average opinion to be"—has
historically been treated in an unfavorable light. That is putting
it nicely. In truth, speculators, especially in this part of
the world, have been considered persona non-grata. Yet
speculators are vital to the process. Without speculators who
are willing to assume the risk, the hedgers have no one with
whom to dance. Indeed, according to Milton Friedman rational
speculators tend to stabilize asset prices. Only through education
can this issue be adequately addressed.
is also natural for the marketplace to have unexpected problems
and failures. Nirvana is not yet attainable. Thus, when an Orange
County or Metallgesellschaft occurs, there are bound to be any
number of finger pointers proclaiming that the futures market
was the cause of the problem, or that derivatives is a four letter
word. Education is the only effective weapon to still those voices.
An arsenal of educated experts both within academia, the private
sector, and government is mandatory to discredit unwarranted
accusations and to defend the free market process against attacks
by lynch mobs of the marketplace.
is precisely what happened in the U.S. after the 1987 October
crash. The attack against futures markets was as vicious as it
was erroneous. We were able to repel the onslaught only because
there was a sufficient body of academic experts whose credibility
could not be questioned, and who were unanimous in rejecting
the notion that futures markets were the cause of the crash.
I must also point out that it was fortunate that the chairman
at the Federal Reserve at the time was Alan Greenspan. He was
someone with a sufficient degree of knowledge about our markets
to know the truth. And he was someone that I personally could
convince to go public with that truth. Said the Fed chairman
in congressional testimony:
these circumstances, it is a mistake to single out one segment
of the broad marketplace as the culprit for large and rapid price
movements, when these price movements reflect economic fundamentals
in the context of modern technology and the prominence of institutional
investors...What many critics of equity derivatives fail to recognize
is that the markets for these instruments have become so large
not because of slick sales campaigns but because they are providing
economic value to their users..."
a prospective exchange dares to open its trading dance hall,
it should know its federal officials and the degree of knowledge
they have about futures, options, and derivatives.
foregoing discussion represents but a synopsis of the critical
issues facing an exchange before it becomes operational.
What awaits the exchange is a myriad of salient considerations
that flow from opening day forward—day-to-day practical problems
that are endless. This represents the second stage in the evolution
of an exchange. I will touch on only one or two of these considerations.
is the foremost factor after trading ensues. Without liquidity
the exchange is useless. Liquidity is the amount of bids and
offers flowing to the market. The more liquidity, the more successful
the exchange. How does an exchange achieve this? It is a question
that has been asked since the day these markets were born. There
is no sure fire answer nor is there a magic bullet. What works
in one place may not work in another. There are some standard
song sheets, however. A ready army of market makers is fundamental
to the process. The more, the better. When the market makers
are members, you must make certain that they direct their activities
in the products where liquidity is desired. This can be accomplished
only if their membership limits their trading rights to a given
it is best when market makers operate their own books and compete
for their own profit. Clearly there are many variations to this
theme but to attract market makers, the exchange will be well
served to offer them extremely favorable treatment. They must
be given some incentive that the rest of the world doesn't get.
It can be rudimentary or sophisticated. One has to know the community.
In the early days of the IMM, I created a breakfast club where
traders received rolls, eggs, and coffee if they showed up early
so they could trade at the opening. Today this would probably
not work—a free Mercedes convertible might be more like it. The
point is, their endeavor must be profitable or they will not
stay. Market makers must also feel they belong to an exclusive
club. You cannot allow the nearest street person to become a
the commercial world must participate with order flow. A ready
collection of institutional players must be willing to give the
market a try, especially in the early stages. Again there are
a variety of approaches to this process, but basically it is
a question of marketing and membership. This issue relates directly
back to the questions about the opening product line. If the
exchange organizers had done their homework and listed instruments
for trade that the surrounding business community needs, commercial
order flow will be less of a problem. But under all circumstances,
education, by way of written material, seminars and workshops,
is indispensable to the process of liquidity. Fortunately, liquidity
begets liquidity. Someone has to start dancing, others will follow.
soon as the original product line shows evidence of success,
the exchange must return to the drawing board. Now the dance
hall takes on the characteristics of a living being. If it does
not grow, its life will be limited and it is likely to die. Growth
can occur both vertically, in volume, or horizontally, in products.
An exchange must continuously address the vexing issue of future
products to be added to its program. Sometimes the road is obvious.
For example, when the original product line leads to variations
on theme or follows a known route. At the IMM, 90-day Treasury
bill futures led to Certificates of Deposit which led to the
Eurodollar market. Sometimes it represents a new invention. This
requires a great deal of examination and analysis since there
are many ideas for instruments in the marketplace. Most of them
are not suitable for an exchange. Generally speaking, to be suitable
for exchange trading, the instrument should be standardized and
act as a benchmark for a class of investment. It is also preferable
that either the instrument is already actively traded in the
cash market, or that it is a instrument or index which is calculated
to be of great value to a large group of market participants.
Still, it is imperative that the exchange be prepared to offer
products that will meet the demand of investors. Much of it is
pure guesswork and luck—as well as danger, because the product
road is fraught with failure.
we were inventing instruments in the early days of the IMM, I
was both the Merc's chairman as well as one of its traders. That
was my secret weapon because to this day I believe that the best
ideas come from the floor, that is, from the trading community.
Traders can sometimes feel the instrument they need. That is
how many successful contracts came to life, and that is how today's
derivatives are created. Traders offer their thoughts to computer
analysts who program the idea—and then out pops another derivative.
They tell me there is at least one derivative invented every
day of the week. But most of these will never end up as an exchange-traded
instrument, they either don't lend themselves to such a transaction
process, or they don't have a large enough audience.
a successful exchange will find itself in the third stage of
its evolution. While all the issues of the inception and first
stage are still very much of concern, the exchange will now also
have to deal with issues such as membership expansion, competition,
and alliances—both domestic and international. These issue are
of such magnitude that they too deserve a separate seminar. Suffice
it to say that an exchange's greatest asset is its membership.
This must be understood and always guarded. On the other hand,
the greatest danger a successful exchange faces also comes from
within. It is what Milton and Rose Friedman call the "Tyranny
of the Status Quo." Success breeds fear of change. The establishment
becomes a centrifugal force that is unyielding. And yet, an exchange
that ignores demands resulting from change is doomed. Evolution
is constant and an exchange must be willing to embrace new ideas
and altered circumstances. It can do so only if its leadership
is in strong and honest hands.
may force linkages between exchanges, but they represent no certain
elixir and are fraught with danger. As someone who has spent
a lifetime in discussions and negotiations with members regarding
plans for expansion and with other exchanges regarding mergers
and alliances, my advice is go slow. Most alliances
have not worked. Attempts at linkages divert an exchange's attention,
are time consuming, and costly. Remember, by definition, if an
exchange is successful, everyone will want to merge with it,
but merger may not serve the exchange's best interests. On the
other hand if the exchange is unsuccessful, maybe nothing will
some linkups may benefit both exchanges. For instance, beginning
in 1982, it took two years of my life to negotiate the SIMEX
connection between the Merc and the Singapore exchange. This
produced an extremely successful result and introduced a mutual
offset innovation. But it was perhaps a unique moment in history
that we ourselves might not be able to repeat. The proposed MOS
arrangement between the CBOT and LIFFE may well work, but it
is far too early to know. On the other hand, the electronic arrangement
at MEFF between Barcelona and Madrid is an excellent example
of a successful linkup. It should come as no surprise that my
personal bias lies in favor of linkages by way of electronic
means, especially on an international scale.
stages of evolution in an exchange are dynamic and never ending,
but my time here today is limited. I therefore conclude my remarks
by admonishing all prospective exchanges that before they open
their doors and begin their own evolution to please, please pay
heed to Lord Chesterfield's advice.
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