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My remarks today relate to the future promise of China’s developing financial market systems and, more particularly, the challenges and opportunities China faces in further developing its derivatives market infrastructure. Let me say at the outset that the opportunity for successfully developing markets for hedging and risk management of financial exposures in China is impressive. The growth of the Chinese economy over the past 20+ years has been remarkable. Since 1980, China’s GDP has grown nearly 8 percent per year, outperforming any other country at any time in history for such a sustained period of time. Last year, in 2003, China’s GDP exceeded 9 percent, while the GDP growth rate for the 30 OECD countries averaged slightly less than 2 percent. Furthermore, China’s eagerness to participate in world trade has resulted in a measurable increase in foreign investment, exceeding $57 billion in 2003. Given these accomplishments, the promise of China’s continued economic expansion, and the attendant growth of its financial market systems, is enormous.
Before I continue with my observations, let me first acquaint you with the Chicago Mercantile Exchange. It is my hope that our own rich history, and our successful transformation into one of the world’s leading marketplaces, will provide you with encouragement as you work to develop China’s derivatives markets.
CME traces its history to 1874 when a private association was formed in Chicago for the somewhat modest purpose of assisting butter and egg dealers. But as our subsequent history demonstrates, the bedrock of our success has been our ability to continually innovate and successfully execute on new ideas that have changed the world. CME has been the leading product innovator in global financial markets, from the revolutionary concept of financial futures first introduced by Leo Melamed in 1972, to cash settlement of the first interest rate contracts in 1981, the development of the world’s first successful stock index futures markets in 1982, and the creation of GLOBEX® in 1987 — the world’s first electronic trading platform for derivatives which, in turn, led to the development of our successful E-mini contracts — the fastest growing products in the history of futures markets. In each of these cases, the world followed our lead.
During the last 5 years, CME has further transformed itself into the largest futures exchange in the United States and the world’s largest clearing house for futures and futures options contracts. In 2003, a record 640 million contracts with an underlying value of $333 trillion changed hands at CME, representing the largest notional value traded on any futures exchange in the world. During this time, CME processed $1.5 billion per day in settlement payments and managed nearly $40 billion in collateral deposits. CME is also the global futures industry’s largest processor of electronic match transactions. Our system’s reliability is currently unsurpassed and the number of daily match transactions done on GLOBEX exceeds that of Eurex and Euronext.liffe combined. Since 2000, our average daily trading volumes have more than tripled, increasing from 800,000 contracts per day to nearly 3 million in 2004. And 50% of all contracts executed at CME today occur electronically on our GLOBEX trading platform.
Our accomplishments were achieved through a series of well thought-out steps, including demutualization and our successful initial public offering, our continued product and technology innovations, our expanding global distribution, and the establishment of key strategic partnerships with leading exchanges and financial institutions around the world. Today, CME is the only publicly traded U.S. financial exchange and its parent company is now traded on the New York Stock Exchange under the ticker symbol “CME.” Our conversion from a membership organization to a publicly traded company fundamentally transformed our great institution, allowing us to broaden our focus from our floor based membership to providing efficient trading and clearing services to all of our global customers and valued clearing member firms. And in doing so, we have created significant value for shareholders in our company.
Many of these achievements could only have been possible through the existence of a flexible regulatory environment – which now brings me back to my central thesis. I believe that the continued expansion of China’s economy may be achieved by more aggressively advancing the growth of China’s financial futures and options markets. Access to global interest rate, stock index and foreign currency futures and options contracts will provide Chinese banks, corporations and financial institutions with valuable hedging and risk management tools necessary to preserve the economic benefits of China’s increasingly free and growing market economy. In this regard, the recent decision by Chinese government authorities to permit China’s interbank foreign exchange market to trade between foreign currencies, rather than simply between the yuan and other foreign currencies, will provide evidence of these benefits. By permitting trading between these contracts, China’s banks will no longer have to sell their excess foreign exchange, easing upward pressure on the yuan. Additionally, the recent action by the China Banking Regulatory Commission enabling Chinese financial institutions to engage in derivatives transactions in The People’s Republic of China should be applauded for providing a clear legal basis and regulatory certainty in respect of financial derivatives transactions.
All of that said, the obvious question is: “What are the challenges associated with achieving this?” Well, surely China faces unique and fundamental challenges relating to credit and monetary policies, property rights, bankruptcy schemes, the free flow of accurate market and financial information, and the adequacy of corporate disclosure and accounting standards. I will not dwell on these topics. First, I believe these challenges are well understood within China and that efforts are being made to begin addressing these more fundamental issues. The recent scandal involving China Life Insurance Co., a New York Stock Exchange listed company, underscores the gap between accounting and disclosure practices within China and the expectations of established public company markets outside China. Second, I prefer to focus my discussion more narrowly on what I know best: how to overcome the unique challenges of establishing successful futures and options markets.
With respect to the latter, surprisingly, the challenge for China is very similar to the challenge that we faced in the United States over the last three decades. You see, only twenty-five years ago, financial derivatives were new and not well understood. We faced skepticism and, indeed, criticism. Our products were labeled unnecessary, arcane, risky, dangerous or, worse yet, tantamount to gambling. But the power of our ideas won out over time. And we were benefited by strong support from three of the world’s great Nobel Prize winning free market economists, notably Milton Freidman, Merton Miller and Myron Scholes. Each of these individuals, and many others, were willing to endorse our market ideas and teach legions of young finance and business students the value and mechanics of how to hedge and manage risks using our products. During these years, we also worked extremely hard with our government to create Federal legislation in the form of the Commodity Exchange Act, and a Federal agency called the Commodity Futures Trading Commission, to provide regulatory oversight of our activities. We also worked to create an industry-funded self regulatory association, today known as the National Futures Association, to test, register and regulate industry professionals who would deal with public users of our markets. And, perhaps most importantly, we invested heavily in developing our own self-regulatory capabilities to ensure market integrity.
In my view, there are at least three fundamental requirements for developing successful futures and options markets. First, an exchange must ensure that all participants have equal and immediate access to accurate and fully transparent market information. Second, an exchange must ensure standardized practices and rules for market participants and have the ability to detect, deter and punish individuals or entities that engage in practices that can lead to market manipulation or unsound business practices. Third, an exchange must guarantee the financial performance of all transactions in its markets, as well as the safety and soundness of the related banking, settlement and custodial functions necessary to support market transactions.
The critical question then becomes the following: “What is the best way to ensure that these three fundamental requirements are met?” I believe the most effective form of regulation in financial markets occurs when government and private sector entrepreneurs work together. In particular, I believe government should strive to create an environment that requires exchange directors and managers to take full responsibility for all business decisions subject to strong incentives to operate efficiently and honestly. Speaking from our experience, we have worked very well with our regulator, the Commodity Futures Trading Commission (CFTC), since its founding in 1974. In 2000, the United States Congress changed the CFTC’s regulatory model from a prescriptive, rules-based regulatory system to a broad oversight function, with flexible core principles that an exchange and clearing house must satisfy. The shift in regulatory approach has worked well for the CFTC and all regulated markets, including the CME. The CFTC is now better able to concentrate its efforts on its oversight responsibilities and the CME is able to devote more time and attention to its own self-regulatory responsibilities.
In my experience, self-regulation is the most effective way to prevent market manipulation and abuse of customers. As a preferred form of regulation, self-regulation not only allows exchanges to work on an immediate basis with their systems, markets and customers to detect abuses, it promotes the continual enhancement of regulatory programs based on experience, capitalizes on the specialized market expertise of exchange managers and frees-up scarce governmental resources.
Another challenge faced by China is how to best gain entrée to the global capital and financial markets. By this I mean, how do China’s exchanges attract global intermediaries and global market participants? Can they succeed, and how long will it take, if they choose to develop solely from within. Alternatively, can they accelerate their entrée to global risk capital flows by opening up to investment, joint ventures and commercial business arrangements with other global exchanges and intermediaries? I believe the latter is clearly the best course for China. Why? Because the global futures and options markets are increasingly standardizing and consolidating in order to meet users’ and intermediaries’ demands for lower operational costs and greater capital efficiencies.
China can successfully develop its derivatives market infrastructure by concentrating on product development, economic analysis, the development of sound market regulation standards and by engaging in extensive education and training efforts to ensure the prudent use of Chinese financial and agricultural derivative contracts. And these efforts both can and should be undertaken solely from within.
On the other hand, China’s exchanges can gain enormous growth and acceleration benefits by collaborating with global exchanges like CME to utilize its extensive infrastructure, trading and clearing platforms, and industry standardized business practices. Here are some concrete examples. Recognizing the demands for greater efficiency, CME has led the trend toward standardization and consolidation. For example, one of Europe’s largest exchanges, Euronext.liffe, uses CME’s Clearing 21® System to clear and process the majority of their securities and derivatives products. In the area of risk management CME literally created the industry standards when, more than a decade ago, it developed its proprietary SPAN® Margining System. Recognizing that risk managers need a standard format across all markets to ensure a comprehensive and accurate view of risk exposures, CME licensed the SPAN System to more than 47 exchanges and clearing houses around the world. Importantly, our most recent licensee is the Shanghai Futures Exchange, an important step for China in the process of moving toward global industry standards. Finally, and perhaps most importantly, our historic clearing processing agreement with The Chicago Board of Trade is an excellent example of our two exchanges’ willingness to seek standardization and consolidation benefits designed to benefit our customers and intermediaries. Our collaboration has reduced performance bond requirements for market users by more than $1.6 billion and has saved our joint clearing member firms more than $200 million in capital.
I want to emphasize that our purpose is not to threaten or overtake the internal development of China’s emerging futures markets. Rather, our purpose is to seek mutually beneficial partnerships in which jointly we can broaden the distribution and reach of China’s futures markets. Citing an example from our own history of how this can be accomplished, CME’s highly successful and long-standing Mutual Offset System with the Singapore Exchange, then SIMEX, was born out of the very same topics that we are now discussing. Our Mutual Offset System represented the world’s first linkage between two financial exchanges, enabling traders to establish Eurodollar futures positions on one exchange and seamlessly offset them on the other.
The plan included a mechanism that would allow market participants to transfer their positions to the CME Clearing House, taking advantage of the financial, risk management and capital and performance bond efficiencies offered by CME. Today, it is clear that the CME/SIMEX partnership, and the strength of CME’s Clearing House reputation, clearly benefited Singapore’s efforts to become a significant financial center in the Asia-Pacific region.
Yet another way to accelerate the growth of China’s futures markets is to make Chinese derivatives products available on other exchange systems and trading networks outside of Asian trading hours. Throughout the last decade, CME has developed, enhanced and refined GLOBEX, our electronic trading platform. Our order Return Delivery Time is 25 milliseconds, among the fastest in the industry. GLOBEX is also accessible virtually 24 hours a day, longer than any other electronic platform. This achievement has come through many years of hard work and listening intently to our customers as they asked for faster systems with high reliability and more capacity. Global customers outside of China that want to trade Chinese financial and commodity contracts can easily access the GLOBEX System from anywhere in the world, avoiding the time and expense of writing electronic trading interfaces and establishing connections to relatively localized trading and clearing systems in China. In today’s marketplace, global standards, global networks and global platforms can be licensed from third parties, both accelerating China’s entry into global financial and capital markets and giving China a much quicker entrée to global intermediaries and sources of capital for credit intermediation of transactions in these markets.
Should this be of concern to Chinese government officials or the private sector? I do not believe so. To the contrary, a very interesting parallel is the significant number of Chinese companies, 16 at the present time, that have chosen to list ADRs on the New York Stock Exchange in order to gain entrée to the world’s largest and most successful capital market. The advantages created by leveraging established non-Chinese equity capital markets with global reach are clearly complimentary to China’s sovereign interests in further developing, over time, its own global equity capital markets.
In this same vein, I believe we can learn a great deal by fairly examining the question of the degree to which the operational components of futures markets and clearing houses that serve China’s economy must be localized in China. Of course, we first need to share an understanding of what it means to be localized in a particular jurisdiction when we are discussing an electronic marketplace. In this age of global financial integration, market boundaries have faded. Previously localized markets in substantially identical financial instruments have largely been unified into a single, global market with market participants dispersed worldwide. By these remarks, I am not implying that the markets won’t be local to or based in China, but there should be consideration and careful thought given to assessing the opportunities to find market expertise, standardization, speed to market and greater efficiencies from other exchanges. This is particularly important in the trading and clearing arena, where reliability and financial integrity literally drives credibility of the marketplace.
It is difficult to find some governing principle that settles the question of the locus of an electronic exchange. At one point, CME’s electronic matching engine was in London. Today, we have marketing offices, telecommunications hubs and customer support capabilities in a significant number of major financial centers. By this time next year, a substantial percentage of CME owners may be non-U.S. entities and an increasing percentage of our customers will likely be foreign institutions and trading firms. If the economics were right, one could imagine that CME’s trading engine and network operations could easily be moved to a foreign jurisdiction. Its GLOBEX Control Center could as easily be in India as in Chicago. Ask yourself the question: “Is there something other than legacy or nomenclature that makes CME a U.S.exchange and Eurex a German exchange?” I submit that the answer is most definitely no.
In conclusion, I wish to emphasize that although China’s markets are facing new challenges in terms of global investment and expansion, this does create an aura of uncertainly. Uncertainty is the normal evolution of economic circumstances that includes successes and failures, as well as accompanying market volatility. Uncertainty should be embraced as the unavoidable and even positive features of dynamic market economies. The changes forthcoming in the Chinese markets should be viewed as a great opportunity for your country. CME has faced uncertainty many times in its history and I know that we will continue to face challenges in the years ahead. As I told you earlier, we have shared our experiences that have benefited many exchanges and we look forward to continuing that tradition with the exchanges of China.
At the Chicago Mercantile Exchange we believe Asia represents enormous opportunities for business growth, and the rapid pace of economic growth in China since the decision to move toward a market economy has been significant. As China continues to become a major factor in the global economy, the country and its markets will continue to receive considerable attention from the world and CME is looking forward to developing stronger business and cultural ties with you.
Thank you.
