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KEEPING THE CUSTOMER ALIVE
Many people might ask why I have devoted an entire chapter of this bookto a single segment of the industry. This is a good question. It’s because, inmy humble opinion, the concept of a multistrategy, multiadvisor managedfutures fund is the only Holy Grail in the trading universe. The answer liesin the fact that over the course of the last decade I have watched legions ofnew customers open accounts with a hope and a prayer. The ﬁrst rule thatI think everyone should learn is that there is no hoping, wishing, or prayingallowed when putting on or taking off a position.
If a trader wishes that the market would go a certain way, then chancesare that the trade was destined to be a loser from the outset. All new tradershope to ﬁnd that Holy Grail methodology of trading futures. That is, they’researching for the foolproof method that will give them incredible returnson their capital at risk and allow the market to give them consistent high-percentage trades. I have watched at conferences and seminars as countlesstechnicians sell their trading methodologies as if they were in a fast-foodrestaurant selling hamburgers. Most of the techniques that are taught atthese places are variations on the same old technical analysis with slighttwists to give them different bells and whistles.
It becomes almost comical when I’m asked to sit on panels with so-called experts on market conditions and ﬁnd out, as I talk with them, thatthey haven’t traded even a single contract. Imagine someone writing a bookan the technical analysis of the market and never having put capital at risk.I always ask the authors of books on the markets whether they trade and,if so, what they trade. It gives me a good understanding of what type of riskproﬁle to attribute to the person. As I sit on these panels, it becomes quiteclear to me that if I were to really speak my mind, I would end up callingthe rest of the panel a bunch of phonies who rarely understand the truenature of the marketplace. Not only do they not fully comprehend marketstructure, but others look to these people for guidance and advice whenmaking critical investment decisions. The numbers of times I’ve heard theterm Holy Grail associated with a trading technique are as frequent as thereare systems.
When I was the executive vice president of Nikko Securities in the early1990s, it became apparent that the Japanese retail public needed to ﬁndinvestment vehicles that gave them real returns on capital at a time whenthe Japanese stock market was in a steep decline. They realized that futuresfunds created in the Chicago subsidiary of Nikko International would be ableto create a structure that protected the principle of the investment with achance to see huge returns on the fund. It became known as a guaranteedfund, which essentially would tie up the investor for a three- to ﬁve-yearminimum and buy zero coupon bonds to guarantee the capital and trade the
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interest on the note. This would create a structured product of sorts, at atime when the concept was relatively new.
Many of the large brokerage houses began to structure products inmuch the same way for the Asian investors, which served a dual purpose;it kept the customers happy at a time when no other investment seemed tobe proﬁtable, and it did something I found very interesting—it kept the cus-tomer in the game! Until that point, the average retail-based customer fromJapan who was trading futures in the United States had a life expectancyof three to six months per account. These managed futures products keptthe customer around for the life of the vehicle, three to ﬁve years, whichallowed the person to invest in other Nikko products with conﬁdence. Thiswas a revelation. Watching the reaction to these funds in Japan made merealize that the future for the industry lay in the hands of the fund managerstrading futures. Not only did Nikko ﬁnd an investment that gave customersthe protection of capital that they desperately needed, they also received anoncorrelated asset into their portfolio that gave them true diversiﬁcationwithout even trying.
I went on to become president of Commerzbank Futures in Chicago,a division of Commerzbank AG of Germany, then the seventeenth-largestbank in the world. I quickly rallied the troops in the hope of talking Frankfurtinto granting the permission needed for the futures subsidiary to get intothe managed funds business. As German institutions go, Commerzbank wasalways trying to play catch-up with its much larger rivals, who had alreadyfound proﬁt centers in structuring the proper products. The meetings inFrankfurt lasted two whole weeks, as we met with board members of thebank hoping to explain the growth we were about to experience and howthe bank could capitalize on the opportunity at hand.
The Germans are notoriously slow when it comes to decision making,mostly because of an indentured middle management that ﬁnds it difﬁcultto streamline anything. Commerzbank was no different, having a chain ofcommand that was pure German in its enforcement and policy decisions.A lack of timely decision making left the bank FCM at the mercy of theinstitutional customer base that pressed commissions lower and lower asthe markets became more efﬁcient. No funds were ever created in Chicago,and the bank folded the operation a few years later under the auspices ofthe investment banking team.
What the experiences at both Nikko and Commerz taught me was thatit’s very important to create products that ﬁll a real need and serve a pur-pose in your customer base. It also gave me the motivation to ﬁnd a way togive the average investor a chance at the same diversiﬁed and well-balancedportfolio that would be expected from any money manager. The need to cre-ate product for the average investor stems from the serious losses incurredby so many small investors during the recent stock market decline. Many
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of these investors were sold the idea that equity markets never correct orget inﬂated. It was the new paradigm!
When the market began to go down, it didn’t discriminate between well-run companies and the ones that were said to be highﬂiers. Of course, manyof the high-ﬂying tech companies had tremendous declines, in the range of90 percent, but even the great names in the Dow Jones were not immune tothe selling pressure. Many of these great names were thought to be a hedgeagainst the crazy rally being experienced in the Nasdaq, but what happenedwas a revaluation in equity prices that hasn’t been experienced, in somecases, since the Depression era of the late 1920s and early 1930s that took theentire market down regardless of pedigree or market capitalization. If therewas ever a case study that extolled the virtues of having managed futures inyour portfolio, the last decade would be a perfect time to analyze it. Not onlydid managed futures programs do well during periods of market strength—albeit not the double-digit returns turned in by the equity markets—butthey showed positive returns during the course of the stock market bubbledeﬂation.
The time has ﬁnally arrived for the small investor to be able toparticipate in the market the way the professionals participate. Many of thenew funds that are being produced are being created with registrations thatallow the average investor to allocate a portion of assets into a proper alter-native. For many of the investment advisors I speak with, the idea of sellinga registered fund to their clients becomes a portfolio sale as long as the ad-visor is educated about the vehicle. This revolutionary concept of allowingthe general public to create a noncorrelated asset class they can incorporateinto their portfolios has not only energized the brokerage community, buthad the ancillary effect of creating huge pools of liquidity into what wouldotherwise be smaller agricultural contracts such as lean hogs or milk. Theproliferation of the managed funds industry has sparked a revolution amonghedge fund managers, who have discovered that they were all in a positionto grow their businesses geometrically with the products being created forthe noninstitutional clients. It’s only the beginning. This industry is in itsinfancy, but everyone who is serious about investing should know about it!
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C H A P T E R 5
Within EveryDisappointment,There Is a Gemof Opportunity
I n the spring of 1997, I took a page out of Leo Melamed’s book. I broke
down the largest traders in the pit into groups and worked on themdirectly in order to garner support for a major change that the boardwas considering: splitting the S&P futures contract. Leo, as I would learn,was a master of breaking down the different ﬂoor constituencies in orderto ﬁnd support for tough board actions. Brian Monieson, a former ChicagoMercantile Exchange (CME) chairman and my self-appointed mentor, hadsuggested the act because he knew the difﬁculties I was about to face.
Brian was an old friend of Leo Melamed’s and was at his side for manyof the critical decisions that shaped the future of the CME. It was Brian’scounsel that led me to hold Melamed-style meetings with the major liquidityproviders in the S&Ps to gain their respect and conﬁdence. I had talked toﬁve of the largest traders in the pit, which included one whose family had adark history in the city of Chicago. As a native Chicagoan, I was aware of therelationship, but I also knew that you can’t choose your family as you canyour friends. I had many childhood friends whose fathers and uncles hadshady backgrounds but took painstaking steps to make sure their childrenopted for a different career path.
As an elected ofﬁcial of the CME’s board of directors, it was my job tobalance the needs and the interests of the membership I was representingwith the day-to-day supervision that my ﬂoor brokerage business required.Every day new traders would come with what seemed to them to be a life-or-death situations that needed my immediate attention and actions. I foundmyself right in the crosshairs of every political argument that pitted the
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ﬂoor community against board decisions. Every small board decision wasa major issue for somebody!
On a Monday morning, as I was standing at my desk with my entirecrew, waiting for the opening of the equity markets, an incident occurredthat would give me a clue about the intensity of the board position for whichI was elected. From my elevated perch between the S&P and Nikkei pits, Iwatched traders walk directly in front of me as they entered the arena tobegin trading. Before the opening bell and after my morning brieﬁng withthe locals, the trader with the nefarious family history stopped directly infront of me on his way into the pit. With my entire crew standing behindme and my colleagues from various other futures commission merchants(FCMs) next to me, he said, “Jack, this better work. If it doesn’t, I’ll haveto join the family business, and if that happens I might have to come lookfor you.” I could see that he was smiling when he said it, but nonetheless Ifelt that it was important to respond. Without missing a beat, I stole a linefrom G. Gordon Liddy, of Watergate fame, and said, “Tell me what corner tostand on so my wife and kids don’t get hurt!” I winked as I said it, but thosebehind me didn’t see the wink or the smile on the face of the trader as hemade what appeared to them to be a threat!
As I spun around, I could see the surprised look and nervous smile onthe faces of those around me because of the comments sent my way and,as I found out later, my response in the dialogue. I put a big smile on myface to defuse the tension and said, “It’s all part of the job. What did youguys think I should have said?” The incident was never brought up again,but I know that it showed all around that I was serious about addressingthe needs of the membership and the exchange.
THE CBOT LANDS THE DOW JONESFUTURES CONTRACT
For a number of reasons, 1997 was an especially difﬁcult year for thoseof us who were elected to the CME’s board of directors. We had decidedto split the S&P 500 contract that had advanced and grown far beyondanyone’s imagination in notional value and had driven performance bondmargins to the limit. As the chairman of the equity index committee, it wasmy responsibility to be the liaison between the membership providing theliquidity to the products and the policy makers in the board room. Thesubject of splitting the S&P 500 futures contract from a 50-0 multiplier to a250 multiplier pitted the brokerage community against the market makers.Those trading the product did not want to see the value of the contractcut because it would force them to trade more to acquire the same exposure.
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The brokerage community, headed by the largest retail brokers of the day,realized that the contract would be undesirable for salespeople unless thevalue of the contract made it economically feasible for them to push theproduct. The heated debate, which took months, was interrupted by anannouncement in midyear that the Chicago Board of Trade (CBOT), theCME’s longtime rival across town, had landed a much-sought-after deal,with the Dow Jones company allowing the CBOT to launch the Dow Jonesfutures contract on their ﬂoor.
As an active member of the ﬂoor community, I had the task of handlingthe impact of this announcement, which sent shock waves throughout theexchange. Many on the ﬂoor saw the CBOT’s landing of the Dow contract asa direct assault on what they perceived to be their franchise—namely, thestock index futures market. We quickly called an equity index meeting inwhich the concerns of both the brokers and the market makers became one.The word was sent to the board that the membership expected a responseto the announcement, and the fact that Leo Melamed was back on the boardcreated a sense of excitement that something big was about to happen.
Leo Melamed, chairman emeritus of the CME, is regarded as the fatherof ﬁnancial futures and, in my humble opinion, the greatest visionary I’veever met. He could be the subject of a variety of books: There’s Leo theholocaust survivor, Leo the father of ﬁnancial futures, Leo the visionary whocreated Globex (the ﬁrst electronically traded futures platform), and nowLeo the coinventor of the e-mini. The e-mini concept and the proliferationof other electronically traded products are as revolutionary in the world ofcapital markets as was the creation of the International Monetary Market(IMM) in the early 1970s.
Melamed is a larger-than-life character who lives up to the expectationsabout him. A trained lawyer, he has always had a way of rousing the troopsand generating the kind of allegiance given to other charismatic ﬁguresin corporate culture. As a young novice trader, I watched as Leo and therest of the exchange power brokers escorted senators and representatives,attempting to convey to them their vision for the futures industry and theimportance of maintaining a free and open marketplace.
It amazed me to see awe on the faces of these important visitors asthey observed the number of transactions and attached a notional value tothe particular trade they were witnessing. Leo’s tours of the trading ﬂoorremain popular among visitors from Washington, who frequently remarkupon them in other contexts. Leo’s contributions to the futures industryare too numerous to mention here; however, as a ﬁrst-hand observer of theactions of the board after his return from semiretirement, I can say, withall due respect to the countless other distinguished board members withwhom I’ve served, that Leo was undoubtedly the greatest thinker I’ve everhad the pleasure of meeting.
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ELECTRONIC FUTURES TRADING
Prior to Leo Melamed’s return from semiretirement, the CME had founditself in what I call “the dark ages of the exchange.” The innovative CME,creator of new products and services, had begun to lose a certain amount ofmomentum to the Chicago Board of Trade (the rival exchange across town)and were ﬁnding it very difﬁcult politically to introduce new technology tothe ﬂoor. After a sharp fall in lease seat prices (the price paid to lease aseat on the exchange in order to trade in the pits) a grassroots organizationcalled the Equity Owners Association (EOA) was formed to protect theinterests of the seat owners and exert some political pressure on the boardof directors.
It was in this climate that I was elected to the board of directors forthe ﬁrst of my three terms. My agenda was clear. Although I wasn’t a seatowner personally (I was an ofﬁcer of Credit Agricole Futures, having takena job with an afﬁliate of the French bank in order to build an equity fu-tures operation), I was representing the community of futures commissionmerchants, who are required by the exchanges to own a certain number ofseats in order to be clearing members. Running my own operation on theﬂoor, it became very clear to me, and others on the board such as DavidSilverman, that technology was needed to counteract the problems of in-efﬁciency caused by the open outcry system. Until this time in exchangehistory, the only real change in the way business was conducted on the ﬂoorhad been the introduction of hand signals to speed the process of transmit-ting orders from the brokers on the phone with customers to the ﬁllingbrokers in the pit.
Silverman, a ﬁne currency trader and board member, thought it wouldbe advantageous for the ﬂoor if we, as a board, were to allow the use ofheadsets to relay the order ﬂow. Prior to this request, the use of any kindof communications technology in the pit had been strictly forbidden. Thiscreated two distinct problems. The ﬁrst was simple: Regulatory concernssurrounded the use of technology that could not be monitored the way theorder ﬂow coming from the traditional order desks was monitored. Thisforced the compliance department to think creatively and permit some ofthe ﬂoor to try using headsets.
The second problem was much more difﬁcult. The political repercus-sions of allowing the headset technology into the trading arena broughtup serious arguments and created divisions among the ﬂoor community.Those who traded in the pit were highly sensitive to any type of listeningequipment being used there, especially because an FBI sting had netteda couple of traders at both the CME and the CBOT a few years earlier.With Leo Melamed’s leadership, both issues were resolved and a new era oftechnology was introduced to the CME membership.
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TECHNOLOGY LEADS THE WAY
As word that the Board of Trade had landed the Dow Jones futures contractspread across the exchange ﬂoor, the concern quickly shifted from the useof headset technology to survival. Many members were convinced that theCBOT was about to steal the equity futures franchise by luring the openinterest to the new Dow contract. It became necessary to address two dif-ferent situations: the perceived threat and the actual threat. The perceivedthreat was that the CME would lose a contract—much like what had hap-pened to the gold contract earlier in the exchange’s history. The CME hadlost the open interest to the New York traders, resulting in bitter and para-noid feelings anytime a similar contact was introduced by a rival exchange.The actual threat was much different. As chairman of the equity index com-mittee, I was aware that the Dow Jones index is not the index of choice forportfolio managers. When the CBOT landed the Dow contract, there wasvery little capital using the index as a benchmark. When asked in a ChicagoTribune interview what I thought of the Dow contract, I responded, “Myparents ask about the Dow; portfolio managers ask about the S&P 500.”The events that followed were a combination of timing, inspiration, andsheer genius.
A meeting of the strategic planning committee was immediately calledto address the situation. I was asked to serve on both the executive com-mittee and the strategic planning committee, which constituted, in essence,the board within the board. It was the responsibility of the strategic plan-ning committee to come up with ideas and solutions that would allow theboard to take action without getting caught in the minutiae of an issue. Theexecutive committee was responsible for setting the board agenda for anygiven meeting. Leo Melamed, who had recently been asked to come outof retirement, along with Bill Shepard, perhaps the most inﬂuential boardmember of the day, had an idea they wanted to discuss.
The concept, to counter the threat brought on by the CBOT’s landingof the Dow contract, was to give traders a smaller version of the S&P 500futures contract. It was to be an electronic form of the much larger pit-tradedcontract, but it would give users lower dollar volatility per trade. In short, theproduct allowed retail investors to participate in the futures market withoutthe huge margins that the advancing S&P contract created. By 1997 the S&Phad advanced beyond anyone’s imagining, creating a contract that, at 500times the index, became more difﬁcult to trade and broker. The sheer size ofthe contract had taken the performance bond margins from roughly $2,500per contract to over $25,000 as the index moved from under 200 to 1000!
This resulted in two fundamental problems. First, the brokerage com-munity was ﬁnding much less proﬁt in equity trading because of thetremendous volatility and exposure a handful of contracts give the user.
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The second problem was that competition for customer ﬂow was becomingmuch more intense with the introduction of ETFs, which acted like futuresbut in the form of securities. This was the atmosphere in which Melamed andShepard came to unveil and discuss the new concept of trading a smallerversion of a proven product side by side with the pit-traded open outcryproduct. This had never been done before—cannibalizing your own provenmarket with a smaller electronic product.
HISTORY IN THE MAKING
As Leo began to speak, I sensed the anticipation and excitement in the room,as if the board members and staff realized the historic nature of this newdirection. His ﬁrst words were memorable: “Behind every disappointmentlies a gem of opportunity.” An incredible orator, Leo had the room in thepalm of his hand with this ﬁrst sentence, but it was Bill Shepard, behind thescenes, who gave him the needed political capital to make history.
Shepard is the quiet genius on the CME board, but his credibility atthe board level came from his days on the ﬂoor as a trader. A large manwith a beard, Shepard walked into the currency pits and put on enormouspositions, usually spreading one against the other. In fact, he would walkin and out of the pits with such conﬁdence that my friends and I called him“the Rooster.” Not only was Shepard the most gifted trader of his day, but,as few people in or out of the industry know, many traders got their startwith his assistance. Stories of successful locals who got their start withBill’s ﬁnancial backing are common.
With Shepard legitimizing the idea, Leo had everything he needed to ac-complish his goal—which was to create the greatest electronic futures mar-ketplace the world has ever seen. Several years earlier, in his book Escapeto the Futures, Melamed had written about his vision for an electronic ex-change. As one of the creators of Globex, the CME’s electronic platform, herealized the power of the electronic platform and what it would mean for thethousands of members who would own equity in a demutualized CME. Wehad arrived at the point where much of that dream was turning into a reality.The weeks that followed the announcement of the e-mini were ﬁlledwith debate about such things as contract size and position limits per trans-action. For the product to proliferate as expected, we believed we wouldneed participation from the local ﬂoor community, who would make mar-kets tapping into the larger contract’s pool of liquidity. By creating a two-sided liquid electronic market, it was thought—and rightfully so—that thepublic would decide which platform it preferred. This was a bold and daringmove—a market-driven solution made by an institution that prided itself on
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creating fair and open markets. It could turn out to be one of the CME’sproudest moments.
One of the driving factors behind such a monumental decision on thepart of the CME was the then recent assault on the London InternationalFinancial Futures Exchange (LIFFE) Bund futures contract by the Germanfutures exchange Eurex. Aside from issues relating to national pride on thepart of the Germans, it was the existence of their electronic trading systemthat gave them the needed technological edge to overtake the establishedLondon market. This act of “stealing liquidity” sent shock waves into theboardroom of every exchange in the world. If it was possible for the GermanEurex exchange to steal the Bund contract from London’s LIFFE market,then it was feasible that the CME’s lucrative equity and interest rate complexwould be in the crosshairs of any predator.
A REVOLUTION IN FUTURES TRADING
As the membership became more and more comfortable with the idea of hav-ing an electronic market trade side by side with the larger open outcry coun-terpart, the world began to understand the value of the new, smaller contractand growth took off at an alarming rate. The question was no longer whetherthe concept would work but rather were we as an exchange prepared forthe phenomenal growth that many of us saw ahead. The board of directors,composed of traders, brokers, and salespeople, became de facto technologyexperts who would lead the exchange into the next century. We all becameobsessed with the speed and efﬁciency of the new, growing market, moni-toring the transactions per second (TPS) as closely as a technology ofﬁcer.One of the ancillary effects of migrating the trade to the electronicplatform was the disintermediation of the ﬂoor. Once liquidity went to thescreen, the ﬂoor would slowly become obsolete. What makes the evolution-ary process in the futures markets somewhat different is that the geometricgrowth in the number of end users has, anecdotally, created two jobs offthe ﬂoor for every one job lost on the ﬂoor. Throughout the entire process,Leo and Shepherd led the charge in the boardroom. Decisions became moredifﬁcult as the concept spread to other sectors of the equity markets andeventually into the other product lines of the exchange. The success of theS&P e-mini led to a launch of an e-mini version of the Nasdaq, the S&PMidCap 400, and the Russell 2000, all of which have been success stories inthemselves.
The board of directors at the time of the creation of the e-mini wasan intellectual powerhouse. Aside from Leo and Shepherd, who led thecharge, many inﬂuential directors worked tirelessly to make sure the ﬂoor
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understood the need for the concept to thrive. Jack Sandner, former chair-man, and Terry Duffy, present chairman, were instrumental in garnering thesupport of the ﬂoor broker community, who, as a collective, had enormousinﬂuence in pre- and post-IPO exchange politics.
Duffy, in particular, exhibited the diplomacy of a seasoned political vet-eran as he explained to the older ﬂoor members the value of the electronicplatform and the endless possibilities it created for the CME. Duffy, one ofthe greatest chairmen in the CME’s history aside from Leo, has given theexchange the fresh blood it needs to survive through the next chapter ofits history. As chairman, Duffy, with the support of skilled strategists likeMelamed and Shepherd, has taken an old, established Chicago institutionand turned it into the global powerhouse it is today. I left the board just asDuffy became chairman, but as his former board colleague I can say, withall honesty, that the CME has never been in better hands.
The growing volume in the e-mini product lines made the use of theproducts more popular among the various proprietary traders in the end-user community. A proprietary trader is one who takes positions for theﬁrm using the ﬁrm’s capital and risk proﬁle. Proprietary trading houses, or“prop shops” as they are called on the Street, have been responsible for themajority of the explosive growth found on the trading screen. Every indexarbitrageur and statistical arbitrageur has automated its system in order toparticipate at a much higher rate of trade than is possible in a traditionalopen outcry environment.
It becomes much easier for a trader to write a code that automates theentire arbitrage process, thus allowing the trader to take positions in manydifferent markets simultaneously. Prior to the maturation of the e-mini, itwasn’t feasible for a single trader to handle more than one or two marketsat the same time. Now, it’s not uncommon to walk into a prop shop with twopeople and ﬁnd that they are trading 20 different markets electronically andeach strategy is fully automated. As the electronic trading system becameeven more reliable and efﬁcient, two major events happened: The customerbase of the electronically traded products began to grow at an alarming rateand the liquidity in the pit moved to the screen.
The ﬁrst effect was a welcome change for the FCM community, whichhad found it difﬁcult to make the same proﬁt per trade they had experiencedyears earlier. Many of the major FCMs are either subsidiaries of larger in-stitutions or are designed to handle in-house proprietary trading. Theselarger institutions looked upon the futures division as a bastard child. Asthe president of Commerz Futures, I witnessed ﬁrsthand the contempt thatthe established banking community had for the entire derivatives industry.It always seemed ironic to me that one part of the bank looked down onthe industry, while a completely different part of the bank depended on theprice discovery provided by the markets in Chicago.
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