The core characteristics of healthy and vibrant futures markets are that they are (1) transparent; (2) highly liquid; (3) efficient; and (4) safe, fair and reliable. We can apply these same characteristics to improve risk management capabilities and processes in any organization. In this two-part series, we will describe these characteristics and suggest some practices on how to apply them to improve risk management and strategy within your own organization.
Futures contracts and exchanges have existed and evolved over the past 275+ years to provide users with the ability to protect their assets and investments against price volatility. A futures contract is simply a standardized legal agreement to buy or sell an asset on a specific date in the future.
The price of a futures contract at any given moment reflects the market's collective view on the uncertainty (or "risk") associated with the underlying asset, whether it is an interest-rate contract, the S&P 500, or a commodity like corn or oil.
The futures markets are used on a daily basis by customers and traders across the globe in a very real and significant way. Just to give you an idea of scale, in 2009, the notional value of future contracts traded on exchanges in the United States was greater than $800 trillion, with an average of 10.5 million contracts traded each day. Needless to say, this is a very healthy and vibrant market.
There are four key characteristics of futures markets that enable them to function. I believe these same four characteristics can be applied in any organization to help promote and create healthy risk management capabilities and processes.
A hallmark of futures exchanges is the fact that they allow every participant in the market to see the prices of any contract being traded, in real time. This price transparency enables participants to understand the current price of a contract before they enter the market to buy or sell. The prices of the last executed trade, as well as the current "bids" (offers to buy) and "asks" (offers to sell) are displayed to all market participants either through the famous wallboards or electronically on trading screens.
This transparency reduces the uncertainty that participants could have regarding the price at which they could execute a buy or sell order in the market at any given time, enabling them to better manage risks in their business and trading activities.
Transparency is also essential to managing risks in any organization. Sure, an organization may not be able to replicate the real-time "risk-adjusted market price" for any given project or financial variable in their own organization (which would be ultimate transparency); however, an organization can certainly improve its ability to form an aggregate understanding of the collective organization's views on the uncertainty surrounding any given variable by creating an environment where transparency around views on uncertainty is encouraged and expected.
One approach to this is through establishing a forum where leaders, managers and staff from across the organization could (and would be expected to) voice their perspectives on uncertainties facing the organization.
One of the key differentiating factors between futures exchanges that are successful and those that are less so is liquidity. Liquidity is typically defined as a measure of how easily and quickly an asset can be converted into cash. In futures exchanges, liquidity refers to how easily and quickly a buyer or seller can execute a transaction in the market by finding another willing seller or buyer to transact with. Liquidity is often significantly influenced by the number of active participants (buyers and sellers) in the market; the more participants and more diverse the views, the better.
Highly liquid markets enable buyers and sellers to execute transactions very quickly, enabling them to transact at prices that are at, or very near, the transparent prices they are seeing on the wallboards or on their screens.
Another characteristic of highly liquid markets is that prices in these markets are seen as the best reflection of the entire market's view on the future value of the underlying asset, factoring in the collective uncertainly surrounding that value. In other words, highly liquid markets are better at valuing (i.e., assessing) risk.
The concept of liquidity is often an undervalued characteristic in organizations' risk management practices. When looking to assess or evaluate any given uncertainty, organizations often include only a limited number of individuals (i.e., perspectives) in the process. As a result, the outcome is analogous to a market with little liquidity; "prices" for risk (i.e., views) that do not fully reflect the entire market's view of the uncertainty.
PUT IT TO THE TEST
To test this in your own organization, think about the last time your organization assessed an uncertainty and then ask yourself: "How many people were involved? Did they all express their true views on the uncertainty? What were their backgrounds (similar or diverse)? Were there active dialogue and debate, or was there just passive participation?"
If your answers to these questions were, "Only a few. Not really. Similar; they were all from finance and accounting. Passive participation," then you are probably like many organizations and have an opportunity to increase the liquidity in your practices.
The good news is that it is relatively easy to increase liquidity. Just add more people and diverse perspectives to the conversation, incentivize them to express their true views, and then incorporate what you learn in the conversation into your assessment of the uncertainty (more on all this next month).
You will quickly find that you get a more robust and comprehensive view on the organization's understanding of the uncertainty, which could be any uncertain variable from the probability of completing a project by a certain date to the range of values associated with sales of product in a given time period. In the end, these more robust views should help enable an organization to more confidently make higher-quality decisions in their business.
Transparency and liquidity are the two most obvious core principles that enable healthy futures markets. However, they would not be possible if the markets are not efficient or safe, fair and reliable. The same relationship holds for organizations. Next month, we will cover the principles of efficiency and safety, fairness and reliability, and then discuss how you can apply these principles to improve the health of your organization's risk management and strategy practices.
DAVID M. WONG is director of enterprise risk management at CME Group, the world's largest and most diverse derivatives exchange.
June 21, 2010
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