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The Masters of Indexing Conference
September 15 -16, 1999
Allow me to take a glance back at yesterday, and attempt a peak forward at tomorrow.
We stand near the finish line of the Twentieth Century, and the events that shaped its tapestry are still fresh in our memory. It was, in the opinion of many, the bloodiest in the history of mankind. Yet the 20th was also the century that showed remarkable promise. It rose from the ashes of the Holocaust and two World Wars, overcome the dual threats of fascism and communism, and by embracing the free market precepts of the likes of Thomas Jefferson, Adam Smith, and Milton Friedman, it fostered the winds of freedom which have swept over the vast majority of people on this planet.
It was the century within which the sciences of medicine, biochemics, and genetics combined to produce breakthroughs that eradicated deadly afflictions that have plagued mankind from the beginning of its species. It was the century in which incomprehensible advances in technology occurred. Where transportation advanced from the horse and buggy to the supersonic jet; where the the radio was transformed into a global cellular communications system; where the primitive flight at Kitty Hawk evolved into a trip to the moon. And it was it was the century in which financial derivatives were born.
There are those who might question the placing of derivatives among the great events of the Twentieth Century. And yet, the 1990 Nobel Laureate in Economics, Merton Miller, had the audacity to proclaim that the invention of financial futures ranked as "the most significant financial innovation of the last twenty years. " And Alan Greenspan very recently unabashedly said:
By far the most significant event in finance during the past decade has been the extraordinary development and expansion of financial derivatives. These instruments enhance the ability to differentiate risk and allocate it to those investors most able and willing to take it. a process that has undoubtedly improved national productively growth and standards of living.
But the best evidence of the significance of financial derivatives in the Twentieth Century are their ubiquitous acceptance as a modern tool of finance. According to the most recent Bank of International Settlements survey, the estimated size of the global OTC market today is at an aggregate notional value of an astounding $70 trillion, and rising. Indeed the notional value of derivatives, either on or off exchanges, grew more than 30 percent last year, the most rapid annual growth since 1994.
Not too shabby for an instrument of finance that is still in its youth. Indeed, it may come to a surprise to students entering financial courses at the universities today, that there is no mention of financial derivatives in the original edition of Paul A. Samuelson’s, Economics, published in 1955, which was destined to become the fundamental textbook throughout American universities; nor will the word derivatives appear in Milton Friedman’s classic statement of economic philosophy, Capitalism and Freedom. published in 1963; nor for that matter, was the concept of financial derivatives seriously considered an important instrument of finance until Harry Markowitz, William Sharpe, and Merton Miller received the 1990 Nobel Prize in Economic Sciences for their pioneering work in the theory of financial economics and corporate finance.
The tender age of financial derivatives is no mystery. The landmark event that spurred the use and growth of financial derivatives as a tool in risk management was the same event that forever changed the way humans work, live and play. It did not occur until mid-century. Indeed, the lynch-pin that changed both the political and economic landscape of this planet was exhibited on December 23, 1947—for on that day, John Bardeen, Walter Brattain, and William Shockley, all Bell Laboratory scientists who would receive the Nobel Prize a decade later, demonstrated the first transistor. It was the birth of a technology that would serve to dominate the balance of this century and, I dare say, much of the next as well. The Digital Age was upon us.
Transistors and their offspring, the microchip, revolutionized everything: the computer, the space program, the television, the automobile, telecommunications, and, to be sure, the markets. It brought the curtain down on the gold standard and replaced it with the information standard, thereby introducing financial market to globalization. The ramifications were revolutionary. Among its many effects, globalization demanded the invention of instruments of finance that would enable market participants to insure against financial exposures not simply limited to a single geographical area, but ones encompassing the entire world. It thus gave birth to the 1970s era of financial futures. These broad based Chicago contracts proved to be the primordial soup which, a decade or so later, financial engineers were able to apply to computer technology and unleash today’s universe of financial derivatives.
Nor should it come as a shock to anyone at this conference that current global stock index markets have barely reached adulthood. Of course, the concept of stock indexing was born at about the turn of this century–in 1896, to be exact, when Charles Dow first published his industrial stock index (initially with only 12 stocks). Later, Standard & Poors followed suit with its first stock index published in 1928. However, the age of index trading, as we define it today and as discussed and examined at this Masters of Indexing Conference, was not initiated until the early 1970s and did not achieve an appreciable breadth of application until the contracts of index futures and options were launched beginning in 1982. These contracts, acting as a surrogate for a portfolio of stocks, or debt instruments, greatly facilitated the use and design of investment strategies that allocated funds among equities, debt instruments, cash, or cash equivalents. First to appear were the Value Line stock index futures at the Kansas City Board of Trade, the S&P 500 contracts at the Chicago Mercantile Exchange, and the CBOE index at the Chicago Board Options Exchange. In 1983, a scant year later, the face value of stock index futures and options contracts outstripped the value of underlying stocks traded in the US.
In quick progression global markets around the world followed suit: LIFFE in 1984, the Nikkei 225 contract on SIMEX in 1986 and in Osaka two years later. Thereafter the MATIF followed with its CAC 40 in 1988, and in 1990 the Deutsche Terminbourse listed the DAX. The Chicago Board of Trade is the last major exchange to join the index parade with its listing of the Dow contract in 1997. Today there are some thirty different global stock index contracts, but I cannot help from noting that the Chicago Merc’s contract presently accounts for 90 percent of the U.S. stock index futures business. Nor can one ignore that by sheer coincidence, which may be no coincidence at all, the birth of stock index futures coincided with the beginning of the longest equity bull market in the history of the world. No coincidence perhaps because of the myriad of applications resulting from equity index derivatives as well as the perceived insurance strategies generated by these products for the global investment community.
And now, what about the future? Will it be a straight line progression for futures and options and for index markets—onward and upward? Or are their best days behind us? Unfortunately, to predict what lies ahead is fraught with danger. Many try, few succeed.
But some things are quite clear. Today, millions of transistors are etched on wafers of silicon. On these microchips, all the world’s information can be stored in digital form and transmitted to every corner of the globe via the Internet. Thus, the Digital Revolution and information technology will be to the Twenty First Century what the Industrial Revolution and electricity was to the Twentieth Century. The markets of the future will be automated. Screens will continue to replace traditional open-outcry architecture. In futures markets this fact is finally accepted and the exchanges are wrestling with the transformation required. In securities markets it is still a mixed bag. While the OTC markets in debt instruments have almost completely embraced electronic trade, the equity markets are still in self denial. We consistently hear of moves to extend the open-outcry trading day. Indeed, the Chicago Stock Exchange just announced exactly that, and the NYSE promises to do the same. Those represent 19th Century solutions to a 21st Century problem. If the traditional equity exchanges insist on looking backward, then the Electronic Communications Networks, the so-called ECNs, will eat their lunch. And I clearly don’t exclude NASDAQ or Instinet from the winners circle in this multi trillion dollar derby.
Today's cyber-wizards have combined the sorcery of electrical and electromagnetic waves, and propelled them at incredible speed, about three-quarters of the way to the moon with every second. In doing so, they have produced a wave of energy that can carry a computer command, the human voice, or virtually any program including market information, quotations, analysis, and orders from anywhere to anywhere. The new technology will create a world in which applications impossible with wires will result in not just a series of new technological marvels, but a spectacular market emancipation. By unplugging us from existing infrastructures, we will suddenly have many more choices about where we live, work, or how we trade. Everyone will be connected. Tiny chips might even be implanted in our bodies that could act as a universal credit card, passport, driver’s license, or even to transmit buy and sell orders. Telephones as we knew them will be history. The Internet changes all the rules. Surely, national and economic borders which have already been blurred, may dissolve completely, as communication satellites enable consumers and traders to do transactions in cyberspace.
But simply embracing technology will not be enough to persevere in the 21st Century. Finance is a dynamic science and the pace of change has accelerated exponentially. The distinctions between types of markets are vanishing. Strategies pertaining to equity, debt, indexing, foreign exchange, futures, forwards, options, swaps, and cash, are all interdependent and interchangeable. The digital age has unbundled all manner of risk and is capable of repackaging it in any form the customer wants at the moment he wants it. Customized strategies and customized instruments of trade are today’s soup du jour. Long gone are the days of narrow based niche market capability. I congratulate the SIMEX and the Stock Exchange of Singapore for their decision to create an interface facility. It is an important step in providing a broader scope of market coverage for the citizens of Singapore. Indeed, those markets that fail to provide total and seamless risk management coverage will be unable to compete in the markets of tomorrow. As Don Ameche said in a recent American movie, "Things Change." I thank Merton Miller for reminding us that steam engine, which revolutionized global transportation, was originally invented to pump water out of coal mines. Similarly, the limited base of contracts on futures exchanges that served the needs of risk management in the latter half of the 20th Century, must be vastly transposed to meet the demands of the Twenty First. The futures exchange of tomorrow must be able to provide full risk management in every financial sense of the word.
Lastly, a word of caution. The only certainty about the future is to expect the unexpected—which by definition is unpredictable. The road for markets that I have suggested may not happen at all, and if it does, it certainly will not be in a straight line fashion. There are bound to diversions, detours, and disasters along the way. But those of us in the markets are commissioned not to shrink from the unforseen nor to fear failure. We are commanded by our profession to seek new market solutions and respond to difficulties as they arise. Above all, we must not become victim to what Rose and Milton Friedman call the Tyranny of the Status Quo. New ideas and innovations must remain our middle name.