BIRTH OF THE INTERNATIONAL MONETARY MARKET1
By Leo Melamed
February 6, 2014
Few things are more symbolic of flexible exchange rates than the International Monetary Market (IMM) in Chicago. Indeed, the birth of this futures exchange on May 16, 1972 is inextricably intertwined with the death of Bretton Woods, occurring as it did but a few months after President Nixon officially closed the gold window and ended the system of fixed exchange rates.
Yet, the IMM represented much more than a new economic era or the successful introduction of currency futures. In May of 1986, precisely fourteen years after its inception, Nobel Laureate, Merton H. Miller, Distinguished Service Professor of Finance at the University of Chicago Graduate School of Business, bestowed upon the IMM a supreme and unparalleled honor. He nominated financial futures as "the most significant financial innovation of the last twenty years."2
It is not my place to admit or deny this distinction. Professor Miller and others of his distinguished credentials are eminently more qualified than I to make such determinations. Rather, I am best placed to reflect on the events surrounding the birth of our currency markets, to recall some of the noteworthy moments of the IMM's formative years, and to answer questions about who we were, and whether we knew what we were doing.
I dare say, if ever one needed proof of the sagacity of "Necessity is the mother of invention,"3 one need only review the economic disorders leading to and following the creation of our new exchange. These events proved beyond anything we could say that the IMM was an invention made necessary by the dictates of the times.
The date most observers would mark as the official onset of financial upheaval would be August 15, 1971. That day, President Nixon announced his economic emergency package which included a wage and price freeze, a 10% import surcharge, and the suspension of dollar convertibility into gold and other reserve assets. Unquestionably, the closing of the gold window was a seismic shock that unleashed financial reverberations that were felt even a decade later. It is unfair, however, to characterize any one event as critical to the actual beginning.4 No one factor is responsible for the chain of events that culminated in the financial tumult of the 1970s and early 1980s, except, of course, the 1945 Bretton Woods Agreement itself.
In my opinion, Bretton Woods was a short-term solution uniquely suited for post-World War II reconstruction. If applied much beyond that, as it was, its basic and fundamental flaw, its rigidity, was to be its undoing. A fixed exchange rate system could not forever effectively cope with the continual change in currency values resulting from the flows of political and economic events, both real and perceived, affecting the member nations of Bretton Woods. The different external and internal interests of the participants, their different rates of economic growth, their different fiscal and monetary policies, beholden to different forms of governments, their different work force considerations, their different election timetables and political pressures would combine to destroy a system dependent upon a unified opinion regarding respective exchange values.
Milton Friedman knew this from the beginning:
From the time Bretton Woods became effective, it was inevitable it would break down. It tried to achieve incompatible objectives: freedom of countries to pursue an independent internal monetary policy; fixed exchange rates; and relatively free international movement of goods and capital. . . .As one of the architects of Bretton Woods, Keynes tried to resolve the incompatibility by providing for flexibility of exchange rates through what he intended to be frequent and fairly easily achieved changes in official parities. In practice, this hope was doomed because maintaining the announced parity became a matter of prestige and political controversy. Countries therefore held on to a parity as long as they could, in the process letting minor problems grow into major crises and then making large changes.5
By December 1971, when the IMM was officially incorporated as an independent financial futures exchange, it was obvious to some of us that the imbalances created and pent up by fixed exchange rates were about to erupt. President Nixon's economic measures were only some, albeit critical, to those effects and were immediately followed by a number of international actions and pronouncements which turned out to be futile.
The "Smithsonian Agreements"6 proposed a new structure for currency realignments which included dollar devaluation. This attempt at a new foreign exchange standard was doomed from the outset since it was not much more than an expanded Bretton Woods. The Basle Agreement for the European Economic Community (EEC) later established the so-called "snake" for EEC currencies.7 This novel regime allowed EEC currencies to jointly float against the dollar while the movement between each currency was restricted to a predetermined band. The concept has, of course, survived to this day (i.e. 1988). Nevertheless, there were an unending series of currency revaluations and devaluations, entering and leaving the snake, IMF agreements, amendments, and inevitable disagreements all proving that the world foreign exchange system was in serious difficulty.
The epicenter of the unfolding disorder occurred in 1973. In October an oil embargo was instituted and the Arab-Israeli war erupted. It set in motion economic distortions that would dramatically change the world financial fabric for a long time to come. What followed was an era of financial turmoil rarely equaled in modern history; turmoil that tested the very foundations of western society: the U.S. dollar plunged precipitously; U.S. unemployment exceeded 10%; oil prices skyrocketed to $39 a barrel; the Dow Jones Industrial Average fell to 570; gold reached $800 an ounce; U.S. inflation climbed to an unprecedented peacetime rate of 20%; and interest rates soared even higher.
These events ensured that our invention was the correct answer dictated by the necessity of the times. Indeed, if one could ordain the perfect backdrop for the creation of a new financial futures exchange such as the IMM, designed to help manage the risk of currency and interest rate price movements, one could not have asked for more than what actually occurred.
It is fair to say that our new exchange, with its fundamental constituent of transparency and continuous flexibility, served as a most effective tool with which to ameliorate the dramatic financial shocks and stresses of the next decade and a half. Floating exchange rates were lauded by the International Monetary Fund as published in its Occasional Paper, July, 1984:
Given the events of the past decade, it is easy to be impressed by the resiliency of the present system...Indeed, in such an environment, managed floating might well have been the only system that could have functioned continuously.
A similar statement was issued by the Group of Ten, as published June 21, 1985, when it said, "It is questionable whether any less flexible system would have survived the strains of the past decade."
Can we claim that we anticipated the exact nature of the turbulence that followed the IMM's creation? Of course not. It was simply that, as traders with an ear to the ground, we had heard the inner rumblings and knew there was trouble ahead. Did we grasp the vast potential of the idea? I believe we did. This was the precise query pressed upon me by Milton Friedman when he served as guest of honor at the occasion of the IMM's tenth anniversary. Did we, he asked, actually envision the scope of our invention at the time of its launch?
The answer was easy to locate. It is to be found my statement to the members in the 1972 Annual Reports of the Chicago Mercantile Exchange (CME), the entity that spawned the IMM.
The opening of the International Monetary Market on May 16, 1972 was as revolutionary a step as the establishment of the first organized commodity exchange when that event occurred.
We believe the IMM is larger in scope than currency futures alone, and accordingly we hope to bring to our threshold many other contracts and commodities that relate directly to monetary matters and that would complement the economics of money futures.8
A year later, in the first International Monetary Market Annual Report, I spoke of the new futures era ushered in by the IMM:
The new era will afford us the opportunity to expand our potential into other areas within the monetary frame of reference. That was the essence of the philosophy that fostered the IMM. Our new market was specifically designed to encompass as many viable trading vehicles in the world of finance as practicable. We must be willing and ready to explore all possibilities.9
Thus, while our grammatical prowess may have been less than perfect, our eyesight was 20/20. We were fully aware of the revolutionary nature of financial futures and equally cognizant of their vast potential. However, we did not delude ourselves about the difficulties that lay ahead.
"It's ludicrous to think that foreign exchange can be entrusted to a bunch of pork belly crapshooters," proclaimed a prominent New York banker on the eve of the Merc's launch of the IMM.
"The New Currency Market: Strictly for Crapshooters," echoed Business Week, condemning us from the start and mockingly reported that "if you fancy yourself an international money speculator but lack the resources...your day has come."10
Not what one would describe as a friendly endorsement. Indeed, the world not only misread our purpose, but our potential as well. In retrospect, the antagonism stemmed from three factors: Misunderstanding the depth and power of financial forces pent up by twenty-five years of fixed exchange rates, misreading the nature and value of the idea we fostered, and miscalculating who we were.
Of course, there were some notable exceptions. For one, Milton Friedman, who not only provided us with the intellectual courage to proceed undaunted by the sea of skepticism about us, but also lent our concept his esteemed academic credentials. Without his help it is questionable whether we could have successfully defended ourselves from the onslaught of official and unofficial negativism awaiting us.
Wrote Professor Friedman in the position paper I commissioned him to write for the CME in the fall of 1971:
Changes in the international financial structure will create a great expansion in the demand for foreign cover. It is highly desirable that this demand be met by as broad, as deep, as resilient a futures market in foreign currencies as possible in order to facilitate foreign trade and investment.
Such a wider market is almost certain to develop in response to the demand. The major open question is where. The U.S. is a natural place and it is very much in the interests of the U.S. that it should develop here.11
Those words and scores of subsequent supporting actions by Friedman on behalf of the IMM were invaluable in facilitating our successful birth and indispensable in supporting our fragile existence during our formative years.
To begin with, although CME counsel, Jerry Salzman, assured us that we did not need governmental sanction to proceed,12 we thought it prudent to notify the indicated U.S. officials of our plans. We felt, correctly as it turned out, that there were compelling reasons to touch base with our government and later with foreign governments. First, to give the IMM concept the proper level of recognition and hopefully prominence; second, to gain, if possible, a positive reaction that we might be able to use in promoting the idea; and third, if the opposite were true, to control any negative fallout.
The first government official to formally receive the Friedman paper was George P. Shultz, who became U.S. Secretary of Treasury shortly after the launch of our market. Secretary Shultz offered immediate and warm support. While he gave the project long odds, he recognized its inherent values and embraced Friedman's philosophical rationale. No doubt his own free market views were in sync with those of his fellow Chicagoan.
In similar fashion, we paid courtesy calls on Dr. Arthur Burns, Federal Reserve Board Chairman, and Herbert Stein, Chairman of the Council of Economic Advisors. In each instance, Friedman's paper had paved the way for a receptive encounter.
No sooner did currency futures show signs of success, than we began to consider the next logical step in the financial revolution: Interest Rate Futures. Toward this goal we were greatly assisted by the current Chairman of the Council of Economic Advisors, Dr. Beryl W. Sprinkel, who as Vice President and Economist of Harris Bank and Trust Co., served on the IMM's original Board of Directors.13
I recall vividly how, in 1975, Dr. Sprinkel accompanied us to Federal Reserve Chairman, Arthur Burns, to discuss our prospective Treasury bill contract. It was a momentous occasion in our history. By extending financial futures to interest rates, we would dramatically expand our horizons. Moreover, the meeting with Dr. Burns was no longer a mere courtesy call. By then, as previously noted, new futures contracts required CFTC approval. Chairman Burns embraced the idea.
Of course, Treasury futures faced one more hurdle, the United States Treasury Department. Its consent was not received until Milton Friedman wrote a letter recommending the new contract to William E. Simon, U.S. Secretary of the Treasury in 1975. Mr. Simon readily agreed.
Still another early and avid supporter of our proposed T-bill market was the recently appointed Federal Reserve Board Chairman, Alan Greenspan, who in 1975 was Chairman of the Council of Economic Advisors. Dr. Greenspan unequivocally embraced the concept. Indeed, I recall his immediate reaction as he offered a litany of uses such a futures market could provide the business community. His list included all the exact reasons why T-bill futures were an instant success. I recall also Herbert Stein's cryptic comment upon learning of this new futures contract. Quipped the former CEA Chairman, "I oppose little between two consenting adults."
While positive reactions from government officials were important, the contributions by members of the business community who served on the early IMM boards were equally meaningful. Not only did each of these gentlemen give us advice and assistance, they provided our fledgling exchange with the initial credibility it so desperately needed. In addition to Beryl W. Sprinkel, our IMM Board14 included such distinguished names as Richard Lyng (currently serving as U.S. Secretary of Agriculture); A. Robert Abboud, Vice Chairman, First National Bank of Chicago; William J. McDonough, Executive Vice President, First National Bank of Chicago; Robert Z. Aliber, Associate Professor, University of Chicago; Henry Jarecki, Chairman, Mocatta Metals, Inc.; and Frederick W. Schantz, Vice President, American National Bank and Trust Company of Chicago.
Of special significance were two officers of the CME: Everette B. Harris, President of the exchange and Mark J. Powers, its Chief Economist. Each of them, in their own way, contributed greatly to the IMM's ultimate success. E.B. Harris had a vast store of accumulated futures expertise as well as friends everywhere, thereby providing invaluable advice and opening important doors to give us the needed opportunities to preach the new gospel. Mark Powers, on the other hand, was a superb economist with a truly fertile mind. He instinctively knew what the specifications of the new currency and T-bill contracts should be. While those specifications have been changed over time, they are still basically traded the way Powers wrote them.
Unfortunately, the soldiers we recruited to defend the IMM, represented but a handful compared to the armies who viewed the idea of financial futures with disdain. It was to be an uphill struggle for many years to come. Fortunately, its success was served by our tenacity and advanced by world events which continuously supplied us with turmoil that proved our relevance. At the Tenth Anniversary celebration of the IMM, I made the following assessment of who we were:
Who were we?
We were a bunch of guys who were hungry.
We were traders to whom it did not matter-
Whether it was eggs or gold, bellies or
The British pound, turkeys or T-bills.
We were babes in the woods, innocents,
In a world we did not understand,
Too dumb to be scared.
We were audacious, brazen, raucous pioneers-
Too unworldly to know we could not win.
That the odds against us were too high;
That the banks would never trust us;
That the government would never let us;
That Chicago was the wrong place.15
And we were fast learners as well. While logic would dictate that unsophisticated bellie, cattle, and hog traders could not long survive the treacherous waters of foreign exchange when pitted against seasoned forex specialists, the odds were shortened by the simple fact that we were using our own money. That singular difference spelled a trading discipline and a thirst for knowledge that became a winning combination for those members who came to the IMM's currency pits.
And come they did, for they represented the quintessential ingredient. Without traders who were willing to brave the dangers of the new untested and illiquid markets, we could never have succeeded. They came and stood there day after day, learning and shouting, giving their time and money, infusing the initial liquidity that ultimately lit the IMM torch.
And we made some very smart moves, two of them decisive. The first was that the new currency contracts were not simply added to the contracts already traded at the CME. Rather, the IMM was created as a separate entity for the express purpose of listing financial instruments. This structure allowed us to build a "financial futures" image without the need to defend our age-old checkered history in agricultural futures.
More importantly, it enabled us to sell memberships at a much lower price and attract traders whose activities would be limited to the contracts provided by the IMM. The new members were, as it were, captive of the currency pits, unable to participate in the more active meat futures complex and thereby forced to generate business in their own arena. It was a crucial element in our growth and became the model adopted by other exchanges when the financial futures idea spread to our competitors.
The second critical component at the outset was the so-called "Class B" arbitrage structure. It was a bold and imaginative innovation for transaction-clearing. In the early days of the IMM, the banks would not participate directly in our markets. This meant that FX values at the IMM were not immediately connected to the prices of the interbank market. To make this connection, we created a separate class of clearing members whose sole function was to act as arbitrageurs between a bank of their choice and the IMM. The Class B firms were given special margin accommodations while the banks who dealt with them were provided unique security guarantees. It worked. And, although Class B arbitrage was destined to become obsolete as soon as the banks realized that dealing directly with the IMM was safe and profitable, the system was essential for the IMM to become relevant.
It is important to note that while at the outset, the major money center banks generally ignored the events in Chicago, the Chicago banks did not. Their long-standing relationship with futures markets was a profitable one and resulted in a futures expertise within their walls. Therefore, it was easier for them to grasp the concept of a futures market in currency. It was most fortunate that this was the case since we were in desperate need for commercial participants. Happily, the four major Chicago banks, Continental Illinois National Bank & Trust Company of Chicago, First National Bank of Chicago, Harris Bank and Trust Co. and American National Bank & Trust Co. were very supportive.
Indeed, the assistance of Continental, then the largest of the Chicago banks and one with a world-wide network, was critical. Continental agreed to act as the delivery agent for the new currency contracts. The delivery system for currency futures was designed under the leadership of John McPartland, an officer of the Continental at that time. Without a delivery mechanism, our new contracts were going nowhere.
In retrospect, in its formative period, the IMM made few mistakes -- but one of them was a whopper. The instant success of our T-bill contract in 1976 made it clear to the world that the IMM's idea represented a monumental new sphere of business. As nothing before, this fact served to enflame the fires of competition. Our largest rival, the Chicago Board of Trade (CBOT), made the decision to follow suit with an interest rate product. But which instrument? The IMM incorrectly chose for its second interest rate product the middle range, a 4-year Treasury note contract. The CBOT chose to go with the long end of the market. Its first attempt with a GMNA instrument failed. However they correctly stuck with the long end and settled on the 30-year Treasury bond. Long-term bond futures launched by the CBOT in 1977 worked famously well and became one of the most actively traded futures instruments. This success is primarily to the credit of Dr. Richard Sandor who devised and championed the US Bond contract for the CBOT.
However, there was a silver lining. The IMM’s success with the US T-bill contract launched in 1976 garnered us an insurmountable hold on the short-end of the interest rate yield-curve. This proved to have monumental dynamism, allowing the IMM to capture the grand prize for interest rate trade, the Eurodollar contract. Today, this 90-day interest rate instrument, devised primarily by CME economist Fred Arditti, represents the bellwether for international short-term interest rates. It has become one of the most actively traded instruments anywhere, and maintains the largest open interest for any futures contract.
The launch of Eurodollar futures was predicated on still another IMM innovation, “Cash Settlement.” Allowing futures to settle its contracts at maturity by way of cash rather than by the traditional method of physical delivery was an idea championed by our General Council, Jerry Salzman and myself. It was a seminal achievement. Cash settlement dramatically expanded the boundaries of the IMM revolution. Its approval by the CFTC in 1981 is to the credit of its chairman, Philip McBride Johnson. It paved the way for futures applications to ideas never before thought possible and became the gateway to index futures.
As befits the one who is first, the IMM ultimately captured the lion's share of financial futures business as well as the most diverse complement of financial instruments. Its success catapulted its parent, the CME, from a lowly secondary position in domestic agricultural markets, to a primary place in international finance. (Today, the CME Group is the largest world futures market.)
However, the IMM served the CME on a more permanent level. It infused the exchange with a revolutionary DNA, implanting a permanent legacy of innovation and experimentation. Innovation, while given lip service by many corporate entities, is actually a rare quality. Status quo is so much safer. This legacy lived on to again revolutionize the futures industry with the invention and launch of Globex, the first electronic transaction system for futures markets. Globex, it is fair to say, is a direct offspring of the IMM.
On October 6, 1987, the CME membership overwhelmingly approved a joint undertaking with Reuters Holdings PLC, the world's largest communications organization, to create a global electronic automated transaction system. Initially called P-M-T (Post Market Trade) and subsequently named Globex, it represents the first major attempt to electronically transport the futures pit to every corner of the globe. Utilizing state-of-the-art technology, Globex operates virtually over the entire 24-hour trading day. This bold and revolutionary concept was a comprehensive CME response to the demands of globalization, one eventually copied by every futures exchange in the world.
The IMM legacy has become a permanent component of CME philosophy and an essential reason for its continued success. At the same time, the IMM made financial futures an indispensable tool in risk management, the rationale upon which Professor Miller's based his most coveted nomination. In his view, “we initiated the modern era of finance.” Thus, while the IMM did not spawn flexible exchange rates, it is inexorably intertwined with its occurrence.
1 The original article by Leo Melamed was published in 1988, within The Merits of Flexible Exchange Rates, An Anthology by the George Mason University Press. Its present reprint includes some grammatical corrections as well as some minor edits for clarity.
2 Financial Innovation: The Last Twenty Years and the Next, Merton H. Miller, Graduate School of Business, The University of Chicago, Selected Paper Number 63, May 1986.
3 Anonymous: Latin
4 A number of scholars have catalogued the events which signaled the end of the fixed rate system. Events cited range from the erratic monetary and fiscal policy in the United States produced by the Vietnam War, the efforts of the Bank of England in 1964 and 1967 to prop up an overvalued currency, similar Bundesbank efforts, increasing demand for U.S. gold reserves, the August 15, 1971 termination of the gold window by President Nixon, the Smithsonian Agreement, the oil shocks. See: Alfred E. Eckes, Jr., A Search for Solvency, "Death of Bretton Woods," pp. 237-271, 1975; W.M. Scammell, The International Economy Since 1945, "The Breakup of the Dollar-Exchange System," pp. 179-201, 1983; Robert Solomon, The International Monetary System, 1945-1976: An Insider's View, 1977.
5 There’s No Such Thing as a Free Lunch, International Economic Policy, Milton Friedman (LaSalle, Illinois: Open Court, 1975).
6 Its name stemmed from the place, the Smithsonian Institution in Washington D.C., where, on December 17 and 18, 1971, the Group of Ten ministers met in an attempt to resolve the international financial crisis.
7 A system established by the EEC countries on April 24, 1972, for the narrowing of the margins of fluctuation between EEC currencies to 2.25% in a tunnel (plus or minus 2.25%). Original participating countries included Belgium, France, Germany, Italy, Luxembourg and the Netherlands.
8 1972 International Monetary Market Annual Report, Message from the Chairman, Leo Melamed.
9 1973 International Monetary Market Annual Report, Message from the Chairman, Leo Melamed.
10 Business Week, April 22, 1972.
11 The Need for Futures Markets in Currencies, Milton Friedman, 1971.
12 In 1972, there was no federal law or agency from which we were required to receive approval before listing a new futures contract. The federal statute creating the Commodity Futures Trading Commission (CFTC) was not adopted by Congress until 1974.
One of the great ironies of this event was that, over our vehement objections, the new agency adopted a rule requiring "proof of economic justification," before a new futures contract would be approved. It is doubtful whether in 1972 the IMM could have "proved" the economic need for a futures market in foreign exchange. This is a classic example of government meddling which results in suppression of market innovation. Surely, only the marketplace itself can "prove" economic justification of a financial product.
13 Beryl W. Sprinkel was named Chairman of the Council of Economic Advisors by President Reagan on April 18, 1985. Prior to that, he served as Under Secretary of the Treasury for Monetary Affairs from April 1981 to April 1985.
14 The first IMM Board of Directors included the following: Leo Melamed, Chairman of the Board; John T. Geldermann, First Vice Chairman; Carl E. Anderson, Second Vice Chairman, Robert J. O'Brien, Secretary; Laurence M. Rosenberg, Treasurer; A. Robert Abboud; Lloyd F. Arnold; Richard E. Boerke; William E. Goldstandt; Henry G. Jarecki; Daniel R. Jesser; Marlowe King; Barry J. Lind; Donald L. Minucciani; William C. Muno; Fredrick W. Schantz; Beryl W. Sprinkel; Michael Weinberg, Jr.
15 From remarks by Leo Melamed on the occasion of the Tenth Anniversary Celebration of the IMM, June 4, 1982.
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