Fifth Annual Conference of Asian Capital Forum

Suzhou, China
October 26, 2002

Published in the 4th Quarter, 2002 Derivatives Special Report:
Profit & Loss: Digital FX

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A few months ago, on May 16, 2002, the Chicago Mercantile Exchange celebrated the thirtieth anniversary of the International Monetary Market, the IMM. It was a jubilant occasion, which included two distinctive congratulatory messages, one from Nobel Laureate, Milton Friedman, the other from the Chairman of the Federal Reserve, Alan Greenspan. It also featured a keynote address by William McDonough, President of the Federal Reserve Bank of New York.

The fact that these world luminaries would take the time to honor the IMM in this fashion, defines the significance of the events that occurred in Chicago in 1972. Looking back, it is easy to forget how revolutionary the concept of financial futures was regarded. Not only did the world then still distrust free markets in general, and futures markets in particular, the idea represented an unprecedented departure from its agricultural tradition. Indeed, the IMM endured a painful process of acceptance by the global financial community, especially its banking establishment. Its eventual approbation and phenomenal success came only as a result of the stubborn determination of its market founders, early pioneers and traders. But mostly its success flowed from the simple fact that the idea was a good one. Its blueprint has since been copied and extended to every financial center in the world. It made the Chicago Mercantile Exchange the number one futures market in America.

Praise for futures and derivatives by these distinguished experts at this moment in history—when economic woes and financial excesses have caused a major downturn in world equity markets and when U.S. corporate transgressions have shaken the credibility of the American corporate landscape—is by itself highly significant. For unlike past eras when any adverse financial event was reason to place blame on our markets, no one—not even the thoroughly uninformed—has pointed a finger at futures markets: Not for the bubble that was created in equity markets during the late 1990s; not for its inevitable bursting which began in March of 2000; nor for the corrupt corporate practices and manipulative accounting procedures which were employed at some firms with reckless abandon prior to their public exposure.

The causes of these corporate wrongs, while committed at but a limited segment of corporate America, were of a sufficiently serious nature to demand comprehensive reforms and were easily documented: Corporate governing boards that were either in alliance with or puppets of corporate management. Stock options to top executives which induced them to inflate near-term share prices regardless of long-term consequences. Accounting tricks to make certain that profits met or exceeded Wall Street expectations. Insider trading practices in violation of ethical standards and SEC regulations. Inflated revenues by virtue of fraudulent transactions and financial shams. Wildly overoptimistic price targets by analysts at many brokerage firms. Forgiving loans to corporate executives and ignoring their use of corporate money for personal acquisitions such as yachts, mansions, jets and other expensive prizes. Distribution of lucrative initial public offerings to company clients and friends. And a multitude of other schemes or transgressions which were camouflaged by the irrational exuberance of an unceasing rising stock market. Until the Ponzi scheme burst as it always does.

When it did, the market exposed the truth: Enron Corp. structured complex financial vehicles with which to fraudulently boost the firm’s cash flow. Arthur Andersen, Enron’s Auditor, aided and abetted accounting shams and later obstructed justice in an attempt to hide their misdeeds. WorldCom disclosed $3.8 billion in accounting misstatements and later uncovered an additional $3.2 billion in accounting distortions. The CEO of Tyco International is accused of evading taxes and conducting secret corporate deals. Cable giant Adelphia inflated financial statements and made $3.1 billion in undisclosed loans to its major shareholders. Global Crossing sold its telecom capacity in a way that artificially boosted its revenues. Dynegy and CMS Energy Corp. made fictitious transactions in order to pump up its trading volumes. Xerox inflated revenue and profits by including future payments on existing contracts. Analysts employed by Merrill Lynch and Salomon allegedly mislead investors for the purpose of furthering income to their firms.

All the while, the markets of futures and options, while far from perfect, continued to carry out their function as a mechanism of risk management. Indeed, the performance of world futures markets deserve the highest marks for their uninterrupted service during recent financial upheavals: Eleven consecutive reductions in the U.S. Federal Funds rate in the course of one year; market disruptions unleashed by the terrorist act of September 11th; a precipitous fall in equity prices; the ensuing war on terrorism, the possibility of new terrorist acts, the potential action against Iraq; and the mind boggling flood of corporate scandals of a magnitude not witnessed since the years preceding the Great Depression.

Little wonder Messrs. Friedman, Greenspan and McDonough saw fit to extol the virtues of our markets. As the chairman of the Fed. recently stated, "These (derivatives) transactions represent a new paradigm of active credit management and are a major part of the explanation of the banking system’s strength during a period of stress." Indeed, one has to wonder how the financial world would have fared were there not the markets of futures, options and financial derivatives to absorb the shock engendered by the afore-described upheavals. I dare say, not nearly as well. Not only did our markets act as a font of information, continuously disseminating price intelligence with which consumers and producers could make informed decisions across a wide spectrum of business demands; not only did our markets provide easy and efficient access to everyone who sought their application; not only did our markets provide financially secure clearing and settlement procedures; but our markets served as a security blanket, offering deep pools of liquidity with a constant flow of bids and offers with which investors and money managers could interact to reduce their risks, diminish their losses, or institute positions with a potential for profit.

For it is axiomatic: The management of risk is the bedrock of futures exchanges. The prospect of any economic dislocation, the potential for any change in value or price, the expectation of any alteration in national economic policies, whether it be the result of international turmoil or the consequence of domestic business disruptions, whether it be in finance or agriculture are the natural drivers of futures business flows. Proof of the value placed in our markets by the international business community during recent stresses can be seen in the surge of transaction volume at the world’s major futures markets: At the CME a 78% gain in the year of 2001, at LIFFE over a 64% increase, at Eurex a 48% increase, and at the CBOT a gain of over 12%. 2001 increases in open interest were commensurately impressive with the CME leading the majors with a whopping increase of 87%. In 2002 the trend of volume increases continues to date: At the CME 33%, at the CBOT 23%, at Eurex 14%, and at LIFFE nearly 10%.

We live in a highly complex and hazardous economic environment. Where geographical borders and time zones that once could limit the flow of capital are but history; where traditional internal protections that insulate ones' citizenry from external price influences are no longer valid. We live in a world in which competition is global, financial volatility is commonplace, and opportunities rapidly appear and disappear on a constantly changing financial horizon. We live in a world that demands products to protect against inherent risks, that demands cost-efficient instruments to adjust portfolio exposure between securities and cash, and that pays a premium for credit-worthy mechanisms which preserve credit lines. In such a world, futures and options markets are critical components of the financial establishment.

Today, the largest difference between rich and poor countries__between economic hope and economic despair for its people__is the freedom and efficiency with which they can utilize their resources. Free and efficient capital markets ensure that resources are allocated wisely. The more efficient the system, the better the allocation of these resources. Efficient markets lead to tighter bid-ask spreads, higher volumes of trading, and greater market liquidity. A liquid market reflects truer price values and gives investors confidence in the marketplace. As a consequence, the cost of capital is reduced, the standard of living is enhanced, and social order is greatly benefitted.

Futures, options and derivatives markets are among the tools to achieve this national benefit. They epitomize the fundamental principles of free market processes. While these processes may not be without fault, they represent the best economic order ever devised by mankind. Consider, even as we lament the market excesses which produced the recent American equity bubble, even as we cringe and denounce the American corporate misdeeds of recent years, we must recognize and applaud the fact that the market worked. Unlike economic systems that are controlled by the heavy hand of government, the American free market system acted quickly to right the wrong. It exposed the truth and unmercifully punished both the corporate entity and corporate executives that violated the rules.

China’s markets are still a long way from embracing all the tenants of the free market. However, the country has made giant strides in this direction and is a nation in transition. Not only have China’s capital market grown dramatically over the past decade, after 15 years of negotiations, its recent entry into the World Trade Organization is a monumental milestone. It will mark a dramatic departure from the past insulated, centrally-planned, economic order into one that will be defined by market forces and global trade. The WTO entry will thus set in motion sweeping changes across the entire Chinese economy.

Among those effected will be the Chinese agricultural community. This nation’s 500 million farmers will have to negotiate the combination of new obligations and new opportunities that will confront them. Protective tariffs must be lowered. Foreign products must be allowed to compete with local produce. Many of these transformations will require patience, engender pain, and take years to institute. Toward this purpose, expansion of China’s futures markets should be given the highest priority. Chinese enterprises, both in agriculture as well as in finance, will find that WTO entry dramatically increases their need for sophisticated futures market tools with which to protect against inherent economic risks.

China’s history in futures markets has admittedly been problematic. Its past experience was the consequence of an inadequate regulatory framework and unprofessional trading practices. These past errors have been corrected. Beginning in 1994 the Chinese government instituted an effort to close illegal futures operations and consolidate many others. Under the direction of the China Securities Regulatory Commission from over 60 futures markets only three remain: The Shanghai Futures Exchange (SFE) which specializes in trading of aluminum, copper and natural rubber, the Zhengzhou Commodity Exchange (CZCE), primarily trading in wheat and mung bean, and the Dalian Commodity Exchange (DCE) trading in soybeans, soybean meal and beer barley. The DCE is today the second largest soybean futures market behind the CBOT.

We applaud the National People’s Congress recent acknowledgment for the need for additional futures instruments. We urge the government to open China’s futures markets to foreign investors and brokerage firms. And we encourage the China Securities Regulatory Commission to look favorably on the application by the SFE to enter into the arena of financial futures. The SFE goal to become the major futures market in the Asia Pacific region is predicated on its ability to launch stock index futures, as well as contracts in interest rates and foreign exchange. We advocate this development.

The people of China are resourceful, determined and resilient. This conference is clear proof of their desire to improve their market efficiencies and expand their market structures. We have no doubt that this nation can achieve these results. The people in America, in turn, stand ready to help. The Chicago Mercantile Exchange is specifically here to extend its hand and provide expertise. Our common goal is to strengthen your capital market, smooth out the difficulties posed by WTO entry, attract foreign participation and foreign investors, and raise the standard of living of the Chinese people.

Looking forward, I would make the following observations about futures markets: What remains unalterable is that hedging activities in risk management will flow to the marketplace that is the most liquid. Second, the world today demands disclosure and transparency, whether in the execution process or in its book-keeping. Third, market participants will gravitate to the market that provides financially secure clearing and settlement procedures. Finally, the market 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.

However, technology alone will not be enough to persevere in the 21st Century. Innovation is the key. Finance is after all a dynamic science. The pace of change has accelerated exponentially and the distinctions between types of markets are vanishing. Strategies pertaining to equity, debt, indexing, foreign exchange, futures, forwards, options, swaps, and cash, are all interdependent and interchangeable. The digital age has unbundled all manner of risk and is capable of repackaging it in any form the customer wants at the moment he wants it. Customized strategies and customized instruments of trade are today’s soup du jour. Thus, the days of narrow-based niche market capabilities are limited. The futures exchange of tomorrow must be able to provide comprehensive risk management in every sense of the word.

Some exchanges and many electronic communication networks, so-called ECN’s who were not up to the above requirements have already vanished, others are being thrust to the side-lines. For those who survive there is bound to be massive consolidation. While there may always be regional exchanges serving a local clientele, they will be irrelevant unless they are tied to a global network. There is also little doubt that the ongoing trend of blurring distinctions between the instruments of futures and securities is continuing. The recent Joint Venture in single stock futures between the CME, CBOT and CBOE is a giant step in that direction.

It cannot be over-emphasized: Transformation in information technology created a world economy. It will continue to foster more globalization, greater interdependence, instantaneous informational flows, immediate recognition of financial risks and opportunities, continuous access to markets of choice, more sophisticated techniques, new innovations, and intensified competition. These are the unalterable trends of the future. As a consequence, the management of risk will remain at the core of every prudent financial strategy__a reality that will continue to have the greatest impact on the use and expansion of futures, options and derivatives markets, global and around-the-clock.

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