Planting Seeds in Emerging Markets

CME is widely recognized as one of the worlds leading exchanges, especially when it comes to vision and innovation. In todays global derivatives marketplace, CME continues to look at ways to help shape the growth of our industry. Consequently, in this issue of CME Magazine, we have chosen to focus on one of the key emerging markets: China. Without a doubt, China is now a leading player across a spectrum of derivatives products, from financial to commodities, in the United States, Europe and Asia. When China moves, so do the markets. Like other emerging markets, China is not content simply with trading on foreign exchanges. It has embarked on a steady path to build its own domestic commodities and financial derivatives markets. As China is relatively new to this effort, however, CMEs long-term expertise in electronic trading, clearing, risk management, regulation and customer service is of great interest and value. So, as part of our commitment to building long-term relationships and staying ahead of the curve, CME co-hosted in September its first ever China Financial Derivatives Forum with the Shanghai Stock Exchange and Shanghai Futures Exchange. This event was attended by nearly 300 participants from China, the United States and beyond, and included market regulators, legislators, exchanges, banks and futures commission merchants. Discussion focused on how business is done globally and how China can adopt the best practices of different markets as it continues to build its derivatives industry. We are often asked to speculate as to when other countries may open their markets more fully to outside trading and when their exchanges may launch stock index, interest rate or foreign exchange futures. While we do not have a crystal ball, it is clear that China and other Asian nations are truly committed to creating world-class derivatives markets. We believe that events such as the Forum create real value for these developing financial centers and for CME. CME also is exploring the potential for working with other market leaders in this part of the world, including India. Indias impressive accomplishments in leveraging its highly educated workforce and entrepreneurial energy to build markets and export technology have been attracting attention throughout the world. To see what CME is doing to build relationships and foster growth in developing markets, please read our cover story, as well as CME Chairman Emeritus Leo Melameds comments in Global Platform about the potential for success. By working more closely with these nations, our goal is to support greater participation in and benefit from the global evolution and growth of derivatives. We hope you enjoy reading CME Magazine.

Terrence A. Duffy
Chairman of the Board, CME

Craig S. Donohue
Chief Executive Officer, CME

Ideas that Change the World

December 2005

features

Vo l . 1

Issue 2

14 20 24 30
on the cover
Shown on the cover is Shanghai, where CME hosted its first ever China Derivatives Forum, in September 2005.

GLOBAL PLATFORM
How Good Cats Make Good Financial Markets in China

FINANCIAL FOCUS
Getting There First

CUTTING EDGE
CME Creates Foothold in the OTC Market

INDUSTRY CONNECTION
Developing Winning Strategies

departments
3 6 18 27 34

CME INSIGHT
CME, long known as an innovator and pioneer, is looking to offer those qualities to a budding financial market in China.

CURRENT PULSE
CME rated among the most innovative FX traders get fee reduction Agreement keeps S&P indexes at CME New traders wanted Traders get data choices Singapore hub launched

CME Helping Unlock the Power of Chinas Markets

As China evolves as a global economic player, the country is slowly and steadily developing its financial market infrastructure. To do so, China is working internally to nurture its derivatives exchanges, and looking to friends like CME to help it create a world-class marketplace. Shanghai, one of the fastest-growing cities in the world with over 17 million people, promises to become one of the worlds largest financial centers.

MARKET INSIGHTS
Focusing on 50 - CME to add new pan-Asia index Better Butter - CME adds electronic butter futures In the Zone - Eurozone inflation contract added Weather Report - New weather contracts storm in Long Ball - Goldman excess returns index launched

GUEST COLUMN
Walter Lukken, Commissioner, U.S. Commodity Futures Trading Commission, offers five sensible lessons to pace the development of Chinas derivatives market.

AT YOUR SERVICE
CME Globex Control Center offers customer support around the clock and around the world.

cme magazine | www.cme.com

Chinese leader Deng Xiaopings philosophy was based on pragmatism and embodied in his dictum to seek truth from facts. He dramatized this philosophy by insisting, No matter if it is a white cat or a black cat; as long as it can catch mice, it is a good cat. CMEs Leo Melamed explains how Chinas markets will act like a good cat.

JPMorgan is known for being a global giant in the derivatives world, but that doesnt mean its not quick. It is the first in many markets, including CMEs Enhanced Options System for Eurodollars.

CME is breaking new ground with CME Economic Derivatives. The contracts bring a host of innovations to established economic reports and mark a major push into the OTC marketplace for CME.

Youth is served at one of the worlds most creative and technology-driven firms. Founded in Amsterdam in 1986 as a market maker in equity options, Optiver has grown with a group of 20-something-year-olds into a leading independent global arbitrage group with the right combination of cutting-edge technology and market savvy.

The stage was set at the Pudong Shangri-la Hotel in Shanghai for the China Financial Derivatives Forum. The Forum gave senior level government, business and financial officials from around the world an opportunity to share ideas and information to further enhance the derivatives markets in the coming years. Shown left is Cheng Siwei, Vice Chairman, Standing Committee of the National Peoples' Congress, PRC.

12.05 | cme

News about CME and its products and services

FX FEE REDUCTIONS
CME has created a program to provide fee reductions for new foreign exchange (FX) traders and current users who increase their trading activity on CME. For CTAs and hedge funds with at least $50 million under management and 125,000 FX trades per month on the CME Globex electronic platform, CME has reduced its total transaction fees from $1.60 per side to $0.60 for nine months. This latest incentive program offers a competitive alternative to over-the-counter FX markets. CME launched a similar program in August for CTAs and hedge funds with at least $2 billion under management but with no monthly volume requirement. www.cme.com/fxprograms

CME REACHES OUT TO NEW TRADERS

CME contracts could soon see trading from some unexpected places. CME recently launched a two-year incentive program of fee waivers called the Emerging Market Partner Program (EMPP) to foster derivatives trading in countries such as China, India and Russia. These incentives aim to encourage U.S. and European firms to set up local trading centers in emerging markets and encourage new users to trade our products. Eligible firms must employ at least five locally recruited traders new to derivatives trading, and at least half of their traders must use CME products over the EMPPs two-year span. CME has already launched three other fee-waiving incentive programs targeting European and Asian markets, aimed at expanding its non-U.S. customer base. www.cme.com/globex

S&P AT CME FOR 12 MORE YEARS

Attention index investors: Standard & Poors index contracts will remain at CME for at least another 12 years. The two firms recently announced that the licensing agreement giving CME exclusive rights to create products around S&P indexes, primarily the S&P 500, will extend until 2016, with an additional non-exclusive year in 2017. Daily trading of S&P 500 futures and E-mini S&P 500 contracts at CME now totals $65 billion in notional value. Daily trading of the E-mini S&P 500 has continued to post double-digit percentage growth over the past year, and E-mini S&P 500 options trading also is growing rapidly. CME also offers equity index contracts on S&Ps MidCap 400, SmallCap 600, Financial Sector, Technology Sector, Barra/Growth and Barra/Value indexes. www.cme.com/trading

cme magazine | www.cme.com

CME GIVES DATA CHOICE

FIVE HUNDRED CLUB

CME has made the top 500, according to technology magazine InformationWeek. The exchange recently was ranked 93rd in InformationWeeks annual top 500 most innovative users of new technology. CME is the only financial exchange to make the list, which is topped by household names such as Capital One, SC Johnson & Sons, Eastman Kodak Co. and BellSouth Corp. InformationWeeks 500 members each invest a total of 3 percent of their annual revenue an average outlay of $293 million per company on information technology (IT) and collectively will spend $147 billion on IT in 2005, the magazine says. www.cme.com/iw500

500

Market data delivery has been a lot quicker since CME launched its Market Data Platform (MDP) in August. The data platform consolidated CMEs existing Market Data Network (MDN) and Market Data API (MDAPI) sources into a single system. By doing so, CME customers can receive data on the markets they trade more efficiently. The MDP is channel-based with a different CME market on each channel. Customers can subscribe to whichever channels they want, and each has a separate channel that will replay data on multicast feeds. The MDP operates on an open network and is compatible with any software or hardware. www.cme.com/realtimedata

WIRED-UP IN SINGAPORE
CME recently launched a Singaporebased local access telecommunications hub for its CME Globex electronic trading platform. The new hub reduces connectivity costs and improves electronic access for all CME-product traders in the region. CME already has established several local access hubs, including seven in Europe. Local access hubs replace costly trans-Atlantic phone connections to CME and deliver customer orders directly to the CME Globex platform. CME customers who use the Singapore hub connect to CME Globex via circuits ordered through CME-approved local telecommunications providers and can determine the bandwidth as well as the number and type of circuits they need. www.cme.com/singaporehub

12.05 | cme

cme magazine | www.cme.com

The impressive and quickly changing skyline of Shanghai is representative of many things in China these days. Over the past decade, the city has been emblematic of the country as a whole a fast-growing, determined and goal-oriented market that stands to become one of the most important financial centers in the world.

With that backdrop, CME is executing a long-term, multi-tiered strategy in China that will give it a major presence in that country. China also folds into CMEs ongoing strategy of becoming a major presence across Asia. CME has been visiting and forging relationships there for decades, but took a major step forward in September when it co-hosted its first China Financial Derivatives Forum in Shanghai along with the Shanghai Stock Exchange and Shanghai Futures Exchange. CME Chief Executive Officer Craig Donohue says the forum was designed to inform Chinese regulators, legislators and market users about some of the key components to building a successful and international derivatives market. They are the fastest-growing economy and this is a revolution that is happening in China, Donohue says. But to be successful they have to go step by step. The big question for market participants is when. When will China begin to launch financial futures on stock indexes and interest rates? When will non-Chinese firms be allowed to trade on Chinas major markets in Shanghai, Zhengzhou and Dalian? There is no clear answer at the moment, but many believe that China is closer than ever to launching new contracts and opening its markets. Step-by-step progress in Chinas derivative markets includes a number of key areas at the regulatory, exchange and futures commission merchant (FCM) levels. By working with China on all three, CME believes it can help the country become a major international participant in world markets. Leo Melamed, CME chairman emeritus, has been visiting China and building relations there since 1985. The plan with China and other emerging markets is not all that different today. If you can get other people to build their markets, they will use our markets too, Melamed says. If you look at Korea, their banks learned to use their market and trade the Kospi and they learned to use our markets as well. You can see it happening in China too, but I cant say it will happen overnight.

12.05 | cme

In the coming years, industry officials believe China will be a powerhouse in the derivatives space with its domestic markets and international participation in others.
Shanghai conference in September. Take this forum. If you look at the scale of this event, and level of people who attended, that is very significant. Other FCMs, such as Alaron Trading in Chicago, are actively speaking with several Chinese-based FCMs about possible joint ventures. Alaron, which launched an international division called Alaron Global last year, established offices in Frankfurt, Moscow and Dubai. China is now high on the priority list, says Scott Slutsky, who heads Alaron Global. He believes the level of sophistication of Chinese FCMs is on par with established markets.

FUTURE OUTLOOK
Leading the charge
One of the key areas that CME has focused on in the past year has been in building the FCM infrastructure within China. The idea follows Melameds principles of market development. If CME can help FCMs establish networks and distribution within China, those same firms can also help CME in terms of distribution of its products as China gradually loosens restrictions and grows. And much progress is being made by FCMs today. Major global firms are opening up representative offices in China, and firms such as ABN AMRO Bank have forged joint venture deals with Chinese FCMs and with many others in the process. CME sees its role as a facilitator for this part of the marketplace. What we can do is provide a foundation on which our global clearing member firms can increasingly gain entry to the Chinese market, not only to generate new business but also to bring their skill sets to the Chinese market, Donohue says. We can, with our efforts with government and central bank officials and regulators, help them get comfortable and put in place the right capabilities for establishing the markets successfully. Donohue and other CME executives emphasize that they are not trying to push Chinas lawmakers and regulators or tell them how and when things should be done. They insist that the current efforts, such as hosting their first derivatives forum with the Shanghai Stock Exchange and Shanghai Futures Exchange, are to inform and assist in building a derivatives marketplace. From my perspective, they are doing it their own way and in their own time and frankly, I think thats the right approach, Donohue says. If the Chinese market grows in a healthy way, there is no question the Chinese banking industry will use indigenous products, but they too will be accessing global capital markets and trading Eurodollars, FX products and so on. If we do some of that early staging, the opportunity for member firms is greatly enhanced. In speaking with various CME member

Cheng Siwei, Vice Chairman, Standing Committee of the National Peoples Congress, Peoples Republic of China, and Leo Melamed, Chairman Emeritus, CME firms in Shanghai, it is clear that CMEs plan is working. Steve Ng, ABN AMROs managing director, regional head of Asia, said the exchange is leading the pack among exchanges in helping firms gain a foothold in China. CME is by far leading all the efforts by exchanges in China, Ng said at the Im very impressed with their knowledge, Slutsky says. The people Ive met are quite well-versed in the derivatives markets. Either they or their staff are doing their homework. They understand the need to hedge their products. They understand that derivatives are needed to help grow their economy. And with a

10

cme magazine | www.cme.com

billion-plus people, they are not going to be left behind. Meanwhile, other firms are echoing CMEs approach of building through education. Calyon Financial, for example, announced plans at the China Financial Derivatives Forum to open a new representative office in Shanghai, a move that could pave the way for a more active presence in Chinas evolving derivatives markets. The initial focus of the office is to help Chinas exchanges and regulators as they sift through a myriad of issues concerning regulation, legal issues and rules concerning exchange traded derivatives and foreign FCMs. Bill Marcus, head of business development with Calyon Financial, says the office will initially be focused on helping current customers with information about Chinas markets and provide trading expertise to potential clients. This is the first time that we are offering our education program to select Chinese entities, Marcus says. We have a history of offering education back to the late 1980s, but it has generally been in the United States. This is the first time we are seeing a significant demand for it in mainland China.

Dr. Myron S. Scholes was a keynote speaker at the China Financial Derivatives Forum. He is Chairman of Oak Hill Platinum Partners and the Frank E. Buck Professor of Finance, Emeritus, Stanford University. Scholes, who was awarded the Nobel Prize in Economics in 1997, serves on CMEs board of directors and chairs its Competitive Markets Advisory Committee. are facing the challenges of getting everything in place, I think we offer them a lot distribution, trade matching, clearing, risk management, Donohue says. I do think and Chinas exchanges. In doing so, CME may be able to more effectively distribute CME products throughout China, while Chinas exchanges could leverage the global infrastructure of the CME Globex electronic trading platform. CME also has hired Johannes Yuan Zhou, a Chinese national, to head up efforts within China to help bridge cultural gaps, as well as forge further relations with Chinese stock and futures exchanges, currency market and government offices. We cannot sit here in Chicago and say we are experts on China and think we are going to develop that business over a multi-year time frame if we dont have anyone there and we dont know the people or what they are doing and dont know how we can help, Donohue said. Ravi Narain, Chief Executive Officer, National Stock Exchange, India there are opportunities to work successfully with them. In a long-term view, CME also sees an opportunity to create win-win linkages for CME CME is no stranger to Asia. The exchange has built strong relationships with other markets such as the Singapore Exchange (SGX) which jointly created the mutual offset system for Eurodollar futures with CME

Making its own in-roads

Helping FCMs is certain to bring residual benefits to CME, but the exchange is working to forge its own relationships too by selling services and technology. Last March, CME announced a licensing deal for its Standard Portfolio Analysis of Risk (SPAN) system to Shanghai Futures Exchange. And CME believes it has more technology and expertise that is valuable to a budding market in China. As they

12.05 | cme

11

In the third quarter, CME launched incentive programs for hedge funds and proprietary trading firms that provide pricing incentives to trade CME products in Europe and Asia. In the fourth quarter, CME generated approximately 100,000 contracts per day from users of these programs. Donohue believes CME can expand its Asian volume figures, especially in China, where banks are allowed to hedge risk using financial derivatives in the United States and other markets. Were looking at trying to enhance the level of involvement from Chinese regional banks as well as other Asian banks and hedge funds, Donohue says. CME also rolled out a new emerging markets partnership program in September, aimed at giving firms with new futures traders a chance to trade CME products at a reduced fee. The idea is that if CME can help train new traders on CME contracts, they may be more likely to continue trading them successfully in the future. CME recently announced plans to launch futures on the S&P Asia 50 Index, and is preparing to further expand its portfolio of Asian contracts in the coming months by developing new pan-Asian products that are directed at the regions users.

Peoples Congress, told the audience in Shanghai that the time is right to launch financial derivatives. However, he added that the legal and regulatory framework still needs to be updated and completed. He said that government officials in Beijing also need to be convinced that derivatives markets are indeed good for the countrys economy, especially in times of economic uncertainty. That message may take some time to gain acceptance. Some of the apprehension comes from Chinas experience with derivatives markets in the 1990s, when more than 50 exchanges were operating. With a lack of regulatory oversight and clear rules, the government shut down virtually all of the futures markets except for the three commodities exchanges that operate today. Meanwhile, a Chinese treasury futures contract pilot program was deemed a failure and the government cancelled it as well. Those experiences have created an air of caution at the legislative and regulatory levels and led to an indefinite delay in launching stock index, interest rate and FX futures contracts. Another major obstacle for stock index futures is the stock market itself. The government owns roughly 70 percent of the shares of stocks traded on the Shanghai Stock Exchange. There is a plan to divest itself from those firms, but until that happens, a reliable stock index appears severely limited. Some bank executives also say China needs banking reform that addresses bankruptcies and insolvency issues. Others say that China needs clear rules to handle omnibus accounts which are used in most markets by FCMs.

John F. Sandner, Retired Chairman, CME

23 years ago. The exchange also has been trading futures on the Nikkei 225 for 15 years. CME has established memorandums of understanding (MOUs) with the Shanghai Futures Exchange and China Foreign Exchange Trading System and National Interbank Funding Center. In December, CME signed new MOUs with the Shanghai Stock Exchange, the Zhengzhau Commodity Exchange, and the Dalian Commodity Exchange in the Peoples Republic of China. In 2003, CME co-sponsored a new master of business administration degree program with a focus on financial risk management and investments for Chinese students with the University of Illinois at Chicago and Renmin (People's) University of China. The exchange also has an MOU with the Korean Exchange, which offers the worlds most traded derivative, the Kospi 200 index options contract.

Chinas hurdles
Without doubt, there is tremendous enthusiasm for financial derivatives within China from the financial community to regulators and even among key government officials. But there are a number of hurdles to overcome as derivatives markets evolve. Cheng Siwei, vice chairman of the standing committee of the National

12

cme magazine | www.cme.com

From left to right: Jiang Yang, Chief Executive Officer, Shanghai Futures Exchange; Dr. Myron S. Scholes, Chairman, Oak Hill Platinum Partners; Craig S. Donohue, Chief Executive Officer, CME; Feng Guoqin, Deputy Mayor of Shanghai, Shang Fulin, Chairman, China Securities Regulatory Commission; Leo Melamed, Chairman Emeritus, CME; John F. Sandner, Retired Chairman, CME; Geng Liang, Chairman, Shanghai Stock Exchange; Walter L. Lukken, Commissioner, Commodity Futures Trading Commission; Yang Maijun, Director, Futures Supervision Department, China Securities Regulatory Commission

One further drawback mentioned by some FCM executives is a law that prevents outside banks or firms from taking more than a 49 percent stake in a Chinese FCM. Another issue in choosing a joint venture is that many of the largest Chinese FCMs are stateowned firms, a situation that concerns some potential foreign partners. Many FCM executives say that Chinas

regulatory regime is in good position to monitor its markets. But the lack of governmental support, along with more complex issues that integrate banking and treasury issues, has clouded the overall regulatory picture.

believe China is quickly edging closer to creating a vibrant international marketplace. In the coming years, industry officials believe China will be a powerhouse in the derivatives space with its domestic markets and international participation in others. I think, over the next 20 years, well see tremendous growth in Chinas banks and asset and liability managers, Donohue says. And that growth is going to mean involvement in our markets. So we want to be there now and make sure they understand CME is a major global market that can serve in hedging and speculative needs. www.cme.com/reach

Looking ahead
Even with all those issues, CME executives and industry leaders

CME is by far leading all the effort by exchanges in China. Take this forum. If you look at the scale of the event, and the level of people who attended, that is very significant.

STEVE NG

12.05 | cme

13

How goodcats make

good financial markets

in China
By Leo Melamed, CME Chairman Emeritus

Late Chinese leader, Deng Xiaoping is regarded by many as the primary architect of modern China and its dramatic economic reform. The crux of Deng Xiaopings philosophy was based on pragmatism and embodied in his dictum to seek truth from facts. The criteria for success, he believed, are determined by common sense and flexibility rather than by ideology. He dramatized this philosophy by insisting,

No matter if it is a white cat or a black cat; as long as it can catch mice, it is a good cat.
It is clear that Deng Xiaopings vision of common sense economics helped produce todays economic miracle in China. Since the adoption of his beliefs, China has pursued a pragmatic path towards a market-driven economy, and the results have been nothing short of astounding. Today, China is the worlds fastestgrowing large economy. The country has grown around 9 percent a year for more than 25 years, the fastest growth rate for a major economy in recorded history. In that same period, it has moved 300 million people out of poverty and quadrupled the average Chinese personal income. By sheer coincidence, Dengs revolutionary economic philosophy espoused in the late 1970s occurred during nearly the same timeframe when another revolutionary economic concept was born: the idea that the mechanics in futures markets, traditionally used in agriculture, could be similarly applied in finance. The idea began in 1972 with the launch of currency futures at the International Monetary Market (IMM) of the CME. Chicagos derivatives innovation,while of an entirely different dimension than Dengs economic reforms, also contributed

14

cme magazine | www.cme.com

greatly to the improvement of national productivity and standards of living. The late Nobel Laureate Merton Miller called financial futures the most significant financial innovation of the last 20 years. Recently, Alan Greenspan, chairman of the U.S. Federal Reserve stated, The financial derivatives markets, which the IMM has played a critical role in developing, have significantly lowered costs and expanded 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.

tables and political pressures would combine to destroy a system dependent upon a unified opinion regarding respective exchange values. In that case, we believed the world would need a futures market in foreign exchange. We asked Nobel Laureate Milton Friedman what he thought about our idea. His answer was emphatic:

Leo Melamed
Changes in the international financial structure will create a great expansion in the demand for foreign cover. It is highly desirable that this demand be met by as broad, as deep, as resilient a futures market in foreign currencies as possible in order to facilitate foreign trade and investment. The idea worked beyond our wildest imagination. The IMM provided commercial enterprises with a tool to hedge foreign currency risk. It catapulted CME to the forefront of financial risk management. Our idea became the model for every center of trade and was extended into the over-the-counter (OTC) market. While central futures exchanges concentrated on broad-based instruments for risk management, the computer allowed OTC financial engineers to devise tailor-made applications. Today, CME offers 36 individual FX futures and 23 options on futures products. It is the largest regulated marketplace for foreign exchange, with a current daily notional trading value of approximately $45 billion. CME FX trading accounts for about 7 percent of the overall $680 billion spot (cash) market. More than 51 million FX contracts, representing $6.2 trillion in notional value, traded at CME in 2004. That Chicago is the birthplace of modern financial derivatives markets is no
Leo Melamed is Chairman Emeritus of CME. He is recognized as founder of the concept of financial futures, having introduced foreign currency futures in 1972. Under his twenty-five years of leadership, CME was transformed into the worlds foremost financial futures marketplace.

It all began with FX

Other similarities between Chinas markets of today and the financial markets in the United States at the time FX futures were launched are worth noting. The critical move at that time was the abandonment of the Bretton Woods system of pegged exchange rates, which lasted from the end of World War II in 1945 until 1971, when President Richard Nixon closed the gold window. If applied much beyond that, then its basic and fundamental flaw, its rigidity, was destined to become its undoing. A fixed exchange rate system could not forever effectively cope with the continual change in currency value resulting from the daily flows of political and economic stresses between the member nations of Bretton Woods. It was clear to us that the different external and internal interests of the participants different rates of economic growth; different fiscal and monetary policies, beholden to different forms of governments; different workforce considerations; different election time-

accident. Chicago has a long history of market innovation. It began in the 1850s with the inauguration of futures markets in the United States. In the 1960s, CME introduced the idea of futures on non-storable products. In the 1970s, we revolutionized the futures industry with the introduction of financial instruments, while the Chicago Board of Trade developed security options. In the 1980s, CME launched cash settlement and introduced the concept of electronic trading, eventually named Globex. In the 1990s, we conceived electronic mini-contracts in equities. Thus, from the beginning, Chicago markets and CME in particular have consistently been the incubator of innovation, and the world continues to follow the lead. We believe what was true for CME is true for the exchanges in China today. In our opinion, the effective development of financial derivatives on futures exchanges should be the next step in Chinas progression. Not only is this directive necessary for the uninterrupted growth of Chinese capital markets, the Chinese futures exchanges Shanghai Futures Exchange, Zhengzhou Commodity Exchange, and Dalian Commodity Exchange have reached

12.05 | cme

15

the level of experience that make such a step feasible and desirable.

Capital efficiency
The greatest benefit from derivatives markets will flow to the people of China. Like Deng Xiaopings white cats and black cats, they will catch financial mice in order to allocate capital efficiently. They will transfer inherent business risks, such as in FX, interest rates or equities, to those

volatility. And there is pricing risk. Pricing models sometimes inadequately reflect market risk when it relates to long-dated or exotic instruments traded infrequently. Finally, there is the issue of transparency, which assures participants that competitive forces will determine the price for a product. Happily, in all of the above areas of concern, derivatives traded at a central exchange provide time-tested solutions that are not readily available in OTC derivatives. While OTC derivatives are typically transacted as bi-lateral agreements, thus creating a counter-party risk, exchange-traded derivatives utilize multi-lateral clearing facilities, providing a central counter-party guarantee to every transaction. The exchange acts as the buyer to every seller, and the seller to every buyer. As for liquidity, central exchanges offer the most liquid and resilient markets possible. They have been time-tested during the most volatile economic conditions. Of course, with respect to transparency, the mechanism for transactions on exchanges provides the most transparent, highly competitive forum ever devised on a real-time basis. And finally, pricing risk, even for exotic or long-dated instruments, is substantially minimized because of the transparent nature of exchange-traded derivatives trading, its daily mark-to-market procedures and its daily margining demands. Most important, derivative application in business has been universally endorsed by the financial experts of the academic community. In a survey of professors of finance at the top 50 business schools worldwide conducted

The financial derivatives markets... have significantly lowered costs and expanded opportunities for hedging risks....

last year by the International Swaps and Derivatives Association, the use of derivatives by companies to manage risks was commonly cited as a contribution to the stability of the global financial system. The respondents 1) unanimously agreed that derivatives help companies manage financial risk more effectively; 2) unanimously agreed that derivatives will continue to grow in use and application; 3) 81 percent agreed that the risks of using derivatives have been overstated; 4) over half agreed that derivatives have not created new types of risk; 5) 99 percent agreed that the impact of derivatives on the global financial system is beneficial. The results of the survey were perhaps best summed up by professor Michael Brandl, lecturer, University of Texas at Austin: By allowing for a more efficient management of risk, derivatives have resulted in a more efficient allocation of capital. An efficient allocation of our resources, including capital, allows for more rapid global economic growth. It is through economic growth that each generation has the ability to live better than past generations. Thus, an expanded efficient use of derivatives is an important component for future economic growth. In other words: financial derivatives in capital markets are the equivalent of Deng Xiaopings good cats catching mice. www.cme.com/chinamarkets

ALAN GREENSPAN
most able and willing to assume and manage the risk involved. They will act like a gigantic insurance mechanism that allows financial market risks to be adjusted quickly, more precisely and at lower cost than is possible with any other financial procedure. By doing so, they will allow capital to be used in a more productive fashion for the benefit of the Chinese economy. According to Federal Reserve Chairman Greenspan, they will provide a process that will improve national productivity growth and standards of living. Of course, these are sophisticated instruments which require expertise and experience. There are inherent risks such as credit or so-called counter-party risk. Will the party to whom risk is transferred be able to perform its contractual obligation? There is liquidity risk, or ease with which the instrument can be traded, especially during periods of high

16

cme magazine | www.cme.com

CME EURODOLLARS

Its easy to spot the

A leader looks the part. And with more than 25 million in open interest positions and an average daily volume of 2 million contracts, nothing comes close to CME Eurodollar futures and options on futures. With more than 83% of CME Eurodollar futures trading electronically on the CME Globex platform, portfolio managers can hedge short term interest rate risk with a variety of trading strategies, like Butteries and Packs and Bundles around the clock from around the world.

leader.

cme.com
CME, Globex, the globe logo and Chicago Mercantile Exchange are trademarks of CME.

Insights on CME
Products and Services
Focusing on 50
CME to add new pan-Asia index Investors exposed to East Asian markets should soon rest easier. CME plans to launch a futures contract early next year based on the S&P Asia 50 Index, which tracks the 50 largest listed companies in Korea, Hong Kong, Taiwan and Singapore. The contract will trade exclusively on the CME Globex electronic trading platform. Hong Kong and Korea have almost identical weighting in the index (32.4 percent and 32.6 percent) although Hong Kong has 19 companies to Koreas 10. Taiwan has a 24 percent weight and 13 companies and Singapore 10.5 percent with eight companies. The new contract is part of CMEs ongoing effort to attract new customers and to bring more foreign-market products to its users in the United States and abroad. www.cme.com/spasia50 www.cme.com/ir

In the Zone

Eurozone inflation contract added CME has targeted European inflation with a new product based on the Eurozone Harmonized Index of Consumer Prices (HICP), complementing CMEs existing U.S. inflation futures contract launched in 2004. The HICP contract measures and compares the market price of goods and services in the 12 Eurozone EC members to arrive at a single value and expresses that as a factor of 1 million euros over 12 calendar months. HICP futures will be quoted as 100 minus the inflation rate of the preceding 12 months of the contract. CME is implementing a market-maker program to support the contract.

18

cme magazine | www.cme.com

Weather Report

New weather contracts storm in There will be a lot more weather soon, at least at CME. The exchange expanded its existing weather futures and options contracts to include three new cities in the United States and four in Europe, adding to the previous 15 cities in the United States, five in Europe and two in Japan. Monthly and seasonal contracts are offered and all are geared to designated indexes that track local temperatures. CME weather futures and options have traded 800,000 contracts so far in 2005, compared with 123,000 in 2004. www.cme.com/weather

Better Butter

CME adds electronic butter futures Butter trading has gone digital. CME recently launched a cash-settled butter futures contract to trade exclusively on the CME Globex electronic platform and named Modern Dairy Markets LLC as a market-maker. The new contract allows food processors to hedge their exposure to butterfat risk without the additional risk of physical delivery. Trade units are sized at 20,000 pounds of Grade A butter compared to the existing CME butter contract of 40,000 pounds. Contracts are cash-settled based on the USDA monthlyweighted average U.S. butter price. www.cme.com/cmebutter

Long Ball

Goldman Excess Returns Index Launched CME is going deep with the Goldman Sachs Commodity Index (GSCI). The exchange announced it will expand on its popular GSCI Spot Index futures contract with a GSCI Excess Returns Index, which will trade exclusively on the CME Globex electronic trading platform.

The new index will incorporate the returns from rolling over the Spot Index portfolio each month over a period of five years, whereas current GSCI futures contracts are dated monthly. Trading on the CME GSCI Index futures contracts in the first six months of 2005 rose 18.5 percent over the same period in 2004. www.cme.com/gsci

12.05 | cme

19

JPMorgan is one of the premier financial services firms in the global derivatives space. Giving customers what they want and evolving with todays demand for innovation is what keeps them there. When it comes to first movers, JPMorgan is, frankly, often first. JPMorgans Futures & Options stands globally as one of the largest players in the derivatives space with its initial roots starting in Australia 26 years ago. JPMorgan was the first bank-affiliated futures commission merchant in the United States in 1981 and today includes the futures trading businesses of JPMorgan, Chase, Bank One (First Chicago) and Jardine Fleming. JPMorgans areas of growth continue to be in new markets, says Richard Berliand, managing director of Futures & Options at JPMorgan. We generally attempt to be the first mover in new exchanges. JPMorgan was one of the original participants on the CME financial floor.

Richard Berliand
Managing Director of Futures & Options at JPMorgan, London.

20

cme magazine | www.cme.com

It also was one of the first adopters of executing Eurodollar options electronically via CMEs Enhanced Options System (EOS) and continues to pass along to customers the kinds of products and services they demand. Regarding other firsts, JPMorgan became the first foreign member of the Taiwan Futures Exchange earlier in 2005. It plans to be a founding member of the derivatives exchange in Thailand and one of the first U.S. participants on the Mexican Derivatives Exchange. That said, JPMorgan also stands as one of the heavyweights among established markets. Its global business operations include five offices in the United States and Canada, a European office in London and eight offices in Asia. That global presence provides customers access to 65 futures and equity options exchanges worldwide with memberships on about 30 derivatives exchanges.

That trend is reflected at CME with major volume increases in products such as electronically traded options on CME E-mini S&P 500 futures and growth in electronic options on CME Eurodollar futures. One particular trend weve seen in CME Globex has been interest from Europe, Berliand says. Two drivers behind that include a significant decline in short-term interest rate volatility in Europe, which has made the European market less appealing, but, secondly, the U.S. market is now accessible to European traders with their own terminals who would rather trade products on the screen. The new enhanced options functionality on CME Globex has also been welcomed by JPMorgan and its clients. The feedback from our customers is definitely positive, says Ros Kemp, an execution specialist with JPMorgan in Chicago. The functionality has clearly been developed by traders and designed with the end-user in mind, which we find extremely beneficial and helpful. Berliand added that not only have the CME Globex initiatives been well received, but so have CME clearing services and the CME-CBOT Clearing Link, which helps firms save substantial money through margin offsets. We consider the clearing at CME to be high quality, especially the riskmanagement side, and we believe it to be well run, Berliand says.

business, which means the brokerage division does not engage in proprietary trading. JPMorgans banking and its proprietary trading desks are separate from JPMorgan Securities. For the futures and options firm, this differentiates JPMorgan from other competitors.

JPMorgan remains at the forefront of electronic trading, connecting customers with its own software.

INNOVATION
Thats a very important attribute of the futures business, Berliand says. Its important for our clients that no one in the futures business is accountable to anyone with risk-taking responsibilities in the firm. That way we can guarantee total separation of the brokerage business from any proprietary activity. JPMorgans customer base is exclusively institutional, and its brokerage and clearing services are directed largely to asset managers; insurance companies; large conglomerate financial firms such as banks, dealers and brokers; hedge fund and commodity trading advisors, and other specialist futures participants. The business also serves some of the worlds most prominent central banks. Berliand says the focus and growth going forward undoubtedly will be in electronically traded markets, where its customers expect to be at the front of the line again. www.cme.com/jpmorgan

Delivering CME
JPMorgan remains at the forefront of electronic trading, connecting customers with its own front-end trading software to futures and equity options exchanges worldwide. The impact for exchanges is that their reach is massively leveraged by their customers onwardly distributing to their underlying clients, Berliand says. We have generally found that when any exchange or product moves from open outcry to an electronically traded environment, clients will produce two to four times more business.

Differing views
One of the unique aspects of JPMorgans futures business is that it operates exclusively as an agency

12.05 | cme

21

Eurodollar options continue to be a critical and growing contract at CME. Recent breakthrough enhancements to electronically traded CME Eurodollar options are giving customers innovations that make trading fast, efficient and transparent.

For many traders, the next frontier for exchanges is electronic options trading that offers deep markets, easy access and sophisticated functionality. CME continues to forge ahead in this space with significant upgrades to its Enhanced Option System (EOS) for CME Eurodollar options on futures.

In August, CME upgraded EOS to provide customers improved access to the platform, expanded trading hours and added liquidity. The enhancements allow more customers to trade options electronically in ways that are unparalleled in the industry. In terms of access to CME options, the upgrade allows customers to connect the options platform through the CME Globex API. That means customers can trade on EOS via CME Globex through several major independent software vendors (ISVs). Seven ISVs are already CMEcertified to offer EOS access to customers. Previously, firms needed to use the CME front end to trade CME Eurodollar options electronically. Robin Ross, managing director of interest rate products at CME, says the upgrade and a number of other enhancements have given a boost to electronic CME Eurodollar options volumes. In September, even before all the ISVs were able to supply the full functionality of the system, CME Eurodollar options on Globex rose to 56,000 contracts daily, almost doubling the average daily volume of about 29,000 contracts in July. (CME posted a record 148,000 Eurodollar

options contracts traded on September 22, 2005.) Thats still a small percentage of CMEs overall daily volume, but were really pleased because the integration of EOS into CME Globex really got the word out to cutomers, says Ross. CME also expanded the electronic options trading to 23 hours a day, up from just over 13 hours, which has attracted more European and Asian trading. Ross says off-hours trading in electronic CME Eurodollar options volumes really start to pick up around 1 a.m. Chicago time, when London desks begin trading. Another component of the upgrade was adding more liquidity providers to the system. With the expanded hours, the exchange added several more lead market makers for the European and Asian time zones, more responding market makers and a new category of market makers called mass quoters or hard quoters. The system features five lead market makers, a dozen responding market makers and eight mass market makers. Lead market makers are required to stream indicative quotes on up to 70,000 options combinations and respond to every request for quote.

CME Equity Index Options

Average Daily Volume

CME Eurodollar Options

ADV and % Electronic

22

cme magazine | www.cme.com

CME Total Exchange

Responding market makers are obliged to respond to bid/ask spreads in a certain size on part of the yield curve. Mass quoters stream hard quotes on the system for straight puts, calls, and at the money straddles. Mass quoting was also implemented in October for CMEs equity index options, and the results have been almost instant. Electronic equity index options average daily volume in November was 30,300 contracts, up from about 21,000 in September. And E-mini S&P 500 options hit a volume record of 938,792 contracts on October 5. CME Globex Open Outcry

2005 Average Daily Volume by Month

(contracts in thousands)

Expanding the possibilities

CME also addressed bandwidth and high-volume messaging issues associated with options trading. In July, CME started migrating its customers to larger 20 MB bandwidth lines to handle the messaging that comes with options trading. CME also introduced new functionality on EOS for mass quoters that allows them to send many two-sided quotes in one message, thus cutting in half the amount of messaging traffic on the system. Before, if you sent a bid and an offer in one call, that was two messages, Ross says. Now I can send all the messages per month on one message. Ross adds, the new functionality will certainly drive more electronic volume in CME Eurodollar options. However, given the complexity of options trading, the floor still remains a viable venue. We think weve made a giant step with our options functionality, but we have more strides to take, Ross says. What were trying to do is offer an alternative for clients who want the anonymity of the screen, cost efficiencies and straight-through processing. But its the clients choice. CME is also working to provide even more customization of options data for customers. Another initiative in development is focused on allowing options traders to customize the amount of data they receive from CME. For example, certain options traders do not need or want to see the entire book of bids and offers. By throttling back on the amount of data received, they can decrease the amount of messaging coming into their terminals and save on bandwidth. It is hoped that EOS will become a major growth area for CME, while also providing customers with the innovation theyve been seeking in electronic options trading. For customers, this means an enormous amount of information at their fingertips that theyve never had before, Ross says. Information like that can really enhance trading. www.cme.com/options

More to come
CME will continue to roll out enhancements in the first quarter of 2006. Among the new additions will be top order allocations for customers who turn the market. EOS will also include order modify functionality as well, so customers do not have to cancel and replace orders. EOS, which already offers a host of spread-trading functions, will continue to add more choices for customers. New offerings in 2006 will include enhanced request for cross functionality and user-defined spreads which will enable clients to execute more complex strategies. This closes the circle and gives us everything we need, Ross says. We then have a complete and superior electronic options trading platform.

12.05 | cme

23

CME Economic Derivatives are breaking new ground at the exchange. The contracts bring a host of innovations to established economic reports and mark a major push into the over-thecounter marketplace for CME.

What are CME Economic Derivatives?

CME Economic Derivatives are options and forwards bought and sold in a marketplace that resembles a universal Dutch auction, an innovative format that maximizes liquidity and results in more order fills than traditional order-matching practices. They are the first suite of products trading on the CME Auction Markets platform. The auctions are conducted using a patented process of mutualized order-filling developed by an independent financial technology development firm.

How do they work?

CME Economic Derivatives include forwards and the basic kinds of vanilla calls and puts that traders are used to at CME

Suppose an institutional portfolio manager is concerned about the risk of a surprise in the upcoming U.S. employment statistics, or perhaps a hedge fund manager, believing that economists employment expectations are wrong, would like to take a position based on his own views. Until recently, these investment managers could only hedge their exposures or express their views indirectly, using cash or derivatives positions in equities, interest rates or other markets. But CME Economic Derivatives now make it possible for each of these managers to hedge or take positions on employment and a range of other government economic indicators directly and without basis risk. Launched in September 2005, in partnership with Goldman Sachs, CME Economic Derivatives are risk-management tools geared to key U.S. and European economic indicators. The products are cleared by CME Clearing, but are not futures, and as such represent a significant move by CME into the over-the-counter (OTC) marketplace.

(with capped payout features), but they also include digital or binary options. These digital options have traded for years in the OTC markets, but they are new for CME. Unlike vanilla options, digital options pay out a fixed amount if they are in the money. CME Economic Derivatives offer two flavors of digital options. The first kind pays out the fixed amount if the underlying statistic is higher than a digital calls strike, or lower than a digital puts strike. The second kind pays out the fixed amount if the underlying statistic is between the two strikes that define that particular digital option. Taken together, this suite of product types allows the client to construct a hedge or exposure tied directly to the particular economic statistic, and to tailor that hedge or exposure very precisely by combining vanilla options, digital options, and/or forwards to create exactly the profile desired.

How does the auction platform work?

The auction platform uses a patented method of mutualized order filling that operates very differently from the traditional futures and options markets at CME. In the traditional markets, the buyer of a specific instrument, such as a June

24

cme magazine | www.cme.com

2006 CME Eurodollar call at a 95.00 strike, must match against the seller of exactly that same instrument. That approach has worked very well in markets with a steady stream of buy and sell orders, or where market-makers can provide two-sided markets efficiently and at low cost. In contrast to those traditional markets, the auction platform does not need to match a buyer in a given instrument directly to a seller in exactly that same instrument. While it can perform that traditional matching, it can also fill orders by recognizing offsetting exposures in completely different instruments.

to evaluate all the bids and offers for all the instruments and determine what prices will maximize the total exposure being managed by the auction. The platform fills orders based on the limit prices and sizes that clients have submitted with their bids and offers (Ill pay up to $1,200 for a $1 million call on the Non-Farm Payroll number falling between 225,000 and 250,000 jobs. ) But the auction platform does more than just fill orders. It also discovers market views and allows clients to watch how the market is shaping up before it actually fills orders. CME typically runs a one-hour indicative period before the auction platform fills any orders, to give participants an idea

For example, suppose the U.S. non-farm payrolls number could only have two values: High or Low. Also, suppose one investment manager wants to buy a $1 million digital call on the number coming out High, while the other manager wants to buy a $1 million digital call on the number coming out Low. If these were the only orders, then a traditional market would have no way to fill those orders. But the auction platform recognizes that the number can come out either High or Low, but not both. If one call is in the money, the other call must be out of the money. If the number comes out High, then the total premium collected on both calls will pay the owner of the High call. If the number comes out Low, then the total premium collected on both calls will pay the owner of the Low call. As a result, the auction platform can fill both of those buy orders, even if there are no sell orders at all. Now fast-forward to the more general case, where a payroll number can take on many different values, and clients can buy or sell a range of calls, puts and forwards on that number. The auction platform uses sophisticated math

about where the market is. During this indicative period, the auction platform is constantly solving its equations to show which orders would get filled and at what prices if the auction closed right then. This creates a series of price distributions during the hour, where clients can see how likely the market thinks each particular outcome is. Instead of depending on economists to predict where the number will come out, participants can see where the market consensus thinks the number will be.

What are the advantages of the auction platform?

The auction platform is very efficient at reflecting all of the available liquidity. It can fill orders even if there is no seller to match a buyer for a particular contract, as long as someone else has submitted an order with a different market view. This power gives new life to markets where it is difficult or costly for a market maker to provide liquidity. For example, the economic derivatives markets have no tradeable underlying, so there is no clean way for a market maker to lay off risk.

12.05 | cme

25

What role does CME play?

CME currently provides clearing for these OTC contracts, and it will also provide electronic order routing through its CME Globex electronic trading platform starting in the first quarter of 2006. CME distribution will extend the auction markets reach to new customer segments, and its clearing will enable new customers to trade these OTC markets without the bilateral credit issues that can restrict OTC trading. CME is also providing marketing and market development services.

What indicators are available?

CME Economic Derivatives offer a broad range of digital and vanilla options, as well as forwards on the outcome of economic data for the following: U.S. NON-FARM PAYROLLS Monthly estimate of change in the number of employees on non-agricultural payrolls ISM MANUFACTURING PMI INDEX Monthly trends in manufacturing orders, production, employment, delivery speeds, inventories and prices U.S. INITIAL JOBLESS CLAIMS Weekly initial jobless claims, adjusted to reflect seasonal hiring patterns

What role does Goldman Sachs play?

Goldman Sachs originally launched the economic derivatives market back in 2002. They have put a great deal of effort into developing products and educating customers about the products and markets. They also put their capital at risk to seed the auctions and ensure that there is a valid price available for every instrument, which enables the auction math to work correctly and efficiently. They are continuing to perform all three of these critical roles. www.cme.com/auctions

RETAIL SALES Monthly dollars spent at retail and food service establishments, seasonally adjusted EUROZONE HARMONIZED INDEX OF CONSUMER PRICES (HICP) EX-TOBACCO Monthly measure of inflation in Europe U.S. INTERNATIONAL TRADE BALANCE Monthly estimate of the balance of payments on U.S. international trade in goods and services, based on two months prior to the release U.S. GROSS DOMESTIC PRODUCT (GDP) Quarterly estimate of real U.S. Gross Domestic Product, seasonally adjusted annual rate

26

cme magazine | www.cme.com

Pragmatic lessons for China based on 30 years of U.S. financial futures regulation
By Walter Lukken, Commissioner, U.S. Commodity Futures Trading Commission As the founding architect of Chinas economic evolution over the last quarter century, the late Chinese leader, Deng Xiaoping, played a critical role in enabling free-market ideals to prosper within Chinas socialist society. His reforms opened up Chinas economy to market forces, lifting the standard of living for millions of Chinese for generations. But Deng Xiaoping was practical in his reforms, understanding that economic change in China would only succeed if steps were deliberate and cautious. Deng captured this pragmatism for economic reform with his proverb, mozhe shitou guo he or crossing the river by feeling for stones. This economic philosophy articulated by Deng and adopted by his successors, is applicable today as we analyze the pace of development in Chinas derivatives market. The maturing of this marketplace will not occur overnight and requires other developed nations and markets to help China feel for stones. The United States is in a unique position to assist China, given the symbiotic relationship of both economies. Together, the United States and China represent over one-third of the worlds gross domestic product. Last year, Chinas total foreign trade volume soared $1.1 trillion, making it the worlds third-largest trading nation behind the United States and Germany. Bilateral trade between the United States and China now exceeds a quarter of a trillion dollars a year. With Chinas recent adoption of a managed float of its currency and indications that more adjustments may be in store, the need for a vibrant on-exchange and over-the-counter derivatives market becomes increasingly important. A free and efficient derivatives market helps ensure capital and resources are appropriately priced and allocated, financial risks are managed and standards of living are enhanced. Though the positive macroeconomic effects of a more flexible currency regime are many, transitional uncertainties still persist. Market participants are now exposed to price risks that did not exist before, and demand will grow for risk-shifting instruments to hedge this exposure. China can ease this transition by fostering the development of its derivatives market just as the United States did 30 years ago when the U.S. dollar was taken off the gold standard.

Crossing the River by Feeling for Stones

Many U.S. political and fiscal policy considerations in play in the 1970s exist today in China. However, China can learn from the lessons of others and utilize regulatory and market models already in place. Striking similarities exist between the development of the Chinese financial derivatives market and the United States. In the fall of 1971, Nobel Prizewinning economist Milton Friedman published a prescient article predicting the end of the Bretton Woods system for fixed-rate global currencies and the creation and growth of a derivatives market in foreign currencies. The volatility engendered by the dismantling of the Bretton Woods system created not only a vibrant

12.05 | cme

27

exchange-traded market in foreign currencies but the beginnings of the interbank currency market, which today is the most liquid financial market in the world. Other futures products quickly followed currencies. Interest rate volatility during the early 1970s led the Chicago exchanges to offer futures on long-term government debt and shortterm interest rate contracts such as the

In doing so, it incorporated some valuable insights the CFTC had gained during its 30-year history. Below are five of those lessons that China may use as stones to feel its way across the river.

participants to use different methodologies or best practices for achieving statutory requirements. In addition, exchanges now have the authority to approve new products and rules through a self-certification process without prior CFTC approval. After the certification, the CFTC has the authority to reject a product or rule if it is found to violate the Act. This was necessary to allow exchanges to react quickly to competitive challenges.

Lesson One: Flexibility is imperative

The regulatory structure for futures trading must be flexible and tailored to market risks for regulators to keep pace with, but not stifle, market innovation.

The regulatory structure for trading must be flexible and tailored to market risks in order for regulators to keep pace with, but not unnecessarily stifle, market innovation.

Lesson Two: Strong enforcement is essential

This lesson, which is a corollary of the first, is that a risk-based regulatory regime must be accompanied by an aggressive enforcement presence. With the agencys recent shift to risk-based regulation, it is essential that the CFTC be equipped to take swift legal action when wrongdoing is detected. The CFTC has been aggressive here shutting down boiler-room operations, working with state, federal and international authorities to lock up criminals and pursuing corporate malfeasance. Such robust law enforcement authority serves as a powerful deterrent.

FIRST LESSON
Eurodollar. Equity futures were next, with index products on the S&P 500 and Dow Jones industrial average. The pace of financial innovation was breathtaking and begs the question: Will China soon experience similar growth? Early in futures market development, a rules-based regulatory regime is practical as regulators seek to meet public goals while gaining appropriate experience and understanding of the markets. But as the markets advance, prescriptive rules lag behind market innovation and regulatory constraints hinder the proper functioning of a competitive marketplace.

Regulatory growth
U.S. market innovation in the early 1970s also spurred a major modernization of laws governing the futures industry. In 1974, Congress created the CFTC and laid out a regulatory structure to oversee financial futures contracts beyond the traditional agricultural ones. Viewed as revolutionary at the time, the law required that trading of all commodity futures contracts occur on a registered futures exchange under the eyes of the CFTC. Over time, electronic trading and competition stretched the industry beyond the original regulatory confines, so Congress passed the Commodity Futures Modernization Act (or CFMA Act) in 2000 to further update the laws.

The CFMA laid out a sliding scale of regulation for exchanges, depending on a products susceptibility to manipulation and sophistication of its traders. This tiered structure allows exchanges to innovate more rapidly to meet competitive challenges while enabling the CFTC to adopt a more risk-based approach in areas requiring greater government scrutiny. This new structure also utilizes a principles-based approach to regulating, rather than a rules-driven one, that allows

Lesson Three: Self-regulation works

Self-regulation, in which agencies delegate and share certain regulatory responsibilities with exchanges and other private-sector entities, has proven to be invaluable. Both the National Futures Association and exchanges are essential complements to the CFTC in protecting the markets from fraud, manipulation and wrongdoing. Without their help, the 500-person CFTC would be overwhelmed.

28

cme magazine | www.cme.com

Self-regulatory organizations (SROs) also enjoy a proximity to the markets that government regulators do not and can often act more quickly to stop harmful market behavior. Additionally, there are significant savings to the taxpayers in having the industry police itself. That said, the CFTC must maintain adequate checks of SROs. Conflicts of interest among the SROs and the exchanges must be minimized and independent decision-making should be guaranteed. The CFTC conducts regular audits of SROs to ensure their proper operation. With the appropriate oversight and protections in place, self-regulation could serve a similar role in Chinas regulatory structure.

bankruptcy laws were needed to ensure that the legal treatment of these products does not jeopardize the integrityof the market or risk a systemic event in the economy. The development of the Chinese derivatives market would be significantly advanced by keeping this lesson on legal certainty in mind.

Walter Lukken

Lesson Five:
Regulatory cooperation matters
Regulatory authorities must cooperate, both internationally and domestically, as agencies do not have the resources or abilities to singularly and sufficiently monitor the breadth of markets and participants. Such coordination is enhanced by regulatory organizations like the International Organization of Securities Commissions, which facilitates international cooperation by developing and promoting information sharing and high regulation standards.

Walter Lukken is Commissioner of the U.S. Commodity Futures Trading Commission (CFTC). Prior to being appointed CFTC Commisioner in 2002, he served on the staff of the U.S. Senate Agriculture Committee, specializing in futures and derivatives markets. In this capacity, Mr. Lukken was involved in drafting the Commodity Futures Modernization Act of 2000 (H.R. 5660).

Lesson Four: Legal certainty is vital

A successful derivatives market requires a clear and predictable legal framework. Markets require transparent and unambiguous rules. Although complex in nature, derivatives instruments are contracts. As such, they require the parties to the agreements be confident in their enforceability, whether on-exchange or over-thecounter (OTC). Any legal doubt about a derivatives contract could severely stunt the growth of this market. Because exchange trades are markedto-market and settled at least daily, the uncertainty as to whether parties will perform on their obligations is minimized. Although some OTC derivatives are beginning to utilize clearing to manage credit risk exposure, most OTC derivatives largely rely on the parties ability to pay and the enforceability of such agreements as dictated by the host nations contract and insolvency laws. Even the United States has struggled in this area and several revisions to our futures and

2004 Top Trading Partners

China 1 2 3 4 5 United States Japan Hong Kong South Korea Taiwan United States Canada Mexico China Japan Germany

The importance of cooperation is not limited to the international arena; domestic coordination has also proven important in the United States as our financial markets have converged. To minimize regulatory gaps or overlaps, the CFTC participates in the Presidents Working Group on Financial Markets, which consists of principals from the Treasury Department, the Federal Reserve, the Securities and Exchange Commission and the CFTC and meets multiple times a year to discuss policy matters that impact the broader marketplace. Some type of policy coordination mechanism might also be considered in China. This is a time of great challenge and opportunity for China. If the Chinese utilize their broad expertise and take note of the lessons learned in the United States and many other nations the journey across the river, one stone at a time, to a more market-based economy will advance Chinas markets and economy and pay great dividends to its people. Based on a keynote address of CFTC Commissioner Walter Lukken before the China Financial Derivatives Forum, Shanghai, China, September 26, 2005. www.cme.com/cftc

Sources: PRC General Admin. for Customs and U.S. Customs

Bilateral arrangements among regulators are equally important. In 2002, the CFTC and the China Securities Regulatory Commission entered into a Memorandum of Understanding regarding a mutually acceptable basis for regulatory cooperation and technical assistance. It is also important that regulators cooperate on enforcement matters, as fraudulent activity knows no boundaries.

12.05 | cme

29

Success in todays derivatives markets increasingly comes down to technology and finding opportunities around the globe. Optiver, one of the worlds leading market-making and arbitrage firms, is a company that has been able to find the right combination of cutting-edge technology and market savvy.

30

cme magazine | www.cme.com

Founded in Amsterdam in 1986 as a market maker in equity options on the European Options Exchange (now Euronext) the firm has grown into a leading independent global arbitrage group, with offices in Amsterdam, London, Chicago and Sydney. Over the years, Optiver has developed highly sophisticated arbitrage strategies, effectively trading momentary anomalies in the international marketplace. Optiver is now a market maker in a number of CME products in large part because of the exchanges liquid markets on the CME Globex electronic trading platform, which operates virtually 24 hours per day.

Optiver background
cme: First, lets start with some basic facts about Optiver. Can you quantify or give us an idea of the size of your business?

a credit line of up to 5 billion to finance positions, buy stock or other investments.

cme: Just to get an idea of the

size and scope of Optiver, how many employees actually trade, develop or refine strategies?

Jelle Elzinga and Randal Meijer (JE and RM in the following interview), both directors of Optiver, sat down with CME Magazine to talk about Optiver, how it trades the markets, and where the companys business is going.

je: We have 195 employees. Of those, we have about 100 traders, and 10 traders that also work on, refine or develop strategies. And then we have some working in human resources and financial administration. The rest are in IT. cme: Your firm is a young firm, je: We are a trading firm and work
with our own money, so we dont have clients or money under management. Our own equity in the firm is about 200 million, and we have with the average employee age of 29. How does that youth fit with your business in terms of the atmosphere, management, strategies, creativity and goals?

12.05 | cme

31

rm: First of all, yes the

average age in our company is 29. However for traders, it is less than 29about 26 or 27. Due in part to this low average age, we are a very informal and non-hierarchical company. Notwithstanding this age, we are a very professional company. Because we expect our traders to have a high drive, we have found that a lower age suits better.

ated for their specific skills. Background is not the most important; it all has to do with skills. In our environment, teamwork is essential.

cme: Does it matter if its over-thecounter or exchange-traded? je: Our strong preference is exchangetraded, because with a central counterparty the risk is much more limited.

rm: We employ people from diverse

backgrounds. We only aim for those who have graduated from college. Within this group, we look for those with a very high level of analytical skills. They can have a background in mathematics, economics or even history. If they are interested in this business and have a competitive attitude, they fit into the profile of an Optiver trader.

cme: Market making is also a major focus for Optiver. What does that mean today and how does market making look today, compared to five years ago? rm: A few years ago, market making
was in open outcry only. Now we focus 100 percent on screen trading.

The differences between five years ago and now are immense. Where we used to have five traders sharing one computer, now one trader has

Trading practices
cme: Optiver is active in a broad
range of arbitrage activities, which are becoming more and more sophisticated. Can you describe some of these activities and how have they evolved over time?

JELLE ELZINGA

five computers.

je: A good example of our arbitrage

is what we call ADR arbitrage, which means we buy shares in Europe and sell them in the United States. Typically, arbitrage is much more professional today than five years ago. Then, you had traders putting orders into the system manually, waiting for execution and then waiting for the other side. Now you have just computers running the arbitrage, doing much more volume with much lower margins.

cme: Do you recruit traders right out

of college? And who do you look for?

rm: Yes, with one or two exceptions.

We also find it important that they fit into our company culture.

je: Indeed, its much more technologydriven now. The differences between five years ago and now are immense. Where we used to have five traders sharing one computer, now one trader has five computers. With screen-trading the need to be on an exchange floor has disappeared. Flexibility has increased and with it the possibilities; for example, a combination of a CME position with a position on another exchange is now easily feasible. cme: How much of your trading then, arbitrage or market making, is automated? rm: I would say 95 percent is probably too low of an estimate. There are very few human actions.

je: The preservation of our company culture is emphasized. In the past we have experienced that it is easier to maintain your culture with younger D people without experience gained at other companies. cme: How would you describe
your culture?

cme: How much cross-asset arbitrage or spreading do you do? je: In theory, you can combine
everything. We look for the best combinations, so it doesnt matter if its a stock, stock warrant, stock options or futures.

je: Looking at floor trading in the past,

the trader in the pit had to trade, update prices, write the tickets and make sure they were delivered to the exchange. All these activities are now automated. Today, the trader is actively changing model and trading parameters, coming

je: In our culture, people have to be

flexible, look for opportunities and go for innovations. Everyone is appreci-

32

cme magazine | www.cme.com

up with new strategies and looking for new combinations.

cme: What CME futures or options

products does Optiver trade?

rm: Currently, we trade CME E-mini

S&P, CME E-mini Nasdaq, currencies such as Euro-U.S. dollar and dollar-yen, and we just started trading interest rate products, the CME Eurodollar. And we make markets in all of those products.

done in Europe. We do 35 percent of our business in Asia and 15 percent in the United States. Partly this is due to the fact that we have been in those other regions longer than in the United States. We do consider the United States a growth area, especially now that more products are moving from floor to screen. This fits into the Optiver model.

je: We are market making in those CME products in European and American trading hours. So that is why its good that we have access to this platform. If you look at the future, some world exchanges will change into what we call world exchanges which will be open 24 hours per day. The CME Globex platform is one of those platforms that offers these opportunities. cme: Who is Optivers competition,
given your strong emphasis on technology hedge funds, CTAs, institutions?

cme: What draws you to

those products?

je: Our company aims to be a

global liquidity provider. To achieve that, we look for not yet very liquid markets where we can add further liquidity as well as markets that are liquid already. In those markets we can set up combinations with other liquid products.

cme: Optiver was founded in 1986 as a market maker in equity options in Europe. What is the main driver to your growth in the United States, Europe and Asia? New trading strategies? Electronic trading? More money flowing into derivatives trading? je: Its all of these because we have to be innovative. We have to come up with new trading strategies because this market is so competitive that if you dont, youll be out of business very soon. Its electronic trading and market flexibility and the number of hours you can trade. Its easier to trade by computer for 24 hours per day than standing on the floor. cme: What role did CME products play in Optivers business growth? rm: If you look at the electronic environment, CME has several contracts we trade. But we also like the model that CME uses. There is no payment for order flow, for example. cme: With Optivers focus on technology, what does that mean in terms of your participation on the CME Globex platform?

je: All of them, but in different ways. If we look at our market-making activities, there are always local players who have specific local knowledge and possibly speed advantages, because they are closer to an exchange engine. Hedge funds and banks, with the right IT, can in certain fields be our competitors as well. cme: What differentiates Optiver
from them?

cme: How does CME fit in with your

arbitrage strategy or market making?

rm: During European hours, we are

one of the main market makers. In some of the already liquid products that are in the process of migrating to screen, we strive to become a Lead Market Maker, as in for example CME Eurodollars.

je: We work with our own capital. The shareholders are all linked to the firm, and that is an ideal situation for a balance between opportunity and risk awareness. That really helps us to be successful in this environment. cme: Given this evolving and
changing environment, what will Optiver look like in the next year or two?

cme: How much of Optivers business is conducted in the United States, Asia and Europe?

je: Optiver started in Europe and we

moved into Asia in 1996. Then in 1999 and 2000 we moved into the United States. Still, the biggest part of the business, at least 50 percent, is

je: Were going to have to keep a flexible approach. I think we will continue to expand our technology in order to trade 24 hours per day on any exchange in the world.
www.cme.com/optiver

12.05 | cme

33

CME Globex Control Center Has the Answers

An essential component to any technology is customer support. At CME, support for its CME Globex electronic trading platform comes from the CME Globex Control Center (GCC), the market operations and customer service station that provides a range of essential and timely services for registered CME customers. GCC is the heart and soul of electronic trading at CME, offering customer support around the clock and around the world, from Sunday afternoon at 3:00 through Friday afternoon at 4:30, says Maz Chadid, CME managing director, operations. With a staff of market experts, many with trading experience, the GCC covers three shifts in Chicago and London and provides global support for market operations, customer communications, technical and project support, and user administration staff. GCC provides registered customers with a range of services, including: Ensuring market integrity. The GCCs responsibilities are to monitor activity, respond to market anom alies and maintain appropriate error prevention functionality. Risk management. By canceling orders on behalf of customers who are experiencing technical issues, GCC mitigates customers risk exposure. Service restoration. GCC works primarily with firm administrators and their technical staffs, individual traders, market makers and independ ent software vendors (ISVs) to get services up and running. As a partner in other exchanges, GCC also assists OneChicago and the Chicago Board Options Exchange. Functionality and general assis tance. As CME continues to upgrade

What You Need, When You Need It

the CME Globex electronic trading platform and expand its functionality, GCC also assists customers with product questions on any contract traded on the system. GCCs growth and varied services are a reflection of CME and its everexpanding CME Globex electronic trading platform and global reach, Chadid says. GCC staff helps customers with new system upgrades such as the new enhanced options trading functionality, implied spreading, market maker protections, expanded connectivity and capacity lines, and customizable market data as well as automated and algorithmic trading systems. In the coming months, GCC will add automatic identification and presentation of callers through a telephone intelligence system to maximize time efficiency for GCC and its customers. It also will be introducing new tools for greater error prevention and detection functionality. For general, non-production issues e-mail gcc@cme.com. (Do not use e-mail if your issue is time-sensitive.) www.cme.com/globex

Reach out and TeleSTAT someone

Another key service offered by GCC is the CME TeleSTAT system, an automated phone service launched in December 2004. TeleSTAT allows CME customers to access a host of critical electronic trading information using a secure identification and personal identification number including: Total matched trades (net position) Last 20 executions Matched trade reports that can be e-mailed to the registered e-mail address. CME plans to introduce more information on TeleSTAT in the first quarter of 2006, allowing users to call and cancel working orders or retrieve a list of working orders via e-mail. CME TeleSTAT is available during regular CME Globex trading hours, Sunday through Friday.

www.cme.com/telestat

34

cme magazine | www.cme.com

CME Magazine
CME 20 South Wacker Drive Chicago, IL 60606-7499 312-930-1000 tel 312-466-4410 fax www.cme.com info@cme.com e-mail

CME Education Opportunities

In addition to the classes listed here, CME also conducts seminars at locations around the world, as well as webinars available on the Internet, sometimes in conjunction with partner brokerage firms or partner vendors.

Senior Editors Anita Liskey, William Parke Editorial Advisory Board Maz Chadid (Operations), Tim Doar (Clearing), John Harangody (Commodity Products), Bryan Hunter (Foreign Exchange Products), David Lerman (Equity Products), Lynn Lipsig (Marketing), Gail Moss (Corporate Communications), Pamela Plehn (Product Public Relations), David Prosperi (Corporate Public Relations), Robin Ross (Interest Rate Products), Allan Schoenberg (Technology Public Relations) CME magazine is published by CME in conjunction with Penton Custom Media. All rights reserved.

On-Site Classroom Courses CME 20 S. Wacker Drive Chicago, IL 60606-7499 312-930-6937 Technical Analysis (7 sessions) Tuesdays and Thursdays, January 5 26 4:00 p.m. 6:00 p.m. Instructor: Ken Shaleen Cost $320 Principles of Futures (7 sessions) Tuesdays January 24 March 14 4:00 p.m. 6:00 p.m. Instructor: Larry Schneider Cost $320 Options for Beginners (5 sessions) Tuesdays January 10 February 7 3:30 p.m. 5:30 p.m. Instructor: John Nyhoff Cost $200 Introductory Trading seminar (1 session) Saturday, January 21 Saturday, March 25 9:00 a.m. 1:30 p.m. Instructor: Mickey Hoffman Cost $150 Advanced Technical Analysis (6 sessions) Tuesdays and Thursdays, February 7 23 4:00 p.m. 6:15 p.m. Instructor: Ken Shaleen Cost $300

Advanced Market Profile (2 sessions) Saturday and Monday, January 28 and 30 Saturday 9:00 a.m. 5:00 p.m. Monday 12:00 p.m. 3:00 p.m. Instructor: Dan Gramza Cost $300 Electronic Trading Strategies (2 sessions) Saturday and Monday, February 25 and 27 Saturday: 9:00 a.m. 5:00 p.m. Monday: 12:00 p.m. 3:00 p.m. Instructor: Dan Gramza Cost $250 Principles of Futures, Part II (5 sessions) TBD 4:00 p.m. 6:00 p.m. Instructor: Larry Schneider Cost $220 Trading in the Eye of the Storm (2 sessions) Saturday and Monday, March 4 and 6 Saturday: 9:00 a.m. 5:00 p.m. Monday: 12:00 p.m. 3:00 p.m. Instructor: Dan Gramza Cost $300

Penton Custom Media 1300 E. 9th Street Cleveland, OH 44114 216-696-7000 tel 216-931-9441 fax www.pentoncustommedia.com Editorial Director Darrell Jobman Contributing Editor James Kharouf Art Director David Bosak Greg Kiskadden

Do you have a question for CME magazine?

E-mail us at info@cme.com with your questions and comments, or to be added to or removed from the mailing list.
Further information about CME and its products is available on our Web site at www.cme.com. Information made available on our Web site does not constitute part of this document. The Globe logo, Globex, Chicago Mercantile Exchange, CME, E-mini, and CME Auction Markets are trademarks of CME. All other trademarks are the property of their respective owners. S&P, S&P 500, S&P MidCap 400, S&P SmallCap 600, S&P Barra Growth/Value, and S&P Asia 50 are trademarks of Standard & Poors, a division of The McGraw-Hill companies, Inc. The NASDAQ-100 Index is a registered trademark of the The Nasdaq Stock Market, Inc., licensed for use by CME. The Russell 2000 Index is a registered trademark of Frank Russell Company. GSCI, the GSCI Spot Index and GSCI Excess Returns Index are registered trademarks of Goldman, Sachs & Co. All matters pertaining to rules and specifications herein are made subject to and are superseded by official CME rules. Current CME rules should be consulted in all cases concerning contract specifications. CME Copyright 2005 CME All rights reserved. CME magazine is printed on recycled paper.

To view CME Magazine online, visit www.cme.com/cmemagazine For a complete list of CME classes, go to www.cme.com/edu

12.05 | cme

35

CME E-MINITM OPTIONS ON FUTURES

Opportunity kicked up a
CME E-mini S&P 500, CME E-mini NASDAQ-100 and CME E-mini Russell 2000 futures and options on futures now trade together on CME Globex. Seize $60 billion in liquidity each day electronically from anywhere in the world, anytime day or night. Discover how more opportunity can change your world.

notch.

cme.com
CME, the globe logo and Chicago Mercantile Exchange are trademarks of CME. S&P 500 is a registered trademark of the McGraw Hill Companies. NASDAQ-100 is a registered trademark of The Nasdaq Stock Market, Inc., used under license. The Russell 1000 Index and Russell 2000 Index are registered trademarks of Frank Russell Company. Frank Russell Company assumes no liability in connection with the trading of any contract based on the Russell 1000 or Russell 2000 Indexes.

PRSRT STD U.S. POSTAGE PAID COLUMBUS, OHIO PERMIT NO. 4416

20 South Wacker Drive Chicago, IL 60606-7499

Change Service Requested