By Leo Melamed

CME Fred Arditti Innovation Award
to Leo Melamed
April 20, 2006
Four Seasons Hotel, Chicago

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This award is more meaningful to me than any others I have ever received. It recognizes innovation and bears the name of Fred Arditti. In 1980 I had the good fortune to bring Fred Arditti to the CME. He was much more to me than a superb economist and innovator. To say that we became close friends does not begin to explain the bond between us. From the very first day, there was a chemistry, a trust, an intellectual love affair that never wavered and lasted until his death. He was the only sounding board I ever needed. The only opinion I valued more than my own. While his tenure at the Merc was intermittent, at no juncture, in the many difficult twists and turns of CME history, was it ever necessary to bring him up to speed. From near or far, he instinctively understood, and always, always provided inspiration, encouragement, and advice. It is a unique privilege to accept an award bearing Fred Aditti’s name.

The American philosopher and historian Thomas Samuel Kuhn argued that scientific change occurs through “revolutions” in which one idea is overtaken by another. These revolutions can be triggered by conceptual breakthroughs, such as the invention of calculus which allowed the laws of motion to be formulated, or by technological breakthroughs, such as the construction of the first telescope which overturned Aristotle’s postulate of a finite, spherical universe, with the earth at its center.

Historically, such revolutions occur many decades if not centuries apart. Futures markets, or what are today loosely referred to as derivatives markets, have in the short span of 30 years experienced both a conceptual revolution as well as a technological one. As remarkable as that may be, we “ain’t seen nothing yet.” While the full potential of both revolutions is far from exhausted, I believe futures markets have the unique opportunity of capitalizing on yet another revolution in the making.

Few would argue with the fact that the launch of financial futures in 1972 was a conceptual revolution. It proved that the traditional idea about use of futures markets in risk management of physical commodities was applicable to finance. In the decade that followed the currency launch, this revolution was validated by the successful launch of interest rate futures in 1976 and stock index futures six years later. Nearly all successful financial contracts that followed at the CME and elsewhere were built on this foundation. Presently, the enormous potential of CME’s reach into yet-untested arenas makes it clear that the building blocks of our conceptual breakthrough have not reached their limitation.

At about the same time as this conceptual revolution began, another revolution was brewing: computer technology. It started to seriously flex its muscles in the early 1980s and ultimately, as we all know, influenced every aspect of life. In financial markets computer technology gave birth to the idea of electronic transaction systems. At the CME this culminated in 1987 with the Globex idea. In the following decade, electronic trading platforms were launched by every futures exchange in the world. The technological breakthrough produced the remarkable consequences futures markets are currently experiencing: global distribution, speed of execution, growth of transactional volume, and computerized algorithmic applications.

Allow me very briefly to put the effect of these two revolutions into perspective: In 1971, the year just prior to the launch of the International Monetary Market, the IMM, there were 14.6 million contracts traded on U.S. futures exchanges—there were no futures exchanges of consequence outside the U.S. Last year’s total global volume reached nearly 10 billion contracts, of which 3.5 billion transactions occurred on U.S. futures exchanges. There are some 35 futures exchanges in foreign domiciles today.

At the CME, in 1971 we had a whopping operating budget of $3,158,590. Our pretax income was all of $192,945. Fast forward to 2005: CME expenses were $412 million and our net income was $307 million—that’s more than $1 million per business day. Even more striking is the volume comparison. In 1971 CME transaction volume was 3.2 million contracts. That number in 2005 is over 1 billion contracts. I will let Myron Scholes figure out what percentage of growth this represents. But whatever it is, I doubt if there is any other institution in the world that can equal, let alone surpass, this record. It represented a notional value of $638 trillion.

The two revolutionary transformations in our markets were coincident with a much broader trend, one that in my mind exemplifies the twentieth century. I have often spoken of the fact that, during the last century, the scientific world moved from the big to the little, from the vast to the infinitesimal. From General Relativity to quantum physics, from individual cells to gene engineering.

Physics dominated the first half of the century. The first understanding of the atom was simply as a solid central nucleus surrounded by tiny electrons. With new technology came a much clearer understanding of the complexity of the atom with its subatomic particles of electrons, protons, and neutrons and a nucleus containing intricate combinations of quarks. Physicists had decoded nature’s age-old secrets, bestowing upon the world perhaps the single greatest achievement of the human mind—the atomic theory and quantum mechanics. In the second half of the century, biology took center stage. Technological advancements taught us that cells, originally thought to be simple repositories of chemicals, are more like high-tech factories in which complex chemical reactions produce substances that travel via networks of fibers. In short, parallel advances in physics, biology, and other sciences made it possible to probe the fundamental components of nature.

In financial markets, the evolution from the big to the little was strikingly similar. Just as in physical science technology brought us to subatomic particles, just as in biological science technology brought us to molecules, so in investment science technology brought us to the basic components of financial risk. The most complicated risk management structure—from alimony to Z-bonds—could suddenly be broken down into its fundamental components. Financial engineers disaggregated, repackaged, and redistributed risks and their corresponding rewards, exchanging one set of risks and rewards for another that responded better to an investors’ preferences. Financial futures and OTC derivatives became the financial counterparts to particle physics and molecular biology. Charles Sanford, the former chairman of Bankers Trust, dubbed it “particle finance.” One might even say that the Scottish-cloned sheep “Dolly” was the biological equivalent to a “new issue swap.”

The process is far from over. Just as futures markets are still expanding the boundaries of the conceptual revolution, so are our markets far from exhausting the potential of the technological revolution. The new technologies offer us the ability to consider risk management applications never before attempted on a global, national, and individual level. For instance, we have the potential to devise instruments dealing with global warming, long-range economic trends, or geographic transformations; we can design instruments for managing the national budget, trade deficits, or foreign currency reserves; we can provide risk management tools for health coverage, Social Security, or retirement. I could go on and on.

It is of course impossible to predict the future. Nor can anyone even predict the next invention or innovation of consequence. Nor its effect on growth of futures markets or the CME. For instance, there was no one anywhere in the world who predicted the effects of the Internet on commerce and trade, and that was only a decade ago. It is particularly foolish to make a prediction at the beginning of a new century when it may yet be decades before the innovation that will define it has occurred. Remember, it wasn’t until the middle of the nineteenth century that Karl Marx published the Communist Manifesto which served to dominate political thought in much of Europe and Asia for most of the twentieth century. Or remember that the lynch-pin of the technological revolution, one that gave rise to the computer and all that followed, did not occur until December 23, 1947, smack dab in the middle of the twentieth century, when John Bardeen, Walter Brattain, and William Shockley invented the transistor. We are not even a full six years into the twenty-first century.

Still, some things seem clear. The technological revolution has speeded up and computer technology is on the threshold of yet another breakthrough. Computer scientists believe that in the next decade or two, a scientific revolution of similar proportions to the last one will be unleashed. Recently, some 34 of the world’s leading biologists, physicists, chemists, Earth, and computer scientists spent some eight months trying to understand how future developments in computer science might influence life as a whole. Their report concluded that computing no longer merely helps scientists with their work. Instead, its concepts, tools, and theorems have become integrated into the fabric of science itself. Computers will soon play a role in formulating scientific hypotheses, designing and running experiments to test them, then analyzing and interpreting the results. It would represent a paradigm shift in scientific methodology.

Others believe that millions or billions of tiny computers will be embedded into the fabric of the real world. Twenty-four hours a day, year in, year out, nanocomputers will be measuring the effects of everything—from an ecosystem, to private sector interactions, to the human condition. The consequential results could then automatically be applied to risk management instruments dealing with employment, inflation, productivity, gross national product, federal legislation, or personal health. The list is endless. It would represent a utopian nirvana for financial engineers.

The impact on our markets from this technological revolution is impossible to fathom. Nor is it for us tonight to attempt a moral judgment on the radical consequences of these changes. Suffice it to say, it would represent a condition beyond Aldous Huxley’s Brave New World. Or as Ralph Cramden might say to Ed Norton, “I don’t even know what I am talking about.

Thank you.

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