In preparing my remarks, I began thinking about the growth of equity derivatives markets, trying to pinpoint when the cash and derivatives markets really started to trade in alignment with one another. The truth is, the stock, futures and options markets have always been somewhat aligned since the inception of equity derivatives, but it wasn't until all of our markets were on the verge of absolutely falling apart that we began to think of them together as one, single market.
Most of you in this room probably have a gut-wrenching story about how you, or a colleague faced or even fell to financial ruin on Black Monday, October 19, 1987. Thankfully that dark day, and the difficult weeks and months that followed, are behind us. But the lessons stay with us.
Initially, many blamed the futures markets for sparking the unprecedented drop in the stock market and called for a ban on equity derivatives. The conclusion ultimately reached by Nicholas Brady, the former investment banker who led investigation into the crash, was actually quite the opposite. In his final report, Brady pointed out that the equity and derivatives markets actually are one single market, moving in tandem. When the two trade out of line with one another, disaster can ensue.
The Brady report did more than exonerate the futures markets from culpability in the '87 crash. In fact, it provided a justification for trading cash and derivatives products interchangeably.
Another legacy of the aftermath of the '87 crash is the Brady report's acknowledgement of a new breed of trading strategy made easier by technology. Program trading, the trading of related baskets of stocks and stock index futures and options, was highlighted as having the potential to exaggerate short-term market moves.
The report's revelations about the potential power of technology only reinforced developments during the nineties, when the derivatives markets were marked by a progression of technological advancements. Those developments laid the foundation for today's electronic trading environment and helped implement operational and risk management procedures. Additionally, technology advancements paved the way for heightened alignment of the equities and derivatives markets by increasing the speed of trade execution.
Today, technology and electronic trading dominate a significant portion of the securities and exchange traded derivative markets. Access to the Internet has also greatly expanded the universe of traders with direct access to the markets. The advancement of trading software and the increased processing speed of PCs has led to further alignment of the markets, with much tighter bid-ask spreads and increased volume being traded. Prices are all linked, and in many cases are kept in line by automated programs - baskets of stocks, futures, options and exchange traded funds rarely get out of line for more than a few seconds.
This industry-wide evolution of technology has created efficiencies and streamlined processes, and at the same time, it has empowered our customers. Customers have asked for direct access to our products, and they now have it. Customers wanted around-the-clock access to certain products, and they now have that as well.
The result of increased access has been an explosion in volume. Since 1987, volume at the Chicago Board of Trade has expanded three-fold. Not only that, but our customer base has expanded. Now more than ever, CBOT®'s customers can, and do, trade our products from locations around the world.
The drive to create a global trading community really began the same year as the stock market crash, in 1987, with the CBOT's night bond trading. During the overnight session, pit brokers took orders that largely flowed from Japan. The CBOT was the first to realize the potential, and the opportunity in making markets beyond traditional trading hours. While many Americans slept, Asia was open for business, and so was the CBOT.
Also helping to build a borderless derivatives market was the mutual offset system set up by the Chicago Mercantile Exchange® and SIMEX. Here, a clearing agreement was the linchpin linking exchanges. CME® and SIMEX struck a deal in 1984, which allowed for CME's Eurodollar contracts to be traded on SIMEX when the Chicago exchange's open outcry pits were closed. This MOS facility was a key factor in developing business at SIMEX and in establishing Singapore as a major regional financial center.
Both interest rate futures and stock index futures were created in Chicago and were the driving force behind the immense growth of the derivatives industry in the last 30 years. CBOT launched the very first interest rate futures contract in 1975 with Ginnie Maes, and Treasury bond futures soon followed -- those two contracts were the first to link cash and futures in the fixed income market. Stock index futures also originated in Chicago, with the CME's S&P futures and CBOT's Major Market Index futures inaugurating the age of stock index trading in the early eighties. Today, the CBOT's DowSM futures complex continues significant volume growth, and our mini-sized DowSM is one of the fastest growing contracts in CBOT history.
That kind of innovation has been a hallmark of the derivatives industry in Chicago for 155 years. Every single derivatives exchange around the world is actually a derivative of our model.
What is more, the innovation has not stopped. Not for a single moment.
Recently, the CBOT reached an agreement with EuronextLiffe to have LIFFE CONNECT® serve as CBOT's electronic trading platform, and the first phase of the arrangement starts in November 2003 and the second in January 2004. With about 90 percent of all of CBOT's U.S. fixed-income futures products changing hands electronically, the decision was a crucial one.
LIFFE CONNECT®' superior functionality, including the ability to complete complicated spread transactions, enables the CBOT to meet ever-changing customer demand. Additionally, LIFFE CONNECT®'s available in all major European money centers as well as Tokyo. CBOT will leverage that global presence and take advantage of the platform's mutual access capabilities to materially increase distribution of our products.
Technology advancements have made the entire world a smaller place and will continue to do so. Some day soon, a farmer sitting in his home in China will have the ability to hedge the outcome of his grain harvest with CBOT derivatives products, just as individual investors in China will one day have access to products like our Dow JonesSM index futures.
In today's global trading environment, one area where we see untapped potential abounding is in Asia's burgeoning markets. Futures trading has a long and rich history there, beginning with rice futures traded in Japan in the early 1700s. Today, there are more than 20 separate exchanges trading futures in Asia, including both futures exchanges and stock exchanges. A few key highlights:
- 17% of global stock index futures dollar volume, and 11% of global equities dollar volume were traded on Asian exchanges in 2002.
- 10% of global debt futures dollar volume were also traded there
- In the last few years, new exchanges in both Korea and Taiwan have developed their own active futures markets
- Many of the CBOT's own clearing member firms are owned by Asian banks
Additionally,
- Asian central banks and institutional investors currently account for 53% of all US treasury securities held outside the United States.
- Japan, Korea and Taiwan have been major importers of U.S. grain for many decades, with several other countries also making significant purchases.
The point here is that exchange traded derivatives have been a key risk management tool for Asian firms operating in the global marketplace for a long time, and that their participation will only increase as more countries in the region continue their move towards market-led economies.
Both the CBOT and CME have reached agreements of cooperation with exchanges in Asia. The CBOT signed a memorandum of understanding with the Taiwan Futures Exchange in August, and the CME's most recent MOU was with the Shanghai Futures Exchange in March. These alliances will help to foster cross-Pacific information flow and will lead to more business being done on all exchanges over time.
Beyond the original "Four Tigers" of Korea, Taiwan, Hong Kong and Singapore there are markets that have very significant potential to impact the futures industry, with the two largest being China and India.
There are currently 3 futures exchanges in China trading contracts on grains and metals: the Dalian Commodity Exchange, Shanghai Futures Exchange and the Zhenzhou Commodity Exchange. New contracts are now being studied on both interest rates and equity indices. India is planning to launch commodity futures on the Multi Commodity Exchange in October, and already trades in equity index futures at the Bombay Stock Exchange.
As both China and India continue their separate and different moves towards market economies, their demand for risk management tools will grow, both domestically and internationally.
With derivatives trading expanding in Asia, Europe and the United States, the outlook for the industry is extremely positive. According to the Futures Industry Association, volume of exchange-traded derivatives rose more than 600 percent in the last 10 years, on a global basis. This upward trend is one we at the CBOT expect to continue.
In order to extend this pattern of expanding trading volumes, we at the CBOT believe that Chicago's track record as an innovator must remain intact. To that end, best of breed technology is crucial to preserving the success exchanges all over the globe have enjoyed in the last decade and a half.
Providing customers with the integrity they want, and need, also will be essential for derivatives exchanges going forward. Our fully integrated market model allows each and every one of our customers to reap the benefits of the CBOT's transparent, level playing field. In the interest of maintaining market integrity, we have made the necessary commitment and financial investments to improve our overall business model, including our decision to transition to LIFFE CONNECT® and the further development of our handheld technology for our open auction market. Further, the implementation of LIFFE CONNECT® will provide the users of our products with unprecedented speed and efficiency.
Putting the customer first does not stop there. One of the most critical issues for our markets is investor confidence and the avoidance or elimination of conflicts of interest. Market integrity excludes self-interested behavior, and that market integrity must extend into the Board Room. A Board of Directors should have a single-minded focus ? to do what is best for the business. Self-interest never enters into the equation. At the same time, market integrity is synonymous with a transparent and centralized pool of liquidity, which eliminates opaque trading practices not in customers' best interest.
Investor confidence also depends on regulatory practices. Investors are examining exchanges with greater scrutiny in this post-Enron era, looking to ensure that exchanges have the tools in place to enforce rules and monitor trading activity. At the CBOT, we are proud of the work our market surveillance and market investigations teams do to insure the integrity of the exchange and its markets.
U.S. regulatory agencies have also been working more closely over the years, and the passage by Congress of the Commodity Futures Modernization Act in 2000 has led the way for greater cooperation between the CFTC and the SEC. The new legislation allowed for the launching of single stock futures in the U.S., a further step towards asset class convergence, and yet another financial tool for investors.
With the increased popularity of electronic trading, exchanges must tread very carefully with respect to anything that comes close to casting aside transparency. Transparency means that trades are executed in an open manner for all to see. Each order has the privilege of market makers competing for that order. One of CBOT's most important financial surveillance tools is the continual exposure of orders to competing market makers, a practice that reinforces market integrity.
Market openness, with no pre-arrangement of trading, no principal/agent conflicts, is critical for continued success of derivatives exchanges. It assures customers that competitive forces will be well informed of market prices so they trade at levels consistent with prevailing market conditions.
At the CBOT, our transparent markets rely upon a single liquidity pool with two points of entry: the trading floors and computer screens. CBOT customers have the choice to decide the execution method that best meets their needs. For example, while almost 90 percent of our financial futures trade electronically, in our financial options, where trades are often more complex in nature, activity takes place on the floor about 90 percent of the time. No matter what our customers decide, they all gain equal access to the same highly liquid and open market.
Finally, exchanges must consistently find new ways to create efficiencies for their customers. The CBOT/CME's Common Clearing Link is one example of such an innovative solution to meet the needs of those who matter most to us. From the outset, the partnership will free up $1.2 billion for our customers, creating capital and margin efficiencies previously unavailable.
Much has changed in the nearly 16 years since the crash of 1987. However, at least one thing remains the same: derivatives markets are still inextricably tied to the underlying cash markets.
The day following Black Monday, many of you may recall that several exchanges were closed, and the NYSE struggled to stay open. Against this backdrop, a couple of traders stood in what was then the CBOT's Major Market Index trading pit and started buying the stock index futures contract. The contract's price began to climb, and so, too, did optimism around the world. The MMI's movement emboldened others to buy equities and derivatives contracts, thus initiating the slow, and painful recovery that took years to be realized fully.
Since then, technological advances and the expansion of borderless trading have altered our professional lives forever. Like the changes in the industry since 1987, progress will likely shape derivatives trading in ways we cannot even now imagine. There are a lot of uncertainties, but of this I am sure: Chicago and the CBOT will continue to be at the forefront of that progress, and those that are most flexible to meet customer needs, and provide the highest level of transparency, will ultimately be the most successful exchanges globally.
