Future perfect?

Author and Chairman Emeritus of the Chicago Mercantile Exchange Leo Melamed and CEO Craig Donohue speak to FinanceChina about their plans for China.

What's the purpose of your recent visit to China?

Donohue: We are here to explore possible areas of co-operation with the Shanghai Futures Exchange, with whom we signed a Memorandum of Understanding last year. In addition, Mr. Melamed's book, Escape to the Future, is being translated into Chinese.

What are the main issues you feel the SHE is facing?

Donohue: It's a question of how fast they want to evolve - whether they want to go it alone or link up with foreign partners such as us. For sure, even if they go it alone, they will benefit from having a huge local market. The question is can they obtain acceleration benefits by linking up with foreign partners? I think if they utilized risk management and back office processing systems familiar to international clients, they would be making a big step forward. After all, many local operators have foreign clients and they want to provide them with a level of comfort. Using our standards, and in view of the market acceptance of our products should be a good incentive to use them. We see it as a partnership.

How do you plan to make money out of China?

Melamed: That's a very important question! The initial step is an investment of time and intellectual property. Fortunately, that's not capital intensive! Then, as people get up to speed, they being to use our products. Sooner or later, that's how the market develops. That's the model we used with the Singapore stock exchange many years ago. We also did it in Europe 15 years ago. They didn't know about risk management and hedging. Since then, the European market has seen great growth, but it couldn't have happened if we hadn't taught the markets about the role of derivatives. EUREX is now even a competitor of ours, but they still use our products, S&P 500s, Eurodollars, currency markets etc.

You must find Chinese capital markets very small compared to what you are used to. What's your view on future developments?

Donohue: Yes, not having a free floating currency, a fully-functioning disclosure system or market-driven interest rates are major macro issues. In addition, in terms of being able to link up with the outside world, there is still an insufficient level of standardization regarding the technology. So there are technical issues and macro issues.

In any case, the people here are making rapid progress, such as adopting the CME's SPAN (Standard Portfolio Analysis of Risk) system, an industry standard for derivatives, which determines risk exposures. It's now used by every major exchange and clearing house in the world. It's important to have a standard to ensure people know what the margins and capital requirements are. We developed this product around a decade ago and have licensed it to nearly 50 futures exchanges and clearing houses.

What's your view of the Shanghai Futures Exchange (SFE) in terms of its capacity?

The value of your trades last year was a staggering $333 trillion, so how does SEF compare?

Donohue: It's been very successful in its metals and commodities products, as you'd expect. Our view is that the SFE is more out in front than many Asian exchanges, especially in terms of buying items such as SPAN. As for growth, it seems to be very satisfactory.

Did you sell the license for SPAN at market price or are you at the stage of making sweetheart deals?

Donohue: No, we charge a standard price for SPAN. We are a for-profit organization, but in any case SPAN is not a revenue driver for us. There are many things we do as an exchange to help create standardization in the industry. So we cover our costs with it, but then it's not intended as a money maker. In fact, we hope exchanges will raise the level of standardization so that they can use our products, such as foreign currency products, stock index futures contracts, etc. That's been the model for the last 30 years. We have expanded not by ripping off some other exchange's product but by having invented our own product and then exported them around the world for people to use. So that's how far we've grown.

But wouldn't you say China is still very far away from using those products?

Melamed: Perhaps not as far away as you might think, despite the closed capital account. Chinese banks are already using forex products right now. The large banks and the central bank use our markets. They trade foreign exchange contracts at the CME - essentially hedging their risks. They have huge foreign exchange reserves they have to hedge, and their hedging operations at the government level show a lot of sophistication, for example in the New York Eurodollar market. The government also recently set up a framework for trading derivatives contracts - that's going to encourage the usage of derivatives both inside and outside China.

How important is the regulatory environment in such a market?

Donohue: It's absolutely imperative. But these issues are not unique to China. Any market needs a healthy regulatory framework which protects customer interests and avoids manipulation. In any case, these are problems all around the world.

Your chosen regulatory framework is self-regulation. Why do you think that's the right approach? In Hong Kong, the stock market demutualized, just like you did last year, but it's being accused of having a conflict of interest between wanting to raise money by allowing companies to list and protecting investor interests through a stringent disciplinary regime.

Melamed: It depends on your philosophical overview. I was brought up to believe in free markets and self-regulation. Granted, there could be thieves in the market, as there have been in the U.S. But irrespective of that, the ultimate best form of regulation is when the entity wants to prove to customers that its marketplace is safe. If you have to depend on the government, you're going to find ways around it and skip rules. But if your livelihood depends on integrity so that you attract customers and if your growth is based on self- regulation, then you will be very careful. In the whole of our 105 years of history, not one public customer has lost money as a result of our member firms. I grant you we still need oversight from government agencies, but ultimately our philosophy is that if you want to compete and want to win, you have to do it right.

In addition, as a publicly-listed company we are also scrutinized by the public market, on top of the government oversight. Enron is an example of an exception, and even then, the severe punishment of Enron shows the system works. People are in jail, and the business is gone.

On the question of demutualizing, how does the system work? It seems your members have to pay fees while sharing in the profit. Is that just moving money from one hand to another?

Donohue: Not really, because the big market makers we rely on to provide the tremendous liquidity we need to make the CME exchange a success pay very low fees. It's the non-members who pay the bulk of the fees. It's a successful model, if you look at our market cap: from $800 million in 2000 to over $4 billion right now. So we're providing a lot of value to our shareholders. In return they are giving us the resources to invest in technology and open up the market.

Do you have to be a member of the CME to trade on it?

Donohue: No. As long as you have an arrangement with one of our member clearing house firms such as Goldman Sachs or Morgan Stanley, as well as an Internet connection, you can start trading. We are open 23 hours and a half per day. That's the longest trading day of any electronic exchange in the world.

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