at the University of Chicago Law School,
November 27, 1974.
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.
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.
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.
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
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.
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.
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?
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
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
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
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.
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.
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.
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.
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.
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:
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.
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.
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
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.
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)
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.
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.
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.
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.
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.
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.
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
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.
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.
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.
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.
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.
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.
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.
then, the Dutch guilder and French franc have been added, and
the Italian lira has been delisted.
by permission. Excerpted from Melamed on the Markets, by Leo
Melamed. John Wiley & Sons, 1993
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