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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 helpshape the growth of our industry.

Consequently, in this issue ofCME 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 de-

rivatives 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 withtrading 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 manage-

ment, 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 othermarket 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 through-

out 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 readingCME Magazine.

Planting Seeds

in Emerging Markets

Terrence A. Duffy

Chairman of the Board, CME

Craig S. Donohue

Chief Executive Officer, CM


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De c e m b e r 2 0 0 5 Vo l . 1 I s s u e 2

Ideas that Change the World

Shown on the cover is Shanghai, where CMEhosted its first ever China Derivatives Forum,in September 2005.

8 CMEHelpingUnlock the Powerof Chinas Markets

As China evolves as a global economic

player, the country is slowly and steadily

developing its financial market infrastruc-

ture. To do so, China is working internally

to nurture its derivatives exchanges, and

looking to friends like CME to help itcreate 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.

on the cover

features14 GLOBAL PLATFORM

How Good Cats Make GoodFinancial Markets in China

20 FINANCIAL FOCUSGetting There First

24 CUTTING EDGECME Creates Footholdin the OTC Market

30 INDUSTRY CONNECTIONDeveloping Winning Strategies

departments

3 CME INSIGHTCME, long known as an innovator and pioneer, is looking to

offer those qualities to a budding financial market in China.

6 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

18 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

27 GUEST COLUMNWalter Lukken, Commissioner, U.S. Commodity Futures TradingCommission, offers five sensible lessons to pace the developmenof Chinas derivatives market.

34 AT YOUR SERVICECME Globex Control Center offers customer support aroundthe clock and around the world.

4 cme magazine | www.cme.com


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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.

512.05 | cme

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.


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and its products and servicesNews about CME

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.

FX FEE REDUCTIONS

CME has created a program to

provide fee reductions for new

foreign exchange (FX) traders and

current users who increase theirtrading 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.

S&P AT CME FOR

12 MORE YEARS

Attention index investors: Stand

& Poors index contracts will rem

at CME for at least another 12 y

The two firms recently announ

the licensing agreement giving

exclusive rights to create produc

around S&P indexes, primarily

500, will extend until 2016, wit

additional non-exclusive year in

Daily trading of S&P 500 futur

E-mini S&P 500 contracts at CM

totals $65 billion in notional v

Daily trading of the E-mini S&

has continued to post double-d

percentage growth over the pas

and E-mini S&P 500 optio

trading also is growing ra

CME also offers equity

contracts on S&Ps M

400, SmallCap 600

Financial Sector,Technology Secto

Barra/Growth an

Barra/Value inde

www.cme.com/globex

www.cme.com/fxprograms

www.cme.co



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5

00

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 financialexchange 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.

CME GIVESDATA CHOICE

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.

WIRED-UP IN

SINGAPORE

CME recently launched a Singapore-

based 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 telecommun-

ications providers and can determine

the bandwidth as well as the number

and type of circuits they need.

www.cme.com/iw500

www.cme.com/realtimedata

www.cme.com/singaporehub

712.05 | cme


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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 andDalian? 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 mar-

kets 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.

912.05 | cme


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Leading the chargeOne 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 areopening up representative offices in

China, and firms such as ABN AMRO

Bank haveforged joint venture deals with

Chinese FCMs and with many others in

the process. CME sees its role as a facilita-

tor for this part of the marketplace.

What we can do is provide a founda-

tion 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 Chinesemarket, Donohue says. We can, with

our efforts with government and cen-

tral 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 theirfirst 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 doingit their own way and in their own time

and frankly, I think thats the right ap-

proach, Donohue says. If the Chinese

market grows in a healthy way, there is

no question the Chinese banking in-

dustry 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

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 firmsgain a foothold in China.

CME is by far leading all the efforts

by exchanges in China, Ng said at the

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 Tradingin Chicago, are actively speaking with

several Chinese-based FCMs about

possible joint ventures. Alaron, which

launched an international division calle

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 sophisti-

cation of Chinese FCMs is on par with

established markets.

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

FUTURE OUTLOOK

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.


Cheng Siwei, Vice Chairman, Standing Committee of the National Peoples Congress,Peoples Republic of China, and Leo Melamed, Chairman Emeritus, CME


11/36

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 exam-ple, 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 develop-

ment 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 gener-ally been in the United States. This is

the first time we are seeing a significant

demand for it in mainland China.

Making its own in-roads

Helping FCMs is certain to bring resid-

ual 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 technol-

ogy and expertise that is valuable to

a budding market in China. As they

are facing the challenges of getting

everything in place, I think

we offer them a lot distribution,

trade matching, clearing, risk manage-

ment, Donohue says. I do think

there are opportunities to work suc-

cessfully with them. In a long-term

view, CME also sees an opportunity

to create win-win linkages for CME

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 infrastruc-

ture 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 futuresexchanges, 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

knowhow we can help, Donohue said.

CME is no stranger to Asia. The

exchange has built strong relationshipswith other markets such as the

Singapore Exchange (SGX) which

jointly created the mutual offset system

for Eurodollar futures with CME

Ravi Narain, Chief Executive Officer,National Stock Exchange, India

Dr. Myron S. Scholes was a keynote speaker at the China Financial Derivatives Forum. He isChairman 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 onCMEs board of directors and chairs its Competitive Markets Advisory Committee.

1112.05 | cme


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23 years ago. The exchange also has

been trading futures on the Nikkei 225

for 15 years. CME has established mem-

orandums of understanding (MOUs)

with the Shanghai Futures Exchange

and China Foreign Exchange Trading

System and National Interbank FundingCenter. 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 finan-

cial 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 theKorean Exchange, which offers the

worlds most traded derivative, the

Kospi 200 index options contract.

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 generatedapproximately 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 Asia50 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.

Chinas hurdles

Without doubt, there is tremendous

enthusiasm for financial derivatives

within China from the financial com-

munity to regulators and even among

key government officials. But there are

a number of hurdles to overcome asderivatives markets evolve.

Cheng Siwei, vice chairman of the

standing committee of the National

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 govern-ment 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 tha

50 exchanges were operating. With a

lack of regulatory oversight and clear

rules, the government shut downvirtually 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 cancelle

it as well. Those experiences have

created an air of caution at the legisla

tive 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



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One further drawback mentioned

by some FCM executives is a law that

prevents outside banks or firms from

taking more than a 49 percent stakein a Chinese FCM. Another issue in

choosing a joint venture is that many

of the largest Chinese FCMs are state-

owned 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 bankingand treasury issues, has clouded the

overall regulatory picture.

Looking ahead

Even with all those issues, CME

executives and industry leaders

believe China is quickly edging closer

to creating a vibrant international

marketplace. In the coming years,

industry officials believe China willbe 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

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 RegulatoryCommission; 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 SecuritiesRegulatory Commission

STEVE NG

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.

1312.05 | cme


14/36

Late Chinese leader, Deng Xiaoping is

regarded by many as the primary archi-

tect 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 bycommon sense and flexibility rather than

by ideology. He dramatized this

philosophy by insisting,

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 fastest-

growing 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 infutures 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 thanDengs economic reforms, also contributed

No matter if it is a white cat o

a black cat; as long as it can

catch mice, it is a good cat.

By Leo Melamed,

CME Chairman Emeritus

HowgoodcatsmakegoodfinancialmarketsinChina



15/36

greatly to the improvement of national

productivity and standards of living.

The late Nobel Laureate Merton Miller

called financial futures the most signif-icant financial innovation of the last 20

years. Recently, Alan Greenspan, chair-

man of the U.S. Federal Reserve stated,

The financial derivatives markets,

which the IMM has played a critical role

in developing, have significantly low-

ered 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 resilientto the real and financial shocks.

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 politi-

cal 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-

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 needa futures market in foreign exchange.

We asked Nobel Laureate Milton

Friedman what he thought about

our idea. His answer was emphatic:

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 andinvestment.

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 billionspot (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

accident. Chicago has a long historyof 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 finan-

cial 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 develop-

ment of financial derivatives on futures

exchanges should be the next step inChinas progression. Not only is this di-

rective 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

1512.05 | cme

Leo MelamedLeo 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.


16/36

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 ofChina. 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

most able and willing to assume and

manage the risk involved. They will

act like a gigantic insurance mecha-

nism 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-calledcounter-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

volatility. And there is pricing risk.

Pricing models sometimes inade-

quately reflect market risk when

it relates to long-dated or exotic

instruments traded infrequently.

Finally, there is the issue of trans-parency, which assures participants

that competitive forces will deter-

mine 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-tradedderivatives 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 applica-

tion 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

last year by the International Swap

and Derivatives Association, the u

of derivatives by companies to ma

age risks was commonly cited as a

contribution to the stability of the

global financial system. Therespondents 1) unanimously agre

that derivatives help companies

manage financial risk more effec-

tively; 2) unanimously agreed that

derivatives will continue to grow i

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 impa

of derivatives on the global financsystem is beneficial.

The results of the survey were perh

best summed up by professor

Michael Brandl, lecturer, Universit

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 o

resources, including capital, allows fo

more rapid global economic growth.

It is through economic growth that ea

generation has the ability to live bette

than past generations. Thus, an

expanded efficient use of derivatives

is an important component for future

economic growth.

In other words: financial derivativ

in capital markets are the equivale

of Deng Xiaopings good cats

catching mice.

ALAN GREENSPAN

The financial derivatives markets...

have significantly lowered costs

and expanded opportunities for

hedging risks....

www.cme.com/chinamarket



17/36

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 Butterflies and Packs and Bundles around

the clock from around the world.

CME

EURODOLLARSIts easy to spot the leader.

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

cme.com


18/36

In the ZoneEurozone inflation contract added

CME has targeted European in

with a new product based on t

Eurozone Harmonized Index oConsumer Prices (HICP), com

menting CMEs existing U.S. in

futures contract launched in 2

The HICP contract measures a

compares the market price of g

and services in the 12 Eurozon

members to arrive at a single v

and expresses that as a factor o

1 million euros over

12 calendar

months. HICP

futures will

be quoted

as 100

minus the

inflation rate

of the preced-

ing 12 months of

the contract. CME is

implementing a market-maker

program to support the contra

Product s and ServicesInsights on CME

Focusing on 5 0CME 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 compa-

nies. 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

18 cm e m agazi ne | w w w. cm e. com


19/36

WeatherReportNew 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.

Bet te r Butt erCME 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 MarketsLLC 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

Long BallGoldman 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 ReturnsIndex, 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 Indexfutures contracts in the first six

months of 2005 rose 18.5 percent

over the same period in 2004.

www.cme.com/weather

www.cme.com/gsci

pounds. Contracts are cash-settled

based on the USDA monthly-

weighted average U.S. butter price.

www.cme.com/cmebutter

1912. 05 | cm e


20/36

JPMorgan is one of the premier

financial services firms in the

global derivatives space.

Giving customers what theywant 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 onthe CME financial floor.

Richard B

Managing Direc

Futures & Options

JPMorgan, London.



21/36

It also was one of the first adopters of

executing Eurodollar options electroni-

cally via CMEs Enhanced Options

System (EOS) and continues to pass

along to customers the kinds of prod-

ucts 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 es-tablished 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.

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 distribut-

ing to their underlying clients,

Berliand says.

We have generally found that when

any exchange or product moves fromopen outcry to an electronically traded

environment, clients will produce two

to four times more business.

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 func-

tionality 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 function-

ality 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 substan-

tial money through margin offsets.

We consider the clearing at CME to

be high quality, especially the risk-

management side, and we believe itto be well run, Berliand says.

Differing views

One of the unique aspects of

JPMorgans futures business is that

it operates exclusively as an agency

business, which means the brokerage

division does not engage in propri-

etary 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.

Thats a very important attribute of

the futures business, Berliand says.

Its important for our clients that

no one in the futures business is ac-

countable 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 exclu-

sively institutional, and its brokerage

and clearing services are directed

largely to asset managers; insurance

companies; large conglomerate finan-

cial 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.

INNOVATI

JPMorgan remains at the forefront

of electronic trading, connecting

customers with its own software.

2112.05 | cme

www.cme.com/jpmorgan


22/36

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 en-hancements 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 CME-

certified to offer EOS access to cus-

tomers. 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 thefull 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 ofCMEs overall daily volume, but we

really pleased because the integrati

of EOS into CME Globex really got

the word out to cutomers, says Ro

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 Eurodol

options volumes really start to pick

up around 1 a.m. Chicago time,

when London desks begin trading.

Another component of the upgrad

was adding more liquidity provide

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 make

called mass quoters or hard quote

The system features five lead markmakers, a dozen responding mark

makers and eight mass market ma

ers. Lead market makers are requir

to stream indicative quotes on up

70,000 options combinations and

respond to every request for quote.

CME Eurodollar Options

ADV and % Electronic


CME Equity Index Options

Average Daily Volume

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.


23/36

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.

Expanding the

possibilities

CME also addressed bandwidth and

high-volume messaging issues associ-

ated 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 mes-

sage, 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 stillremains 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.

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 cus-

tomers. New offerings in 2006 will

include enhanced request for cross

functionality and user-defined

spreads which will enable clients toexecute 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.

CME is also working to provide

even more customization of options

data for customers. Another initiative

in development is focused on allow-

ing 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 anenormous amount of information

at their fingertips that theyve never

had before, Ross says. Information

like that can really enhance trading.

www.cme.com/options

CME Globex Open Outcry

CME Total Exchange

2005 Average Daily Volume by Month(contracts in thousands)

2312.05 | cme


24/36

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-the-

counter marketplace for 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 toolsgeared 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.

What are CME Economic DerivativesCME Economic Derivatives are options and forwards b

and sold in a marketplace that resembles a universal D

auction, an innovative format that maximizes liquidity

results in more order fills than traditional order-match

practices. They are the first suite of products trading on

CME Auction Markets platform. The auctions are cond

using a patented process of mutualized order-filling de

by an independent financial technology development

How do they work?

CME Economic Derivatives include forwards and the

kinds of vanilla calls and puts that traders are used to at

(with capped payout features), but they also include dig

or binary options. These digital options have traded for

in the OTC markets, but they are new for CME. Unlike v

options, digital options pay out a fixed amount if they a

the money. CME Economic Derivatives offer two flavor

digital options. The first kind pays out the fixed amoun

underlying statistic is higher than a digital calls strike, o

than a digital puts strike. The second kind pays out the

amount if the underlying statistic is between the two str

that define that particular digital option.

Taken together, this suite of product types allows the

to construct a hedge or exposure tied directly to the p

lar economic statistic, and to tailor that hedge or expo

very precisely by combining vanilla options, digital o

and/or forwards to create exactly the profile desired.

How does the auction platform work

The auction platform uses a patented method of mut

order filling that operates very differently from the tra

tional futures and options markets at CME. In the tra

markets, the buyer of a specific instrument, such as a



25/36

2006 CME Eurodollar call at a 95.00 strike, must matchagainst 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 instru-

ment. While it can perform that traditional matching, it

can also fill orders by recognizing offsetting exposures

in completely different instruments.

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 re-

sult, 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

to evaluate all the bids and offers for all the instrumentsand 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

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 some-

one else has submitted an order with a different marketview. 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.

2512.05 | cme


26/36

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 newcustomer 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 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 correctlyand efficiently. They are continuing

to perform all three of these

critical roles.

What indicators

are available?CME Economic Derivatives

offer a broad range of digita

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 onnon-agricultural payrolls

ISM MANUFACTURING

PMI INDEX

Monthly trends in

manufacturing orders,

production, employment

delivery speeds, inventori

and prices

U.S. INITIAL

JOBLESS CLAIMS

Weekly initial jobless

claims, adjusted to reflect

seasonal hiring patterns

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

www.cme.com/auctions



27/36

As the founding architect of Chinas

economic evolution over the last quar-

ter century, the late Chinese leader,Deng Xiaoping, played a critical role

in enabling free-market ideals to

prosper within Chinas socialist soci-

ety. 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 market-

place 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 sym-

biotic 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 theworlds 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 deriva-

tives 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 uncertain-

ties 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.

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 Prize-

winning 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 dis-

mantling of the Bretton Woods system

created not only a vibrant

By Walter Lukken,Commissioner, U.S. Commodity Futures Trading Commission

Pragmatic lessons for China based on30 years of U.S. financial futures regulation

Crossing the River byFeeling for Stones

2712.05 | cme


28/36

exchange-traded

market in foreign

currencies but the

beginnings of the

interbank currency market, which today

is the most liquid financial market inthe 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 short-

term interest rate contracts such as the

Eurodollar. Equity futures were next,

with index products on the S&P 500

and Dow Jones industrial average. The

pace of financial innovation was breath-

taking and begs the question: Will

China soon experience similar growth?

Regulatory growth

U.S. market innovation in the early

1970s also spurred a major moderniza-

tion 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 revolu-

tionary 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.

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.

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.

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.

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

participants to use different met

gies or best practices for achiev

statutory requirements.

In addition, exchanges now have

authority to approve new produrules through a self-certification

without prior CFTC approval. Af

certification, the CFTC has the au

to reject a product or rule if it is

to violate the Act. This was neces

allow exchanges to react quickly

competitive challenges.

Lesson Two:

Strong enforcement

is essential

This lesson, which is a corollary othe first, is that a risk-based regul

regime must be accompanied by

aggressive enforcement presence.

the agencys recent shift to risk-ba

regulation, it is essential that the

be equipped to take swift legal ac

when wrongdoing is detected. Th

has been aggressive here shuttin

boiler-room operations, working

state, federal and international au

ties to lock up criminals and purs

corporate malfeasance. Such robu

law enforcement authority serves

a powerful deterrent.

Lesson Three:

Self-regulation works

Self-regulation, in which agenc

delegate and share certain regu

responsibilities with exchanges

other private-sector entities, ha

proven to be invaluable. Both t

National Futures Association a

exchanges are essential comple

to the CFTC in protectinmarkets from fraud,

nipulation and wr

ing. Without the

the 500-person C

would be overwh

FIRST LESSON

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.



29/36

Self-regulatory organizations (SROs)

also enjoy a proximity to the markets

that government regulators do not and

can often act more quickly to stop harm-

ful market behavior. Additionally, there

are significant savings to the taxpayers inhaving 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 appropri-

ate oversight and protections in place,

self-regulation could serve a similarrole in Chinas regulatory structure.

Lesson Four:

Legal certainty is vital

A successful derivatives market

requires a clear and predictable legal

framework. Markets require transpar-

ent and unambiguous rules. Although

complex in nature, derivatives instru-

ments are contracts. As such, they

require the parties to the agreements

be confident in their enforceability,

whether on-exchange or over-the-

counter (OTC). Any legal doubt about

a derivatives contract could severely

stunt the growth of this market.

Because exchange trades are marked-

to-market and settled at least daily,

the uncertainty as to whether parties

will perform on their obligations is

minimized. Although some OTC de-

rivatives are beginning to utilize clear-

ing to manage credit risk exposure,

most OTC derivatives largely rely onthe parties ability to pay and the en-

forceability of such agreements as dic-

tated by the host nations contract and

insolvency laws. Even the United

States has struggled in this area and

several revisions to our futures and

bankruptcy laws were needed to ensure

that the legal treatment of these prod-

ucts does not jeopardize the integrityof

the market or risk a systemic event in the

economy. The development of the

Chinese derivatives market would besignificantly advanced by keeping this

lesson on legal certainty in mind.

Lesson Five:Regulatory cooperation

matters

Regulatory authorities must cooperate,

both internationally and domestically, as

agencies do not have the resources or abil-

ities 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 interna-

tional cooperation by developing and

promoting information sharing and

high regulation standards.

Bilateral arrangements among regula-

tors are equally important. In 2002,

the CFTC and the China Securities

Regulatory Commission entered into

a Memorandum of Understandingregarding a mutually acceptable basis

for regulatory cooperation and techni-

cal assistance. It is also important that

regulators cooperate on enforcement

matters, as fraudulent activity knows

no boundaries.

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 CFTCand 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.

2004 Top Trading Part ners

China United States

1 United States Canada

2 Japan Mexico

3 Hong Kong China

4 South Korea Japan

5 Taiwan Germany

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

Walter LukkenWalter 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).

2912.05 | cme

www.cme.com/cftc


30/36

Success in todays derivatives markets increasingly comes

to technology and finding opportunities around the globe

Optiver, one of the worlds leading market-making and a

trage firms, is a company that has been able to find the r

combination of cutting-edge technology and market savvy



31/36

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.

Jelle Elzinga and Randal Meijer

(JE and RM in the following inter-

view), 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.

Optiver backgroundcme: First, lets start with some

basic facts about Optiver. Can you

quantify or give us an idea of the

size of your business?

je:We are a trading firm and work

with our own money, so we donthave clients or money under manage-

ment. Our own equity in the firm

is about 200 million, and we have

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?

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,

with the average employee age of

29. How does that youth fit withyour business in terms of the

atmosphere, management,

strategies, creativity and goals?

3112.05 | cme


32/36

rm:First of all, yes the

average age in our com-

pany is 29. However for

traders, it is less than 29-

about 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.

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:The preservation of our company

culture is emphasized. In the past we

have experienced that it is easier to

maintain your culture with younger

people without experience gained at

other companies.

cme: How would you describe

your culture?

je: In our culture, people have to be

flexible, look for opportunities and go

for innovations. Everyone is appreci-

ated for their specific skills. Background

is not the most important; it all has

to do with skills. In our environment,

teamwork is essential.

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 mathe-

matics, economics or even history. If

they are interested in this business and

have a competitive attitude, they fit intothe profile of an Optiver trader.

Trading practicescme: Optiver is active in a broad

range of arbitrage activities, which are

becoming more and more sophisti-

cated. Can you describe some of these

activities and how have they evolved

over time?

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: 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.

cme: Does it matter if its ov

counter or exchange-traded?

je: Our strong preference is ex

traded, because with a central c

party the risk is much more lim

cme: Market making is also

focus for Optiver. What does th

mean today and how does mar

making look today, compared

years ago?

rm:A few years ago, market mwas in open outcry only. Now w

focus 100 percent on screen tra

je: Indeed, its much more tech

driven now. The differences betw

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