Tokyo Conference

Tokyo, Japan
November 2001

Printed in the 2002 Edition of Handbook of World Stock, Derivative and Commodity Exchanges

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Most scholars, businessmen and government officials will agree that what occurred on September 11, 2001 in the United States ushered in a monumental change in civilization. The events of that day proved that a civilized world cannot coexist with unbridled terrorism. And since the first responsibility of government is to provide a safe and stable environment for its citizens, the events of that day represent a rude awakening—a watershed moment that will be viewed by history in the manner all extraordinary events are marked: before and after. This distinction may define much if not most of the twenty first century.

It represents a grand irony. The twenty first century had begun on such a high note, full of hope and promise: democracy had spread throughout the world overpowering most forms of dictatorship and tyranny; capitalism had vanquished communism; free market mechanisms were replacing bankrupt state-driven economic orders; globalization had forged a global economy; the Digital Age was born, bringing forth unprecedented changes in the lives of everyone; new technologies were creating efficiencies and enhanced productivity throughout every facet of industry; the Internet provided an unequaled means for rapid and inexpensive communications and informational flows; exploration in space had become the newest frontier in man’s quest for knowledge about the universe; medical, gene splicing, and cell-cloning, research promised longer life and the eradication of the world’s worst maladies; description of the entire human genome, its DNA and chromosomes, was completed opening unlimited possibilities in human biochemical research; standards of living were rising throughout the world; world stock markets had reached record levels creating an enormous wealth effect on the back of a so-called "new economy;" and scientific knowledge was expanding on every front of human endeavor. Indeed, the human race seemed on the threshold of a new golden epoch, a new paradigm.

Then the events of September 11th intervened. Things changed. By that I do not mean to imply that underlying precepts of freedom and democracy have changed. The world’s march against dictatorship and tyranny is the unalterable course of mankind; acts of terrorism, no matter how dastardly, will not revise this goal. Indeed, if anything, the war against terrorism will ultimately pave the way to a freer and more enlightened world society. Similarly, scientific knowledge moves forward under most circumstances. The forces that sponsored technological advancements cannot be diverted from their ongoing destiny. Medical science will continue its pursuit of knowledge and its struggle against disease. Space exploration will find the will and way to move forward.

But while the fundamental direction and doctrines of mankind will not be materially altered by terrorism, the pace of their change will. In some instances slowed, in others accelerated. Thus, the events of September 11th have ushered in what I would call a Changed World Order. Unfortunately, there isn’t time for these remarks to examine the vast array of changes that one can foresee effecting many aspects of social existence—from freedoms that will be relinquished, to security costs that will be escalated, to efficiencies and productivity that will be diminished.

Allow me here to examine but a singular line of change—the one that will directly effect the markets of derivative exchanges. It centers on the pace of their evolution which gives rise to several interconnected questions. When will open-outcry be totally replaced by electronic trade? Is there a continued necessity for a centralized transaction system in an E-commerce world? And, is there a use for the traditional trading floor in an age of electronic automation?

While the confrontation between technological advancements that permeated the marketplace over the last two decades and traditional open-outcry methodologies has been brewing for over a decade, the immediate catalyst of the war that unfolded was the 1998 SEC promulgation allowing Alternative Trading Systems. Status quo was forever changed. It caused a swarm of Electronic Communications Networks, so-called ECNs, to be created. ECNs can and do encroach the traditional turf of exchanges and represent the greatest threat in the battle for transactional dominance.

Their general catch-all definition is that they are transaction mechanisms developed independently from the established marketplaces like the NYSE, Nasdaq, Chicago Mercantile Exchange, Chicago Board of Trade, Chicago Board Options Exchange, and so on, and designed to match buyers and sellers on an agency basis. Some are designed for equities, some for cash, others for derivatives. They can also be grouped into market types: Interest rates, credit instruments, foreign exchange, energy, weather, metals, chemicals, and even hedge funds to name a few.

There are different types of business models among ECNs. Most of them end up serving different client needs, but their most significant difference is that some are destination networks, which are principally execution systems, others are simply routing mechanisms. In addition there are also crossing networks; hybrid models of electronic order routing and trade execution; smart-order-routing facilities; and non-continuous automated call auction models. Each of these designs either has unique features that serve a specific array of clients, or has built-in order flow from the systems users. There are literally hundreds of them and their sheer number makes one suspect of the genre. It is inevitable that many of them face the same dismal fate of a multitude of B2Bs and "dotcoms" that sprung up during the height of the Internet bubble—when even street-people had their own website. Still, those providing the greatest value-added, will flourish.

In the past, US market structures—generally composed of exchanges and broker-dealers—have catered to the needs of institutional and retail investors by focusing on centralization of trading activity. In that fashion, buyer and seller interaction is maximized. However, the explosion of ECNs have led to the potential for the undoing of centralization. These issues have resulted in a debate whether it is feasible or not, good or bad, and who wins or loses.

While to a large degree the battle is between ECNs and traditional exchanges—specifically derivatives exchanges— it must be understood that many of these platforms were created in conjunction with traditional broker-dealers and nearly all are owned by consortia of market participants, many of which are broker-dealers. For instance, BrokerTec Global represents an electronic inter-dealer trading platform backed by a consortium of 14 of the most powerful institutional firms—ABN Amro, Lehman Brothers, Merrill Lynch, Morgan Stanley, UBS Warburg, Credit Suisse, Banco Santander, S.A.Barclays, Deutsche Bank, Dresdner Bank, Goldman Sachs, JP Morgan, Salomon Smith Barney, and Greenwich Capital. BrokerTec recently received CFTC approval as a futures exchange. It will offer a single, fully electronic platform that aims to trade cash and traditional futures contracts, and claims that it will do it cheaper. One cannot dismiss this type of competitor lightly.

At the heart of the tug-of-war are three basic issues: 1) Where is liquidity best achieved; 2) Where can a participant receive secure processing, clearing, and banking facilities for the transaction; and 3) In what forum will a participant achieve the best price at the lowest cost. The transaction system that provides the best combination of answers to these three propositions will dominate.

That liquidity is a mandatory element for success of any transaction system is a given. Without it there is no market. One needs not dwell on this point; examples of failed systems because of a lack of liquidity are legion. In comparing who offers the most of what, I will simply state that with respect to liquidity there is no contest. It is the hallmark of traditional derivatives exchanges. Can this hurdle be overcome by ECNs? Yes, it has happened—Eurex’s wresting of the Bund contract from LIFFE is the clearest example of such a case—but it is a rare event and doesn’t come easy. Especially not, if an exchange is alert to the threat and takes the indicated measures.

This brings us to the ability to clear, process and settle transactions. To stay viable in an E-commerce world, a transaction system must provide this capability or partner with someone that can. Again, clearing, processing and banking on a multilateral basis has historically been the strong suit of traditional exchanges. This is not a skill ECNs are born with. Indeed, existing clearing organizations, sensing an opening in the battle, are stretching their reach to provide greater value to member firms and even extending their clearing services beyond the traditional markets. The announced intention by Deutsche Borse (the holding company for the Frankfurt Stock Exchange and Eurex) and by Euroclear (the clearance and settlement system for internationally traded securities) to purchase Clearstream, the other major European clearance and settlement system is solid evidence that the trend toward centralized clearing continues to advance.

Finally, can a centralized marketplace do better than the ECN in achieving the best price at the lowest cost? On one side, is the contention that centralization is necessary for order-competition—in other words, to achieve the best price. Again, this would point to the centralized marketplace which maximizes order flow. On the other side, is the contention that fragmentation maximizes venue competition—in other words, it offers competitive efficiencies to achieve the best "all-in" cost. Surely those broker-dealers that wish to sacrifice their bottom-line by subsidizing their clients in this respect, can beat out any other private sector competitor. But I submit that such subsidies will not continue to work for very long in a competitive system.

Long before the terrorist attacks, there was mounting acceptance by users that centralized exchanges provide the best combination of the necessary three requirements: liquidity, clearing, and best execution at the lowest cost. Since September 11th this view has been greatly enhanced by a coincidental consequence of the attacks. More than ever, users want to take fewer chances. There is much less tolerance for experimentation. "Carry out my business on a forum that has withstood the test of time, that has established expertise, and that has unquestionable financial integrity"is the message we are getting. That message was certainly fortified—by an order of magnitude—as a consequence of the recent Enron experience. Indeed, EnronOnline seemed to epitomize a successful ECN providing worldwide energy and related financial trading facilities. Its sudden failure sent a troubling signal to the trading community about the reliability of a private ECN, even one as large as Enron seemed to be.

Moreover, because sophisticated application programming interface (API) serves to mask the geographical location of both the matching engine as well as the clearing facility, the technological revolution actually favors centralized exchanges. By virtue of an API, every broker-dealer can plug into any sophisticated transaction system it chooses as well as clear its trade at the clearing facility of his choice. This gives the traditional exchanges a huge leg up.

We are then left with the questions of electronic versus open outcry trade and the continued necessity of the traditional trading floor. To me it has been clear for a very long time that with the coming of the technological revolution, screen-based trading, or what used to be call the black box will overtake the traditional pit-trading environment. It is axiomatic. At the core of the technological revolution lies the capacity to collect orders, transmit them, and execute them in nanoseconds. Technology provides speed, efficiency and lower costs.

It was that belief that led us at the Chicago Mercantile Exchange to propose Globex way back in 1987 before any other futures exchange in the world considered making such a revolutionary proposal. Since then of course, the world has embraced the concept of electronic trade. In Europe there are no open-outcry exchanges left to speak of; in Asia this trend is recognized as well. In the US the pace toward a full electronic replacement has been much slower. But with September 11th and the danger of a trading disruption that can incapacitate a trading floor—such as happened for the first time in its history of the NYSE,—the pace toward electronic transaction systems is bound to accelerate. This much is certain, those exchanges that are ill-prepared or insufficiently funded to provide an automated mechanism that can in an instant take over from a floor trading environment are marked for failure. What isn’t certain is the exact date when automation will completely take over.

The issues are complex. American derivatives exchanges have a long history of successful open-outcry trading. Our floor trading community still represents a majority of our ownership. Thus, the livelihood of our owners is to a large degree dependent on a floor-based system. At the CME we have spent a good deal of time educating our members. They have learned to recognize the facts of life and accept the reality that some day the floor will cease to function. But we have agreed with them that the exact date is uncertain. Instead, we have struck a bargain with the floor members. The Merc will continue to expand the capabilities of Globex to provide the best electronic system possible; our management will continue to list as many products on the screen as it deems necessary. Indeed, most of the Merc’s product line has an electronic counterpart. Some of our most successful products are exclusively electronic. But we will not close the floor operation on any product so long as the product maintains its competitive viability—based on an explicit test that includes requirements of volume and open interest.

In other words, while we have no doubt that ultimately electronics and automation will prevail to the exclusion of the trading pit, we will let the market itself determine the exact date for this transformation. Without a doubt, September 11th has quickened this metamorphosis. In the meantime the CME operates in dual fashion. I would also argue that when open-outcry goes, so will the purpose of the trading floor as we have come to know it. But in my view, the trading floor can be transformed into an important resource of a centralized exchange. While it is far too expensive to build a new one, as long as the infrastructure of the trading floor already exist, its function should be transformed to fit the demands of automated transaction mechanisms. Namely, it should become an "Electronic Arcade."

To understand the rationale behind this thought, one must understand that a trading floor was always more than simply the place where a transaction occurred. Humans are by nature gregarious and function best in an environment which tests our thoughts against those of others. The trading floor acted as a crucible of ideas for transactions. It was a gathering place for traders where new ideas could germinate from old ones. It is precisely the reason that giant trading floors at banks and investment houses exist. While the trades their employees make may be executed strictly in a technological fashion, the traders shout at each other; information is easily passed either at the terminal or in hallways or in nearby meeting rooms or at the water-cooler or over coffee or at lunch. There are private electronic trading rooms springing up throughout the marketplace. A large electronic trading arena sponsored by a centralized exchange can be an important addition to the successful evolution toward automation.

The good news is that for derivatives markets there is one unchanging constant: Uncertainty lies at their very foundation. In other words, the uncertainties of a changed world order represent a strong vote of confidence for the necessity and viability of derivatives exchanges. Case in point, the volume statistics at the Chicago Mercantile Exchange. Since the first of the Federal Reserve reductions in the federal funds rates that began in January of this year—known lovingly as the "Greenspan Effect"—the CME continued to achieve record volumes. Clearly, a change in federal interest rate policy was an unsettling event in the private sector, requiring a retooling of investment policies as well as contractual expectations and costs. The terrorist attack is of similar consequence.

So much is therefore clear: The management of risk is the bedrock of derivatives exchanges. The prospect of any economic dislocation, the potential for any change in value or price, the expectation of any alteration in economic policies or behavior, whether it be the result of international upheaval or the consequence of domestic disruption in business flows are the natural drivers of transaction volume on derivatives exchanges. The events of September 11th served to underscore this truth.

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