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Remarks by Leo Melamed presented
at the 20th Anniversary
of the Nikkei 225 Futures Market Symposium in Osaka
September 2, 2008
twenty years ago, I came to the Osaka Securities Exchange to participate
in an historic event, the launch of the Nikkei 225 futures contract.
The theme of my remarks at that time was the old American saying, “What goes around,
comes around.” For it was in Osaka some 200 hundred years earlier,
in 1730, that the first futures market was actually born. Thus, in
a sense, this was a homecoming. However, instead of rice, as was traded
at the Dojima Rice Market in the house of the merchant named Yodoya,
the instrument coming to the OSE had been converted into a stock index.
In 1985, recognizing the value of the Nikkei 225 as the primary benchmark
of the performance of the Japanese stock market, I forged an agreement
with the Nihon Keizai Shimbun (NKS), your country's giant communications
organization, to jointly work toward the development of this index
as a futures instrument. I applauded the OSE for its courage in embracing
this new risk management tool, since the concept of stock index futures
was barely six years old. Today, twenty years later, I am delighted
to celebrate with you this revolutionary and most successful undertaking.
At the time of its launch, the Nikkei
225 contract served as clarion call to the financial world that Japan
was evolving from its insular past. It was also an important milestone
for the Hanshin region. Just like the CME of Chicago served as a counterpoint
to the markets in New York, so did the OSE of Osaka serve as a counterpoint
to the markets in Tokyo. It gave the OSE global recognition and served
as a bridge to the world futures community. It represented a major
step for Japan in the direction of international market reform. And
over the years the Nikkei 225 has performed admirably. Since 1988,
with few exceptions the volumes of trade for the Nikkei at OSE have
continued to grow. In good times or bad, in bull markets or bear,
this instrument has provided the Japanese and the global financial
community the ability for price discovery, the ability to hedge market
risk, and the ability to take advantage of speculative opportunities.
There have been no systemic problems. Besides a vibrant trader community,
your users include all of the world premier investment banks, commercial
banks, hedge funds, and proprietary firms.
the OSE, the Nikkei 225 also created a special alliance with the
world’s largest futures market,
the Chicago Mercantile Exchange, today the CME Group. This, in turn,
cemented a relationship between Nihon Keizai Shimbun, the owner of
the index, the OSE, and the CME. A relationship that has flourished
over the past two decades. Beginning in 1990, the CME listed the Nikkei
225 futures contract during the American time zone, extending the
importance of the Japanese equity market. Over time, with license
from NKS, the CME extended the Nikkei 225 trading to an electronic
Globex venue of nearly around the clock coverage while continuing
to respect the Asian time zone. We also listed both a yen and dollar
denominated contract. Our first year’s volume of 60, 000 trades,
has grown to a 2007 futures and options volume of nearly 7 million
contracts. Our first year’s open interest of 5,000 has grown
to a 2007 futures and options total of over 117 million contracts.
Without question our OSE, CME listing, coupled with a similar listing
in Singapore at the SIMEX, now SGX, has been of immeasurable value
to our respective exchanges and financial families. Clearly, a most
valuable and successful enterprise.
is possible today with the advantage of hindsight, to examine not
only the value of stock indexes, but to assess the performance of
financial futures over the past two decades. Most important, we
have the opportunity to make this assessment during a time period
when the world, and particularly the U.S., has experienced financial
upheavals of an unprecedented nature. Although I am not an economist,
allow me to briefly sketch the history of today’s
global problems. Their origin can be traced as far back as the collapse
of the savings-and-loan industry in the 1980s and early 1990s which
engendered changes in the banking system. Regulators insisted banks
and thrifts hold more capital against risky loans. It created an incentive
for banks to seek means to shift liabilities off bank balance sheets.
Securitization of their loans by selling them to investors through
Over-the-Counter derivatives proved to serve this purpose. Banks packaged
pools of securities into collateral debt obligations, CDOs, or structured
investment vehicles, SIVs, which shifted default risk from lenders
to global investors. The SIV industry grew to become a $400 billion
Indeed, the OTC derivatives market greatly
overshadows exchange-traded futures instruments. Notional amounts
outstanding of OTC derivatives increased more than tenfold between
1995 and 2007, a growth rate of over 20% per year.2 Simply
stated, OTC derivatives have become an essential financial instrument
in the management of financial risk. It is highly doubtful that today’s
intertwined, interdependent global markets could function without
the use of OTC derivatives. But as I always caution, these are complex
and sophisticated financial tools. They require expert application.
Used improperly, they can create unacceptable risk. Some world banks
recently learned this the hard way.
and SIVs became conventional during a time period when the world
became awash with liquidity. Low interest rates were engineered
by world central bankers, first, in response to the bursting of
the tech-stock bubble in 2000, and, second, to the terror attack
of 9/11 in 2001—the U.S. Fed actually cut
interest rates to the lowest level in a generation. Money became exceedingly
cheap. Such an environment when combined with loan syndication and
securitization produced some highly unintended consequences. To improve
on low interest rates, investors were willing to take larger risks.
Borrowers got loans they wouldn’t otherwise have attained. People
bought homes they could not afford in the fallacious belief that housing
values will go up forever. As mortgage lending boomed, bankers found
ever-more ways to repackage trillions of dollars in loans. Pension
funds, banks, and endowments, seeking higher returns, invested in
hedge funds and private equity firms who used the money to take on
risky investments. The conditions created a pyramid of debt.
Today, the depth of the problem has been
recognized. Regulators from France, Germany, Switzerland, the UK and
the US issued a joint report, released on March 6, 2008, which stated
the obvious: Major banks and securities firms that have suffered huge
credit losses failed to understand the inherent risks of the securities
they bought.3 Some economists have compared the current
global crisis to the Asian crisis of 1997-98. At that time, large
quantities of credit became available in some Asian countries which
generated a highly-leveraged economic climate, and pushed up asset
prices to an unsustainable level. These asset prices eventually began
to collapse, causing individuals and companies to default on debt
obligations. The resulting panic among lenders led to a large withdrawal
of credit from the crisis countries, causing a credit crunch and further
as we know, stock markets throughout the world have become pressured,
credit has become scarce, unemployment has risen, consumer confidence
has fallen, market volatility has increased, and the U.S. and Britain’s housing markets have fallen into
disarray. Add to that inflationary pressures that seem to be global
and you have a toxic brew. While the emergency actions taken by world
central bankers has slowed the contraction of credit and cascading
of defaults, the full story is yet unwritten. Given these turbulent
global eventualities, one question comes to mind: How did futures
markets fare? Exchange traded futures, after all, are an integral
part of the global financial market. Just like the growth in OTC derivatives,
exchange-traded derivatives grew from a $38.6 trillion global total
in 1994 to $400 trillion in 2007. Annual CME average daily volume
rose from 917 thousand in 2000 to 11 million in 2007. So how did exchange
traded derivatives perform during these very turbulent market conditions?
The answer is clear: Futures markets continued to operate and perform
flawlessly. No defaults, no failures, no federal bailouts. Which begs
the question, why? There is no mystery to the answer. There are dramatic
differences between the market model in the OTC market and the one
in futures markets. While nothing is perfect and no one can foresee
all eventualities, the structures and procedures at regulated futures
exchanges represent a time-tested mechanism—the very essence
of their default-free success.
futures markets continue to perform their two essential functions:
They create a venue for price discovery and they permit low cost
hedging of risk. And they do so in an open and transparent fashion.
Gretchen Morgenson, financial editor of the New York Times, recently
stated, “If we have learned
anything from (today’s) unrelenting credit mess, it is that
greater disclosure is needed if investors are to regain their trust
in the financial system.4 On regulated futures exchanges,
disclosure and transparency are the hallmarks of their transaction
and clearing mechanisms. More than that, there can be no doubt about
the integrity of their daily settlement procedures. Even in the most
distant Eurodollar contract at the CME—priced ten years into
the future—there exists a real price established every day in
a notoriously open forum—now primarily Globex. In futures, no
artificial pricing can occur. There is no “mark to modeling.”
Their critical attributes can be summed up with the following:
• Central Counterparty Clearing
(CCP), with a central guarantee to every transaction—eliminating
counterparty credit risk;
• Transparency of valuation with
twice daily (at the CME) mark-to-market disciplines—eliminating
accumulation of debt;
• Real time confirmation from a
trusted counterpary directly to the back office and the risk manager—risk
management systems know the trade the moment it is done;
• Daily payment of settlement variation
and margining—making it difficult for traders to hide losses
or disguise unusual profits;
oversight and financial surveillance procedures.
are dramatic differences between OTC and exchange traded derivatives.
And what is true for the CME is equally true for the OSE. Both futures
markets are based on the same principles, the same procedures, the
same regulatory framework. Since their launch, financial futures
have grown beyond anyone’s
imagination. In 1971, the year just prior to the launch of the IMM,
the world’s first financial futures market, there were 14.6
million contracts traded on U.S. futures exchanges—there were
no futures exchanges of consequence anywhere else. There are today
some futures exchanges in nearly every corner of the planet. Last
years’ exchange traded volume reached nearly 10 billion contracts.
Today, irrespective of current difficult
economic conditions, both OTC and exchange traded derivatives provide
risk management capabilities on a vast array of products from finance
to energy, from securities to the environment, from banking to agriculture.
Derivatives are used by domestic and international banks, public and
private pension funds, investment companies, mutual funds, hedge funds,
energy providers, asset and liability managers, mortgage companies,
swap dealers, and insurance companies. For the vast majority of financial
managers these risk management tools have worked exceptionally well.
They allow market risks to be adjusted quickly, more precisely, and
at lower cost than is possible with any other financial procedure.
A process that has improved national productivity, growth and standards
Congratulations to the Osaka Securities
Exchange. I trust you will invite me to the 40th Anniversary.
1 Primarily the concept was created by
two bankers, Nicholas Sosidis and Stephen Partidge-Hicks. In 1988-89
the bankers launched the first two such structures for Citigroup called
Alpha Finance Corp. and Beta Finance Corp. In 1993, the two men left
Citigroup to form Gordian Knot. It become the world's largest SIV
with some $57 billion in assets. The concept had a bank create a fund
that would borrow money---short term---by issuing commercial paper
close to the interest rate of LIBOR. Then it would use the money to
lend---long term---by investing in Asset Backed Securities (mortgages,
credit cards, student loans and similar products). These liabilities
were sliced into tranches of varying degree of risk that were rated
by rating agencies. It is now very clear that the rating agencies
did not fully understand the degree of risk involved and in effect
mis-priced the risk. Some CDOs got triple-A ratings even though they
contained subprime loans. Some structures were so opaque the markets
could not properly value them. The tranches were sold to investors.
Since the bank did not take the credit risk, it could keep the CDOs
and SIVs debt off its balance sheet.
2 BIS Quarterly Review, December 2007.
3 BIS Quarterly Review, December 2007.
4 Gretchen Morgenson,
Sunday Business, August 17, 2008, New York Times.