In the Twenty First Century
By Leo Melamed
Chairman Emeritus and Senior Policy Advisor
Chicago Mercantile Exchange
COUNCIL ON FOREIGN RELATIONS
Chicago, Illinois
June, 2004
Hog Butcher for the World,
Tool maker, Stacker of Wheat,
Player with Railroads and the Nation’s Freight Handler;
Stormy, husky, brawling,
City of the Big Shoulders.
Many claim that Carl Sandburg’s Chicago of the 1920s is a distant memory,
I am not one of them.
True, the Stock Yards are gone;
And with manufacturing down, Chicago’s tool making may have suffered,
As for stackers of wheat—those twelve famous grain-houses on the Illinois & Michigan Canal
— yes, they are gone,
And the big banks are gone as well!
Chicago has changed.
What of it! So has the entire world!
But Sandburg’s vision of Chicago is as true as ever.
Fierce as a dog with tongue lapping for action,
Cunning as a savage pitted against the wilderness,
Bareheaded,
Shoveling,
Wrecking,
Planning,
Building, breaking, rebuilding
Under the smoke, dust all over his mouth,
Laughing with white teeth,
Under the terrible burden of destiny,
laughing as a young man laughs
Who has never lost a battle........
Come and show me another city with lifted head singing
So proud to be alive and coarse and strong and cunning.....
Sure, U.S. slaughter houses are no longer in Chicago, but the nation’s forward prices of cattle and hogs are still determined in this city. The city has exchanged animal blood and guts for the mettle of futures and finance. Sure, Cyrus Hall McCormick’s grain reapers that made the city a premier center for grain distribution is gone, but more grain is traded in Chicago than anywhere in the world. The city is still the center of one of the world’s richest industrial and commercial complexes; it is still the major transportation node of the continent; it is still the world center of architectural innovation; it is still the premier center for trade shows, conventions and fairs; it is still one of the most diversified cities in the nation;
Most important, the city is the proud architect of the “Chicago School” of economics. That moniker is owned by the Department of Economics at the University of Chicago which gave birth to a brand of economics that adheres strictly to the philosophy of “free market” libertarianism and laissez-faire commerce. As a consequence of its stature it attracted the brightest economic minds in the world and took the lion’s share of the Nobel Prizes in economics during the 20th Century.
Under its best known and most forceful advocate, Milton Friedman, “Monetarism” found the theoretical and empirical means by which to roll back the Keynesian revolution, and bring market-driven economic order to the world. No other city in the world, except perhaps the London of Keynes and Carl Marx, is entitled to claim a philosophy that altered the economic and political direction of the entire planet.
Thus, it was fitting that Chicago emerged as the Risk Management Capital of the World—particularly since the 1972 introduction of financial futures at the International Monetary Market, the IMM, of the CME.
Two decades later, Nobel Laureate, Merton Miller, pronounced that financial futures were "the most significant financial innovation of the last twenty years."[1] Three decades later, on its 30th Anniversary, Federal Reserve Board Chairman Alan Greenspan sent the following congratulatory message to the IMM of the Chicago Mercantile Exchange:
The financial derivatives markets, which the IMM has played a critical role in developing, have significantly lowered the costs and expanded the opportunities for hedging risks that previously were not readily deflected. As a consequence, the financial system is more flexible and efficient than it was 30 years ago, and the economy itself may be more resilient to the real and financial shocks. Indeed, the transformation of the financial system has been so profound and the benefits so great, that it seems questionable whether even those that launched the IMM could have fully appreciated what they were setting in motion. What is clear is that participants in financial markets across the country and around the globe have good reasons to join the International Monetary Market in celebrating their 30 years of accomplishment.[2]
High praise indeed from the high priest of finance. So what exactly is he talking about?
There is little mystery about it. We live in a highly complex and hazardous economic environment where information travels at Internet speed. We live in a world in which competition is intense and global, where interest rates, exchange rates, and other asset prices are volatile, and where dangers as well as opportunities rapidly appear and disappear on a constantly changing financial horizon. We live in a world where the possibility of any economic dislocation, the prospect 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 demands the means by which to limit the attendant risks or an opportunity to capture the perceived or real profit potential.
To manage these financial risks, the marketplace has turned to derivatives—what the Wall Street Journal called “little miracles of financial engineering.”[3] The economic function of these instruments is to provide a safety-net based on benchmark groupings of inherent business exposures or to unbundle the risks into their basic components and transfer them to those most able and willing to assume and manage each component. Consequently, financial derivatives—both on centralized futures and options exchanges or customized in the OTC market—represent some of the basic tools necessary in the mechanics of efficient capital markets and have become an integral part of the financial system in the world’s leading economies. A process that in the words of Alan Greenspan, “has improved national productivity growth and standards of living.”[4]
The concept was formalized in Japan with the first physical futures exchange. To be exact, the house of a wealthy rice merchant named Yodoya, in Osaka, in the year of 1650 is recorded as being the first stationary meeting place for merchants where they would gather to exchange and negotiate their "Rice Tickets." These were, in fact, negotiable warehouse receipts representing either rice already grown and stored or rice to be produced for future delivery.
It was not until 1826 in England, and 1867 in the United States, that the traditional futures market was established. In the US, Chicago was the natural locale as it represented the great railroad center for products grown in the West to be moved to the population centers in the East. It proved to be a huge commercial success for the city. Throughout its formal history, traditional futures were based on agricultural products. It wasn’t until 1972 when some young lawyer, without economic credentials, without permission from New York bankers, explained to a bunch of hog traders in Chicago that the Swiss Franc was not some kind of foreign hot-dog.
The shock was seismic and resulted in a primordial financial soup on the floor of the Chicago Mercantile Exchange which ultimately changed the nature of global markets. It ignited the CME’s meteoric rise from a secondary Chicago backwater exchange in eggs and porkbellies, to a global financial powerhouse that is number one in the U.S. and by most measurements first in the world. In 1971, on the eve of the birth of financial futures, the transaction volume at the CME was 3.2 million contracts—totally in agriculture (a number that is less than our daily trading average today). In 2003 the CME traded 640.2 million contracts—an increase of nearly 20,000 percent from their inception—and all but one percent are in financial products.
Our idea was emulated by every financial center, or would-be financial center, the world over. Years later, our trader cousins—euphemistically known as financial engineers—fed our concoction to their hungry computers and the age of financial derivatives sprang to life which today boasts of 200 trillion dollars in outstanding contracts. A good deal of the credit must go to Nobel Prize Laureates, Merton Miller, Harry Markowitz, William F. Sharpe, Robert Merton, and Myron Scholes for recognizing and heralding the value of derivatives in business application. Their pioneering work in the theory of financial economics ushered in the modern era of risk management and made it the accepted standard worldwide. Today, Messrs. Scholes, Merton and their fellow Nobel Prize winner Gary Becker, as well as other Chicago financial experts, serve under the auspices of our Competitive Markets Advisory Council, providing CME with their invaluable counsel in formulating competitive strategy.
Earlier today, Craig Donohue, CME’s Chief Executive Officer, gave you some of the practical results. He said that at the CME, the average daily May volume of contracts traded was 3.4 million — that is number one in the world. He told you that the notional value of those contracts traded equaled 179 trillion dollars so far in 2004—again number one in the world and bigger than at the NYSE, Eurex exchange of Germany, and the French/British Euronext.liffe exchange of London. He said that the open interest—that is fancy terminology to define our open book of business—represents more than 38 million contracts. Our nearest world competitor, Euronext.liffe, is about half that number.
He also explained that on Globex—CME’s electronic transaction system—566,000 transactions are matched daily. Our nearest electronic competitor, Eurex, does about a third of that number. And that does not include another 100,000 daily transactions executed on the floors of the CME. He underscored that Globex, which does more than 50% of CME transactions, operates 23 1/4 hours per day—no other system in the world equals that feat. As a topping on the cake, last year’s clearing processing agreement with the CBOT created the world’s largest derivatives clearing house at the CME —clearing 85% of U.S. market share.
Meanwhile at the Chicago Board of Trade, the 2003 volume soared to nearly 454 million contracts, a 32 % increase over 2002 total of 344 million contracts. The first quarter of 2004 witnessed an additional 48.7 percent increase over 2003. Total trading volume in May was 55 million contracts up nearly 26 % from 2003, and up 44.7 % year-to-date. The exchange saw average daily volume in May rise 32.2 percent from May 2003 levels, as their membership values surged to record highs.
During 2003, the Chicago Board Options Exchange remained the leading exchange in overall securities options volume, garnering a 33% market share—although its position as number one is threatened by the International Securities Exchange (ISE) a fully electronic marketplace based in New York. Nevertheless, nearly 270 million contracts were traded at the CBOE, with an average daily volume of over 1 million contracts. Total equity options volume in 2003 was 159 million contracts, representing the fourth highest fiscal year total in the exchange’s history despite a 2% yearly decrease.
For Chicago these statistics are of colossal consequence. According to the study conducted by Civic Committee in 1996, Chicago’s futures and options exchanges are the “dominant factor in identifying Chicago’s position as a world financial center.” The risk management industry, it concludes, has a huge impact on the economic health and well-being of Chicago, the state of Illinois, and, indeed, the nation. It has led to the creation of a vibrant community directly and indirectly involved in trading. Researchers at the Federal Reserve Bank of Chicago, calculated total employment generated by the securities and commodities sector at 151, 500 in 1996. These markets have grown by an order of magnitude since then. The jobs created directly and indirectly includes jobs for thousands of graduates of the city’s high schools, a significant percentage of whom are minority students, as well as for college graduates and those with advanced degrees.[5]
The Chicago futures exchanges have a total of 41 billion dollars on deposit in Chicago banks in the form of performance-bonds deposits. An additional 1.5 billion dollars in 2003 was held on behalf of the Options Clearing Corporation, which is based in Chicago and is responsible for clearing margins for all of this nation’s stock options exchanges. Approximately $108 million of income taxes were paid by the 4 Chicago exchanges in 2003 of which the CME paid $79.7 million. These figures do not include the amount of money paid in sales and real estate taxes. To put it succinctly, Chicago derivatives exchanges represent the economic engine of Chicago.
Becoming the capital of Risk Management brought us new fame, a new image, new industries, new jobs, new strength, a new future. But our legacy is as precious as it is tenuous. Competition is an unceasing taskmaster and the imperatives of the Twenty-First Century make new demands: Can Chicago exchanges meet the challenges of change and protect their priceless franchise?
To find the answer it is imperative to understand the long-standing successful strategy employed by the CME. It can be explained in two words: Innovation and Diversification. No, you did not hear me say that any part of our strategy depended on wresting a successful product from an existing competitor—as our European competitors are attempting to do. Instead we concentrated on what we do best.
Beginning in the 1960s with the first “live” delivery of product, we continued to revolutionize the world of markets though innovation. In 1972, by initiating the first financial exchange, the IMM, and the first financial product, foreign currency futures; in 1976, the first short-term interest rate instrument, T-bills; in 1981, the first cash-settled instrument, eurodollars; in 1982, the first successful equity index product, S&P futures; in 1987, the first conceptual electronic transaction system, Globex; and in 1997, the first downsized product, the e-mini S&P contract. We then became the first American futures exchange to demutualize and go public in 2002.
During that breathtaking epoch of innovation, one that spanned thirty years, the CME conscientiously diversified its market breadth, covering nearly every sector of the business landscape from agriculture to finance, from meats to dairy to weather, from foreign exchange, to interest rates to equity index products, from futures to options—becoming without equal the most diversified derivatives exchange in the world. And throughout, our mode of expansion was based on a two-pronged strategy: First, to aggressively market our own products into every corner of the globe—thereby becoming the only true international market. And second, to assist emerging markets and new participants in the development of futures and options. The latter consisted of educational and missionary work on the premise that competition is the fuel for CME success, that participants created anywhere eventually become CME customers, and that ultimately a CME-assisted market will expand its reach by partnering with the CME or utilizing the Globex platform.
Our missionary labors are no idle boast. They included the DTB exchange in Germany, precursor to the Eurex, the LIFFE exchange in the U.K, precursor to Euronext.Liffe, the Simex exchange in Singapore, now the SGX, the futures and securities markets in Japan and Korea, and now, for obvious reasons too numerous to mention, our newest focus is China. Time will not permit to discuss the breadth of this Asian strategy. Allow me to just whet you appetite by suggesting that you watch tomorrow’s newspapers.
It is also instructive to differentiate the foregoing strategy from the one recently employed by our two foreign competitors, Eurex and Euronext. In providing the following analysis I mean no disrespect to the European exchanges. They are both successful and competent markets. Moreover, since it has only been about six months since the first of these foreign competitors began their American campaign, it is a bit early to draw definitive conclusions. The CME is committed to remain vigilant in this match, one that is bound to be long and arduous. Nevertheless, based on the results thus far, one cannot help but suspect that the strategy of our European counterparts has been ineffective. At best, neither of the foreign markets has achieved more than about one percent of the market share of the instruments they targeted at the Chicago exchanges. Anything less than ten percent of market share in an established instrument can be considered nothing more than “noise.”
Not only have our European competitors generally failed to create original product ideas, copying instead American innovations—mostly originating in Chicago—forgive me for saying that they have also neglected to do their homework. They embraced both a strategy and policy based on an old, cliche-ridden falsehood, namely, that the Chicago futures exchanges are antiquated markets, owned and operated by a clique-driven crowd, opposed to technological change, which could not compete with their aggressive pricing models, and were committed to an open-outcry venue. That image is so far from the truth as to make it laughable. Speaking for the CME I can categorically state that our exchange represents as modern, efficient, and exceptionally well managed a corporate entity as can be found in the business world anywhere. We have achieved a remarkable balance between talented management and board leadership that is steeped in expertise and experience, and is perhaps one-of-a-kind in the exchange universe. It represents a unified mind-set and a team approach, one that has a clear vision of the exchange’s future, is alert to competitive challenges, committed to technological excellence, and most important, successfully executing its growth strategy.
It was only after this reality took hold and the actual truth—facts and figures—made itself felt that the Europeans and the media began to reassess their original mistaken impressions. One could hardly deny our breathtaking and continuous record volumes, dramatic business breakthroughs, and successive flow of innovative ideas that kept emanating from the CME boardroom. Moreover, by then it was also obvious to most observers that not only had European strategy been based on a false premise, it had ignored an overpowering fundamental principle pertaining to market liquidity—one, to which I alluded to earlier.
The European strategy was for the most part based on an exceptional experience. That experience was predicated on Eurex’s 1990s ability to wrest a successful existing futures instrument—the Bund contract—from the London Financial Futures Exchange where it was devised, initiated and traded. The exceptional circumstances that caused that market to be lost by LIFFE and transported to Eurex so mesmerized both exchanges that they blindly concluded that it represented the modern model for market cannibalization. Nothing can be further from the truth. By every measure of market experience, it is highly difficult to transfer liquidity from the locus in which it was first developed as long as the original product provided is equal or better than the competition and offers more value to its customers.
Long ago the CME recognized that the current European strategy is expensive and nearly impossible to carry out. We learned from experience, sometimes from our own failed attempts, more often from attacks on CME markets by would-be predators. History is full of names the likes of Kansas City Board of Trade, New York Futures Exchange, London Financial Futures Exchange, Finex, Comex, Blackbird, BrokerTec, Cantor Fitzgerald’s E-speed, and a host of others who tried and failed. And although one cannot guarantee that CME will never again make such an attempt, we generally recognized the futility of such a strategy.
So there you have it. In our considered view Chicago’s solid foundation as a financial center is secure and poised for further greatness. It is and will continue to be the unquestionable global Capital of Risk Management in the Twenty First Century. Thus, Carl Sandburg’s vision of Chicago may have been recast, but is no less prescient and valid than it was when he first penned it. Forgive my modest attempt to redefine it:
Chicago: Risk Capital for the World,
Center of Innovation, of Finance,
Player with Concepts and Global Derivatives,
Stormy, husky, brawling,
City of the Big Ideas
Thank You.
[1] Financial Innovation: The Last Twenty Years and the Next, Merton H. Miller, Graduate School of Business, The University of Chicago, Selected Paper Number 63, May 1986.
[2] From the congratulatory message by Federal Reserve Board Chairman Alan Greenspan on the 30th Anniversary of the International Monetary Market (IMM), May 16, 2002.
