A FUTURES MARKET IN CURRENCY

Presented to the New York Society of Security Analysts, Inc.,
New York, New York,
April 19, 1972.

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I criss-crossed the United States dozens of times during the months leading to the birth of the IMM and hundreds of times more during the years thereafter in an unending attempt to explain our new concept and the rationale behind it. I was like an evangelist spreading the gospel of a new religion, obsessed with the concept, its promise, and its potential. I accepted every opportunity to be heard.

To say I was cognizant of the revolution and potential this new market represented was a bit of an understatement. In what amounted to nothing short of audacious bravado I stated in the first Annual Report to the IMM members that: "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," I concluded, "that 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."

At the time of this address, we were less than thirty days from what was to become the dawn of the financial futures revolution. Most of the financial world had ignored the coming event. Others scorned our idea, ridiculing the idea that financial instruments could become the realm of futures trade. The chance to appear before the New York Society of Security Analysts was a welcomed opportunity to preach to the heathens.

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On the eve of the birth of the International Monetary Market, it is fitting to address the Society of Security Analysts. My mission is to explain why there should be a futures market in currency, how this market will be different from the existing interbank forward system used by the commercial world, and why we believe the IMM will succeed.

Indeed, why is there a need for a futures market in currencies?  In other words, might this not merely be the invention of a legalized form of gambling, another unnecessary evil?  Certainly that has been suggested by many, on more than one occasion. One might even ask why a futures market in anything

The fact of the matter is that, whether we like it or not, we deal in futures all the time.  The housewife who buys more than she immediately needs because a given product is on sale; the butcher who contracts for delivery of pork at an agreed price months in advance of his anticipated sales: the weaver who agrees to deliver his cloth at a future date, long before the product is ready; the wholesaler who builds inventory in advance of anticipated demand.

Isn't the investor in real estate speculating in futures?  Isn't the farmer doing the same when he plants his crop? Surely a securities analyst is speculating in futures when he gives a buy recommendation on a particular stock on the basis of his projection of future earnings. Doesn't the buyer for a department store take into consideration the same elements that go into a futures market trade? What is the supply, what is the demand, what is the trend? Indeed, there are thousands of everyday examples in business and social life that inherently include the elements of futures trade and futures speculation. Dealing in futures is an ordinary, daily occurrence.

Does this suggest that we are always gambling? I suppose so, in a sense. But only in the sense that we gamble when we cross a busy intersection. Rather, I think what we are doing is applying to our social and business needs those factors that experience has taught us are necessary and prudent in moving successfully through life. We walk on the green light and look both ways before we cross the street. A futures exchange is an extension of this principle. It is a central facility for businessmen who wish to cross the street —more safely. It is a mechanism which provides the procedure and prescribes the rules by which certain spheres of commercial activity can shed some risk and implement their business needs in a more prudent and organized fashion.

When the first question posed is approached from this perspective, the question is not why, but rather why not a futures market in currency?  And why did it take so long to come about?

To begin with, an organized exchange cannot establish a market in a given product unless society has an inherent need to transfer risk. In other words, to be viably traded on a futures exchange, the commodity in question must be subject to consistent and substantial price changes which necessitate forward transactions. This also implies that the commodity to be traded at a futures exchange must be one that already sustains an active, albeit, decentralized transaction market.

Currency meets the foregoing requirements. Even before the decision on December 18, 1971 by the financial ministers of the Group of 10 foreign—to substantially widen the permissible band of exchange-rate differentials between the dollar and other currencies from existing parity to plus or minus 2.25 percent—currency was actively traded in the interbank market on a spot and forward basis. The decision by the Group of 10, necessitated by the dictates of reality, officially recognized that currency price fluctuations were going to continue in a consistent and substantial manner. The new rate of parity—and the strong probability of further band expansion or even currency floating, whether by traditional floating methods, crawling pegs or other forms of parity adjustments—dramatically increased the need for importers, exporters, multinational corporations and financial institutions to learn and utilize the currency interbank market for their international business transactions. One can hardly open the newspaper these days without coming across an item about a loss suffered by a major company as a consequence of currency value changes, or about a corporate comptroller who was relieved of his duties because he neglected to protect his employer from the possibility of currency devaluation or revaluation. Clearly, the basic elements for currency to be listed for trade on a future exchange are abundantly evident.

The real question is should a futures exchange undertake to do so? For the answer, allow me to quote from Professor Milton Friedman's paper, The Need for Futures Markets in Currencies, commissioned by the Chicago Mercantile Exchange 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.

This leads us to the second question: How is the futures market different from the existing interbank market?  If one simply examines a general definition, the interbank market performs the same functions as our intended futures market. Both markets will provide the mechanism for the purchase and sale of currency for delivery on a forward date. Both, then, allow for the transfer of risk. However, the similarity ends with the general definition. The differences begin in application.

The most basic difference is that the interbank market is restricted to the commercial world.  A futures market will not succeed unless it draws participation from both the commercial user as well as the speculator.  And, why not the speculator?  Doesn't the individual—be he speculator or not— have a similar right as does the businessman to protect his estate from possible loss by virtue of currency change? Would it be fair if the individual—speculator or not—were excluded from the stock market, the bond market, or the real estate market?  But, more importantly, could these markets work effectively without the individual speculator? The speculator's role in a futures market is imperative.  It is the speculator who can provide constant bids and offers in the market. It is the speculator who is willing to accept and offset the risk of the commercial user.  It is the speculator who can fuel the necessary liquidity without which the commercial participant cannot effectively use the market. Friedman's requirement for breadth, depth and resiliency are precisely the features that can be best provided by an organized futures exchange.  Or to put it another way, it is our view that a market in currency will become viable only through the interaction of speculative and commercial activity in an open, free and competitive arena. Such an arena is what we provide.

The second paramount distinction between the interbank and futures market is the nature of the transactions. Futures markets are impersonal.  They are not tooled for the specific needs of each separate business transaction, nor is each transaction defined by the buyer's or seller's specific need of that moment. Instead, every transaction is based on the same uniform unit of trade, the same uniform manner of delivery, on the same uniform predetermined forward date.  The element of uniformity is unique to organized futures exchanges and is perhaps the quintessential ingredient of their existence.  This ingredient makes it possible for every participant to offset an existing market position with any other participant regardless with whom the original transaction was undertaken. Consequently, the exchange becomes the clearinghouse of all the transactions which allows the exchange to act as the guarantor to the buyer as well as to the seller. No similar capability exists in the interbank market. It is the underpinning of liquidity in futures.

Another difference is in the way transactions are made. In the interbank market transactions are private, making it necessary to get other quotes to ensure the price you are quoted is fair and competitive. In the futures market, bids and offers are by open outcry in an open and competitive arena.

Less dramatic but also important is a futures exchange's capacity for compiling and disseminating facts, statistics and information concerning a particular market.  There is no other agency, except perhaps the federal government, that can better serve the public and industry concerned.  And there is today an overwhelming need for information on the subject of currency.  This demand is going to continue and increase.  A futures exchange is capable of fulfilling this need in an organized and comprehensive manner.

Futures exchanges can also provide the necessary service and communication mechanisms to make their markets accessible to every segment of commerce, industry and the public in every corner of the globe.  An exchange can and will provide instant access to all participants, enabling them to translate their needs to action in seconds.  Consequently, interest in the currency market will expand substantially. When it does, the need for informed advisors will grow and an educational process within the brokerage industry will ensue. While this process is slow and often intangible, it nevertheless is very real and desperately needed. When it happens, it will greatly benefit the interbank market as well.

Finally, a futures exchange will act as a public weather vane and instant barometer of the market.  It will offer an up-to-the-minute opinion poll of skilled, unskilled, public and commercial experts concerning the value, stability or lack of stability of a given currency.  Good news or bad will openly and immediately be reflected in the price of the product. This is a vital element of a competitive marketplace and integral to the free enterprise system.

The foregoing are but a few of the basic differences between the futures and interbank markets.  There are many more, but none of them are such that they prevent co-existence.  As a matter of fact, we are certain that if the IMM is successful, it will both complement and supplement the existing spot and forward currency market. The interbank market will learn to depend on the futures market and vice versa.

Will we be successful?  The best and honest answer is that only time will tell.  We have the will and the fortitude; we have the facilities, the infrastructure, the personnel, the breadth of membership, the communications mechanisms and (we think) the correct contract specifications. Moreover, while there are many who disagree, in our opinion all indications so far are that we will triumph with this idea. The interest we have generated from commerce and public alike—even before we started trading—has been phenomenal.  Even the banking community—which received the idea coolly at first—is taking a second look and in many cases has lent a hand. Several respected bank officials have even joined our Board of Directors.  In addition, we have received help, advice and encouragement from virtually every segment of the academic and financial world as well as from the federal government. And this is only the beginning. 

We realize we have much yet to learn and that much of our knowledge will come after the market has opened. As we learn, our market may change; in fact, it may be dramatically different from what it will be on opening day.  Nor do we anticipate instant success.  We strongly feel that because the concept is important and correct, our market must be given a minimum test of two or three years before it can be judged. 

Finally, why us and why here? Again Milton Friedman answered the query:

Such a wider market is almost certain to develop in response to the demand.  The major question is where.  The U.S. is a natural place and it is very much in the interest of the U.S. that it should develop here.  Its development here will encourage the growth of other financial activities in this country, providing both additional income from export of services and easing the problem of executing monetary policy.

Us—because the Chicago Mercantile Exchange is a large and established futures institution with the expertise to take on such a mission; us—because the Chicago Mercantile Exchange has created a unique and separate futures entity to exclusively trade in financial instruments. We believe in the future of the International Monetary Market. We are ready to do everything that is necessary and to give it the full measure of our ability toward its success.

Reprinted by permission. Excerpted from Melamed on the Markets, by Leo Melamed. John Wiley & Sons, 1993

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