THE SLEAZY SPECULATOR

Presented at the University of Chicago Law School,
Chicago, Illinois,
November 27, 1974.

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In spreading the word about the new currency futures market at the IMM, I was conscious that some of the concepts we espoused were either foreign to Americans or contrary to orthodox teachings. While I attempted to explain all the principles of the revolutionary market we were nurturing and the rationale for its creation, I often found it more productive to concentrate on one or two of the most critical issues.

Of particular note was the recognition that it was imperative to focus on two of the fundamental components of our marketplace: First, few understood or even heard of the Bretton Woods Agreement—the IMF's official system of fixed exchange rates. What was it, who created it, why was it being replaced, and what relationship did it have to the IMM? Second, the role of the speculator in markets was totally misunderstood and viewed with suspicion by the vast majority of the American public.

The very foundation of the IMM was based on the logic that Bretton Woods was not returning, that present global realities demanded a floating system of exchange rates, and that the new financial order would foster a futures market in foreign exchange in which speculators were necessary participants.

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For a number of years during the past decade, the Bank of England fought to maintain the value of the British pound at levels not commensurate with reality. They did this with continuous and tortured intervention in the marketplace. Finally, in November of 1967, the Bank again surrendered to the inevitable by devaluating pound sterling from $2.80 to $2.60. From that point forward, it became fashionable in official British government press releases to blame the devaluation on the pressures caused by speculators. Other governments joined the charade. We were given to understand that speculators were persona non grata, enemies of the state, and that if their activities were not curtailed, they would surely bring down the currency system of the civilized world.

Consequently, the lowly image of the speculator, became even lowlier. Speculation, never an occupation to be proud of, took on obscene proportions. And of all the speculators, the very worst of the breed were those who dabbled in currency—those sleazy-looking characters who lurked about the financial centers of London, Zurich and Frankfurt selling a pound here and a dollar there, buying a yen or a Deutsche mark, going short francs when it pleased them—for no other purpose than personal greed. We envisioned these despicable characters gleefully laughing up their proverbial sleeves whenever they earned a profit at the expense of the Central Banks, and jumping for joy whenever they caused a devaluation or revaluation. Speculators, those unpatriotic, irresponsible, no-good louts, became the rallying symbol of the Central Bankers, the patriotic, responsible good guys who fought bravely for law, order, and fixed values for their currencies.

When on Saturday, January 19, 1974, the government of France floated the French franc, the sad news was out.  The good guys had lost.  France, the last embittered proponent of fixed exchange rates, had given up the battle. But by then, many of us had taken a closer look at this drama. By then we had ample opportunity to read the economic analyses of such critics as Milton Friedman, Otmar Emminger, Fritz Machlup, Robert Aliber and George Shultz.  They were among the very first who were brave enough to advise us that all was not quite as we were given to understand; later their ranks swelled. 

We first learned that the bad guys—the speculators—were often corporate treasurers of respected multinational firms, or bankers, or finance ministers of nations, or highly regarded financiers.  By establishment rules, how could these guys be so bad? We also learned—quite to our amazement—that their motivations were not always personal gain. Quite often, these market participants were acting to prevent or minimize a loss on behalf of the enterprise they represented—be it a bank, corporation or nation. Indeed, their actions were based on what they perceived to be prudent business judgment. To our surprise, we learned that they considered the well-being of the interests they represented every bit as important as is world monetary order to Central Bankers. A shocking discovery, indeed! But the most startling revelation came when a growing number highly respected economists openly dared to suggest that speculators were acting rationally and that it was the Central Banks that were unwilling to face reality; that those who represented themselves as the good guys were reading from a script which was no longer valid. How was such a turnabout possible? 

Under the foreign exchange system designed in 1946 known as the Bretton Woods Agreement, the countries within the International Monetary Fund (IMF) agreed that their currencies would have fixed parities in terms of both gold and dollars.  The dollar, in turn, was not to have a fixed parity. It was to be freely convertible into gold for official holders of dollars at the fixed price of $35 an ounce.  The maximum range of permitted deviation from ascribed parities was 2% (1% on each side of the parities).  In practice, the range of fluctuations in relation to the dollar was actually 1.5%.

The Bretton Woods system worked quite well for a time; in fact, longer than expected.  It would still be a good system today had nothing changed after 1946, or if all the changes had occurred equally to all nations.  Alas, that was not the case. Ultimately, the rate of exchange of one nation's currency for another nation's currency is determined by the forces of supply and demand for the given currency.  The factors that influence supply and demand are based on the economic and political—but primarily the economic—conditions of the given nation. Would it be surprising to learn that the economic conditions of the IMF nations changed since 1946—that they were drastic changes—and that these changes were not equally proportioned among the nations?  We all know what has happened since the end of World War II with respect to the relative economic conditions of the United States, Great Britain, West Germany, Japan, etc. In fact, the world has changed in its entirety. It has grown small while various nations within its structure have grown big. We also know that world economic and political conditions are in constant and sometimes dramatic flux. The Bretton Woods script—which was inflexible and insensitive to major change—was not written for the new and changing world conditions. Today, technological advancements have made it possible to immediately know of every economic or political change occurring within every nation, such that the reaction time to such announcements is dramatically reduced.  The effects of all such internal changes can now be felt in terms of weeks and months rather than years. At the same time, the growth of private industrial complexes are of such a magnitude that they now play as large—or larger—a role than the Central Banks in determining currency supply and demand.

These realities were officially ignored by the nations within the IMF for a very long time. Finally it became so unmanageable that the Central Bankers had to come to grips with the truth. It became impossible for a government to maintain its currency for very long at the official rate when economic and political logic dictated a higher or lower value.  It was an exercise in futility for a single or a combination of Central Banks to support a given currency at the established rate when all the world's so-called speculators responded to reality by selling or buying against the fictitious rate.  The unceasing pressure toward the real value of a currency virtually bankrupted IMF member nations in their attempts to abide by an outdated agreement. It was particularly difficult for the United States to maintain the agreement since the American dollar was the parity mechanism for all other IMF currencies.

Finally, the United States—which had suffered dearly as a consequence of maintaining unrealistic dollar values—forced everyone's hand. On August 15, 1971, President Nixon closed the gold window and aborted the Bretton Woods system.  The era of fixed rates had ended and the financial world would never be the same. The shock waves of that decision are still being felt today and will continue to be felt for years to come.

The Chicago Mercantile Exchange watched the events leading to this momentous event with more interest than that of an idle bystander.  We envisioned what was coming, we saw the opportunity, and we saw a necessity in the making. With the demise of Bretton Woods, we believed a new era was dawning, not only with respect to flexible exchange rates, but in the very essence of American psychology. For we recognized that the United States was no longer alone in the financial world and that this would offer futures exchanges an important opportunity.

We recognized that Americans would soon understand that the United States economy is very much dependent on the economies of other nations; that our economic strength is affected by such factors as balance of trade, interest rates, and rate of inflation; that our nation alone could not determine the value of its currency; that the value of the dollar was not absolute, but relative to the value of other currencies. Indeed, we foresaw a rude awakening for many Americans and that this would have special relevance to our exchange. We believed that when the phrase balance of trade became a topic of concern for all informed Americans rather than an a subject limited to economists, it would result in dramatic changes in the financial fabric of this nation. In other words, it seemed reasonable to assume that many people would soon seek investment and speculative opportunities in arenas involved with international finance. We saw this as a trend that would grow for decades, and one that would demand investment instruments of an international monetary nature. 

Thus, the philosophy of the International Monetary Market (IMM) was born: To organize a futures exchange for the express purpose of dealing in financial instruments. Our first financial instruments were to be foreign currencies. Later we planned to add other instruments of finance. 

Even under the fixed regime of Bretton Woods, exchange rates fluctuated. In other words, there would be no changes in a given currency value until pent-up forces compelled the world system to catch up with reality. Suddenly one morning you were advised that the British pound was devalued by 8%, or that the Japanese yen was revalued by 12%.  That is the way of a fixed market: an abrupt and violent eruption in price, a sudden inordinate change in value, followed by the fictitious and temporary peace of a fixed new parity. Fixed order then chaos; chaos then fixed order. Such a world offered no chance for a futures market. Futures markets can exist only when prices are allowed to respond freely to the continual changes brought about by the forces of supply and demand.

The Chicago Mercantile Exchange had to wait until such a day was upon us to introduce currency futures at the IMM. But while we waited, we did some homework. Approximately one year before the Smithsonian Agreement, and with the fervent belief that the era of fixed exchange rates was doomed, we asked Professor Milton Friedman two critical questions: Will the new financial order include exchange rate flexibility? If so, will there be a need for a futures market in currency? His unqualified affirmative response to both queries gave us the courage to proceed. In his position paper on this subject which he wrote at our behest in September 1971, Professor Friedman asserted:

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.

He was not alone in his opinion.  Many other notable economists concurred and encouraged us.  But Professor Friedman's opinion meant more to us than all the others combined. Without his credentials on our side, our idea would not have had the credibility we thought necessary.

The Smithsonian Agreement on December 20, 1971, brought official flexibility to the world currency system and was the first step in the desired direction.  The agreement provided that currency rates would be allowed to fluctuate 2.25% higher or lower than a predetermined parity.  It was obvious to us that this new system was also too rigid to last. Nevertheless, it officially provided a 4.5% range for currency fluctuations, sufficient flexibility to justify the need for a futures market in foreign currency.

Two days after the Smithsonian announcement, the Chicago Mercantile Exchange announced the birth of the International Monetary Market. We were about to become singular pioneers in the frontier of flexible exchange rates. On May 16, 1972, the IMM listed its futures contracts in British pounds, Canadian dollar, Deutsche marks, Italian lira, Japanese yen, Mexican pesos and Swiss francs.(1) 

As everyone knows there is no such thing as a little bit pregnant. The world quickly realized that if flexible exchange rates were better than fixed, floating exchange rates would be even better.  Thus, at a much quicker pace than even Friedman predicted, one nation after another was forced to admit that the world of today demanded a system where exchange rates were determined to the largest extent by free market forces rather than by government edict or government manipulation.  In other words, the official world recognized what Milton Friedman had preached, that currency rates between nations must be allowed to freely adjust on a day-to-day basis.  In other words, they must float. 

Today, all the major currencies float against the dollar.  The common market nations, however, have set a range for parity between their own respective currencies known as the tunnel; their currencies fluctuate against each other like a snake in the tunnel; and the tunnel itself floats against the dollar.  The snake in the tunnel concept has experienced some problems and, from time-to-time, there have been adjustments to the agreed parities. One cannot assume with certainty that this system will continue to exist.  However, irrespective of the tunnel or the snake, the IMM was clearly on the right track, and the world followed.

Was the IMM the first or only futures market for foreign currencies?  Of course not.  To begin with, there has always been a forward market in currency conducted by the world's major banks. The interbank market is a highly active and viable market that conducts billions of dollars of transactions on a daily basis.  But, just as its name implies, the market operates on a bank-to-bank basis.  In this sense, it is limited exclusively to banks that act for themselves and their clients.  In order to fully understand the IMM, we must examine the characteristics that distinguish it from its interbank counterpart.

The first and most-telling difference is that the IMM is an open market—one that is open both to hedgers as well as speculators—while the interbank market is not.  Those who do not have a commercial reason to trade foreign exchange are excluded from this avenue of investment in the interbank market. To us, speculators are as welcome as hedgers. Our philosophy is never to differentiate between a commercial or private motivation for making a trade. Both reasons, we believe, are driven by the same or similar motivation. In a free society, everyone ought to have this right.

Indeed, this very feature spells the quintessential difference between a competitive market and one that is monopolistic.  We believe that no forward market can achieve Friedman's desired "broad, deep, and resilient" level of efficiency without the participation of speculators. A market that is limited to commercial transactions must, by definition, remain narrow.  Commercially motivated transactions usually tend to move in the same direction at the same time.  Thus, in times of stress when commercial elements want to sell, there are few buyers, and vice versa. 

The impact is lessened when speculators are involved.  For example, when speculators establish short positions, they can be buyers at a time when commercial interests wish to sell, and vice versa. It works that way in all open futures markets.  Speculators provide a market with liquidity.  Liquidity gives a market breadth, depth and resiliency which, in turn, lowers the cost of hedging.

There are also some important technical differences. The IMM is conducted on the floor of an exchange. Its participant brokers include approximately 80 brokerage firms; its members include the five major Chicago banks and many commercial concerns.  Orders for trading in currencies are placed through these firms, allowing easy accessibility to the market no matter where the orders originated.  It also means continuous availability of market quotations and currency rates. The rates are determined as at an auction—bids and offers are made by open outcry in an open and competitive fashion.  The exchange itself does not engage in trading.  We believe that an open and competitive auction mechanism will, in the long run, produce the lowest market rates.  That has been the historic result of every successful commodity traded on any futures exchange.

Our currency contract sizes and specifications are uniform and impersonal.  Contracts are bought or sold only in units of prescribed sizes and delivery can be taken only on specified dates. Because futures contracts are standardized, a position can be offset by making the opposite trade. No position is locked in until maturity as in the interbank market. We are developing a market for 18 months forward.  The current bank market operates mostly for 30, 60 or 90 days forward.  The majority of its business is in spot transactions.  The IMM does not conduct a spot market in currency. The user of our market does not need a compensating bank balance, but he does require margin.  Margin is small, ranging between 1.5% and 5.0% of the value of the contract.  He also will pay a $45 round-turn commission.

These are the major visible differences between the IMM and the interbank market. But it is important to note that the IMM was not created to act as a competitor to the banks. Its primary function is to act as an additional tool in the world of international trade.

In the past, businessmen have had several alternative means for protecting themselves against the vagaries of exchange rate changes: Hold assets in strong currencies; hold liabilities in weak currencies; employ leads and lags in payments and receipts; buy spot currency and hold until needed or borrow spot currency for future payment; or hedge in the forward bank market. Since May of 1972 when the IMM opened for trading, they have one more alternative.  They can call their local broker and hedge with a futures contract traded on an organized exchange.

Is there a need for such an additional tool? Emphatically so. There are two additional reasons for the birth of the IMM that cannot yet be measured and may be more important than all of the others.

First, the new world order—which subjects individuals or corporations that conduct business overseas not only to normal business risks but also to a change in currency rates—demands a broad foreign exchange market. This need will grow in geometric proportion. It requires a market of wider scope and much easier access than the present interbank market.

There is an equal critical need for information and education in the use of foreign exchange. American enterprise must learn how to utilize foreign currency hedging as a marketing tool. An organized exchange can fill this need better than any other institution except the Federal government. In the two and one-half years of our existence, we have produced and published more statistics and practical information on the use of foreign exchange than was published in the previous decade.  And through the far-reaching facilities of our brokerage firms, we can disseminate this information and material in a manner that would be hard to equal. We have organized study courses, we have offered a multitude of lectures, we have held symposia and conferences, we have instituted courses at the college and university level, we have published tape cassettes, we have produced a 30-minute movie, and this does not begin to enumerate the continuous flow of printed material we have made available. And that is only the beginning.

We believe the IMM to be in synch with the new world monetary order.  Whether we have floating rates, snakes in tunnels, worms in tubes, crawling pegs or whatever, there will be more flexibility in exchange rates.  The fixed rate system of the past will be impossible to reinstate. And therein lies the economic justification for the International Monetary Market. The IMM was organized to provide hedge services to commercial interests who need protection changes in exchange rates and to provide opportunities for speculators to participate in the price discovery process. In short, it is an invention created by the necessity of our times.

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     (1) Since then, the Dutch guilder and French franc have been added, and the Italian lira has been delisted.

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

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