Reality Check
by Leo Melamed

CME FX Seminar
April, 2007
New York, NY

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If one had to pinpoint the birth of globalization, one can't do much better than August 15, 1971, when President Nixon dropped the U.S. dollar convertibility to gold. It led to an irreversible breakdown of the system of fixed exchange rates and unwittingly initiated the modern era of globalization. Similarly, few things are more emblematic of the era of flexible exchange rates than the International Monetary Market (IMM) launched by the Chicago Mercantile Exchange in December of 1971. Indeed, the birth of this futures exchange is inextricably intertwined with the death of Bretton Woods.

The IMM's timing could not have been more perfect. It coincided with new technologies that were making it possible for news to travel at the speed of light. Information effecting valuations in currency, interest rates, and equities was becoming available in days, hours, and minutes (today seconds), rather than weeks or months. It is important to recall this history because the United States was its greatest beneficiary. We were the only nation on the planet after World War II to be in position to fully capitalize on the potential that globalization represented. As the world left the gold standard in favor of the information standard, we had the so-called "First Mover Advantage."

For the next three decades we dominated the world's capital markets, dwarfing everyone around. In derivatives, the IMM initiated a series of revolutionary financial futures products in foreign exchange, interest rates, and equity indices, upon which the superstructure of the modern CME was built. But there was much more to it. Together with the CBOT and NYMEX, we served as a catalyst to accelerate the growth of financial engineering, CBOE stock options, the development of OTC instruments, and spawned financial futures exchanges in every corner of the globe. Similarly in securities the New York Stock Exchange, the NASDAQ, as well as other American exchanges grew without equal-thicker, deeper, and more liquid than anywhere else.

According to Jonathan Macey, deputy dean of Yale Law School there are two primary reasons for our enormous success. Economists point to the fact that at the time we were the world's only source of investment capital. There can be no doubt that this is true. According to regulators, however, our success was the result of superior government regulations which protected investors. Our safe borders, strong enforcement of laws, and transparent markets engendered trust and trust brought business. Also true.

Allow me to add two additional components that were critical to this calculus. First, the U.S. had the academic and institutional structures in place that served to encourage innovation- specifically, financial innovation. Second, as Americans we had the unique combination of Constitutional guarantees coupled with a cultural heritage that allowed us to think freely, experiment, and create-call it political freedom intertwined with economic freedom. According to The Encyclopedia Britannica's classification of the 321 world's great ideas and inventions, better than 50% were conceived in the U.S. That doesn't happen by accident.

Nobel Laureate in economics, Merton Miller, liked to say the period between the mid-1960s and mid-1980s was singular. In his view, no other twenty-year period in recorded American history witnessed even a tenth of the financial innovation of those two decades. It enabled financial engineers to make derivatives the primary tool in the management of risk. We won't argue. But Merton Miller did not foresee, nor could he have possibly foreseen, the revolutionary advances in technology that were to follow. Advances that profoundly influenced the conduct of markets and exchanges, resulting in increased competition, greater efficiencies, global distribution, electronic trade, speed of execution, enormous increases in volume, algorithmic applications, and unceasing waves of continuous innovation.

The idea-foreign exchange futures-that a prominent New York banker said in 1972 "couldn't be entrusted to a bunch of pork belly crapshooters in Chicago," in 2006 averaged 5.4 million financial contracts per day with a notional daily value in excess of $3 trillion. According to the BIS, the notional value of outstanding contracts in global derivatives, $47 trillion in 1996, is today a whopping $454 trillion. And the end is nowhere in sight. To state the obvious, financial innovation has enabled the U.S. capital markets to become the unquestionable world leader in finance, the NYSE to become the largest securities market in the world, and the Chicago Mercantile Exchange the largest global derivatives exchange.

But suddenly, perhaps even rudely, we find that the American first-mover advantage is over. The growth track the U.S. maintained in the decades after the onset of globalization, has been steadily leveling off, while the growth track of other industrial nations has ramped up. Suddenly, the U.S., its commercial enterprises, and its exchanges are facing serious competition from other capital markets. In November 2006, a market-oriented blue-ribbon Committee on Capital Regulation led by Glenn Hubbard and John Thorton observed that America was losing its dominance of world securities markets. In early 2007, a study commission by NY Senator Charles Schumer and NY City Mayor Michael Bloomberg came to the same conclusion and urged a lessening of regulatory requirements, pointing to the Sarbanes-Oxley Act of 2002. Recently a panel commissioned by the U.S. Chamber of Commerce and led by Secretary of Treasury Henry Paulson reached similar conclusions.

Lessening of the Sarbox regulatory requirements is a good idea and will help, but in and of itself it will not alter the dynamic that is involved. Nor will we fix the problem with populist demagoguery that is advocating a protectionist agenda. "America-First" solutions have been tried before and are self defeating. In the globalized marketplace of today, such remedies would be devastating to both U.S. capital markets and the American standard of living. To find a solution, or in this case, solutions, one must first recognize and understand the cause of the problem. We have entered a new era in the global marketplace. The industrial world has caught up with us. The world has learned the value of Milton Friedman's free market precepts, adopted them, and put them to work. And is doing it with gusto. There are now three or four great pools of liquidity outside of New York: London, Frankfurt, and Hong Kong, to name the obvious. All major capital markets have modern trading capabilities and systems. They have competent and competitive securities and derivatives exchanges. Their banks are as solid as our own, and in some case they are our own. They have cutting edge technological skills. They have a skilled and talented labor force. Point in fact, we were excellent teachers and our students learned well. Our dominance in capital markets is now very much at risk.

In addition, we are only beginning to feel the competitive pinch from the two Asian giants that are just beginning to flex their international muscles. Presently, China and India's competitive advantage lies mainly in cheap labor. Within a decade their competitive presence will be felt in every segment of the marketplace. China's potential seems so overwhelming that many economists predict China will replace the U.S. as the leading economic power in the 21st Century. China is drawing imports from Asian neighbors, machinery from Japan, steel from South Korea, palm oil from Thailand. Its need for raw material has created an unprecedented boom in world commodities. It has become the worlds largest consumer of copper, aluminum, and cement. Last year it overtook Japan as the worlds second-largest importer of oil. It is the world's No.1 market for mobile phones, and the No 2 market for personal computers. The government has liberalized former communist labor laws and made them flexible. Workers now have the freedom to seek jobs that suit their talent and interests. China has opened its economy to foreign investment and domestic entrepreneurs-something the Soviet Union, Japan or even Germany never really did. China is learning and quicky adopting new technologies brought by these investors. And above all of that, China's long history of great respect for knowledge and scholars has returned. Forget the "Cultural Revolution," education is "in."1

The long and short of it: To remain competitive in the Twenty First Century, the U.S. must first accept the reality of the modern global paradigm. We cannot pretend or assume that things will ever again be as they were. In the future we will have to fight for business flows on a world stage and embrace solutions that will keep us competitive. Without question, this is not news to our multinational banks, global hedge funds, or Fortune 500 companies. But in some cases even they do not completely get it. However, more than anything else, it is our elected officials and our regulatory agencies, federal and local, who must accept what has occurred. Some of them may give lip-service to the idea of world competition, but are still regulating our commercial enterprises as if they were the mamma-pappa concerns of the mid 20th Century. Did you know that in every federal budget cycle, no matter whether a Republican or Democrat is in the White House, there is a proposal to institute a transaction tax on futures trade? Do they know how long it would take before our financial transaction business, which is 75% electronic, is diverted to a foreign competitor? Maybe all of 30 minutes.

American government officials must accept the fact that U.S. businesses will in the future not be competing across the street or across the river. Our competitors will be from across the ocean-from the U.K., Russia, Europe, Asia, South America, the Middle East, and even Africa.

The old road map is history. The new road map entails continued deregulation in order to promote continued innovation; it requires the reduction of burdensome compliance costs; it necessitates the containment of baseless litigation and their consequential monetary burdens; it demands we maintain open markets for goods. Beyond that, we must redouble our efforts to maintain our academic competence-the advantage that had so much to do with our first-mover advantage in the first place.

The bad news is that in international tests relating to math, U.S. performance at the high school level is below the relevant international average. We do okay in our K to fourth-grade level, we are about average in the eighth grade, but we are near the bottom by the time our students reach twelfth grade. That is unacceptable in a competitive environment that will depend on intellect, academic skills, and talent. At the Chicago Mercantile Exchange we receive tons of applications from highly skilled foreign students who speak English and more than one other language, often Mandarin. What is the national U.S. percentage of American born students that can speak another language besides some Spanish? I hate to hazard a guess. In Chicago, six years ago, Mayor Daley initiated a Chinese World Language Program for Chicago's Public Schools, K to 12. Unfortunately, it was the first major city in the U.S. to undertake this initiative.

The good news is that America's system of higher education is still the best in the world . Americans have always had a passion for higher education. Harvard College was established in 1636 just two decades after the Puritans arrive in New England. Recent international studies have concluded that 17 of the top 20 universities in the world are American; no less than 35 of the top 50 world universities are in America. There are many reasons for this, but at the top of any list is the fact the federal government plays a limited role and universities compete for everything-from students to professors to recognition to federal research grants to private sector gifts to basketball players. No one can safely rest on his or her laurels. This excellence must be maintained.

Given the foregoing, the fruit of our labor resulting from our three-decade first mover-advantage can become our arsenal of competitive weaponry for the future. Whether it relates to services, physical objects, conceptual ideas, or intellectual property; whether it pertains to financial products that serve organized exchanges, OTC markets, or financial intermediaries; whether it involves the delivery of goods or the communications infrastructure, it embodies a priceless intellectual legacy-a reservoir of knowledge, ideas, and experience unique to the innovator. When coupled with our Constitutional and cultural birthright to experiment and create, it represents an endowment of extraordinary potency on which to build our competitive future.

1 Becker-Posner Blog

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