THE DEVELOPMENT OF FINANCIAL FUTURES IN THE UNITED STATES

By Leo Melamed
Presented at the Chicago Mercantile Exchange Seminar
Financial Futures for European Institutions
London, England
October 1, 1980

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We have come together at this conference to explore what I believe can be justly called the leading edge of a new era in international finance. That edge is, of course, the use by participants in the world economy of the instruments known as financial futures.

Futures are, as we all know, distinctively American, products of the perils and promise of American agriculture. Financial futures, that is, futures contracts based upon currencies, metals and interest-bearing instruments, have evolved from that background. For my part on this program, I wold like to trace for you the development of financial futures, believing that such a recital will be helpful to your fuller understanding of the further presentations at this conference.

I.

Only a decade ago, in 1970, financial futures were unknown in the United States. There were no financial futures contracts on any exchange anywhere. Such instruments simply did not exist.

Last year, in the final year of the decade, financial futures traded on six exchanges represented more than 34 percent of record volume on all exchanges combined, a total of 76 million contracts. From zero volume in 1970 to a volume of 25.9 million contracts in 1979. That record for financial futures represents growth -- impressive growth in any language.

Yet, to get a sense of the strength surging through the financial futures markets, it is necessary to know that this volume has come quickly. It is not growth spread gradually across the decade. On the contrary, 72 percent of the total volume of financial futures transactions has occurred only in the last two years. In other words, three out of every four financial futures trades ever made were made during the past two years without even considering the volume during 1980.

What I am attempting to convey is the fact, the very important fact, that we are, at this very moment, in the midst of a development which, by any standard, must be regarded as truly phenomenal. Within less than a decade, a new kind of financial instrument, an instrument unknown eight to nine years ago, is suddenly surging to the forefront as a prime instrument of financial management. And, let me make the further point that this is, in no sense, an exclusively American phenomenon.

We who represent the International Monetary Market are proud and pleased, as you would expect us to be, that our pioneering venture in financial futures -- the 1972 opening of the International Monetary Market -- is successful on a very large scale. But, as pragmatists, a trait necessary for traders, we are more stirred and more excited by the growth and spread of the futures instrument, by the prospect that new financial futures markets may soon be operating here in London, on the continent, in Singapore, Hong Kong and elsewhere.

The omens tell us, as I am sure they also tell most of you in the audience, that financial futures are, in every sense of the term, the leading edge of international finance for the balance of this century and beyond. We know futures, we believe in them, and we are convinced that, for these times and the times ahead, financial futures present an unparalleled potential for meeting the needs of financial managers in an age of historic uncertainty and risk. Hence, it is especially gratifying for all of us from the states to be able to meet with you and to have this opportunity to introduce you and to welcome you into the world of futures.

II.

In reciting the story of the swift and dramatic growth of the financial futures sector, I recognize that those statistics fall against a certain institutional reserve. Financial institutions and financial managers must be, and are, by their very nature, cautious. Despite the volume, despite the active presence in the financial futures markets of a truly international spectrum of major banks and businesses, I am sure the question persists in some minds: Can new instruments and new markets, not yet ten years old, really be trusted to serve your purposes? Are financial futures markets fully and adequately tested? Is this phenomenon still, somehow, in the experimental stage? Should we let it mature, let the Americans work on it further, "get the bugs out," as we say, before we enter the futures markets?

I am happy to say that questions such as these only serve to expose the strength of our financial futures rather than any weakness. A future is a future is a future. What underlies a futures contract, whether it be an agricultural commodity or a financial instrument or a currency or a precious metal, does not, in any way, alter or affect the function of the future itself or the function of the contract or market on which it is traded. Therein lies the secret of the success of financial futures.

Americans have been at this business of trading futures and conducting futures markets for a very long time. Futures were trading in Chicago sixty years or more before the first automobiles were coming off the assembly lines in Detroit. There were futures before there were railroads or skyscrapers, even before there was baseball.

Very few financial institutions anywhere, in Europe as well as the United States, approach or exceed the longevity and continuous operation of our Midwest exchanges. The Chicago Board of Trade began operations in the 1840s. The Chicago Mercantile is a relatively young upstart, having come into existence in 1898. The average age of the exchanges in Chicago and Kansas City is 100 years.

This emphasizes a very important point. While the futures community in the United States is small, it harbors more financial expertise and more cumulative financial experience than any other segment of finance in the nation. In plain spoken terms, futures have been tested by almost 140 years of active use. There is nothing experimental about futures of any kind. The futures markets are mature. The "bugs" have been out of the futures markets for a very long time.

The only new thing about financial futures, then, is the name. What we have done, what we are doing, is simply to take our oldest, most tested, most trusted, most reliable mechanism and offer it for use in and by a new and far broader segment of the total economic community, both in the United States and abroad. If there are reasons why you should not use the futures markets, and it is hard for me to conceive of what they may be, the supposed "newness" of the instruments and the markets is not among them.

III.

I am committed, of course, to trace for you the development of financial futures. Within the framework of what I have been saying, I believe it is best to begin at the beginning...not at the beginning of financial futures, but at the beginning of futures themselves.

As I have said, futures originated in Chicago. This occurred primarily as a function of the transportation system within the interior of the United States. Because of its location at the confluence of East and West in the United States, Chicago was (as it remains today) a hub of the transportation network bringing produce from the rich agricultural belt of the Midwest to the markets of the processors providing food for the populous eastern seaboard.

Where producers and processors met, there was, on both sides, a strong common interest to protect against risks on future deliveries. The inherent conflict between those interests had been present in every agricultural marketplace since civilization began with producers trying to sell "high," processors trying to buy "low," and both sides being subject to the unexpected and unforeseeable risks of weather, crop failure, economic panic and countless other perils. The climate under which those transactions were concluded bore many striking resemblances to the climate under which we all are operating today on both sides of the Atlantic.

History does not accurately record who it was or when it was that someone came forward with the idea of converting the dilemma of producer and processor into an opportunity for gain and profit. At some point, though, a third presence was introduced. The trader, or, as he is more commonly called, the speculator entered the bargaining. On the basis of his judgment regarding the supply or demand situation at a certain time in the future, the trader offered to take the position of the buyer or the seller at a price, committing himself in the process to perform on the contract. In doing so, the trader assumed the risk inherent in whichever position he might have taken, buy or sell.

The assumption of risk was not undertaken, needless to say, out of a spirit of benevolence or charity. The trader, or speculator, expected market influences to have moved so as to enhance the profitability of his position by the maturity of the contract. This was then and is still the essence of futures trading. But there is another key element.

The presence in the market of traders willing to take "buy" and "sell" positions opened new opportunities for both producers and processors, or "commercials" as we call them. Knowing their own future needs in the
markets, these participants were able to enter the market to establish positions which served to hedge their future commitments. While it was not possible to eliminate risk altogether, informed hedging strategies functioned to minimize or cushion risk.

In consequence, the commercial participants in the markets, as distinct from the traders or speculators, were able to stabilize their balance sheets. This was achieved by the ability to "level" or "flatten" price fluctuations, to plan ahead financially with more certainty and confidence and to free their capital resources for the most productive use.

This has been, and is, the basic structure of our futures markets. The futures mechanism came into being expressly and specifically to permit better and more effective management of marketplace risks. In this respect, it is fair to say that futures are designed for these times.

IV.

Now, let's look at the exchanges where futures markets are made.

Over the period which I have been describing, futures transactions were most often accomplished along side railroad yards or other open-air centers of transportation. In time, though, traders being traders, it became the preference to conduct these transactions under roofs and within walls. These sites became known, as they still known, as "exchanges."

It is important to a correct understanding of futures markets to know that today's exchanges are what they were in the beginning. They are, simply, facilities providing a common site for the conduct of trading. Exchanges take no positions in futures contracts and hold no positions in commodities or financial instruments. Exchanges are not-for-profit institutions. The expenses of the supporting staff and space, as well as sophisticated computer and communications equipment, are paid by clearing fees charged against futures transactions. Fees are solely and strictly a function of volume and have no relationship to the value of traded contracts. Thus, the single interest of the exchange is to generate and maintain trading volume by offering futures contracts of the widest appeal.

This interest, or perhaps, self-interest, of the exchanges had its effect upon the creation by the Chicago Mercantile Exchange of the International Monetary Market. The Mercantile Exchange began as a butter and egg exchange and continued successfully on that basis through World War II. Over the 1950s, however, technological factors, such as refrigeration and air conditioning, functioned to diminish the buyer interest in those commodities. In consequence, at the start of the 1960s, the Mercantile Exchange began what was to become a program or strategy of innovation unique among American exchanges.

In the early 1960s, we introduced, first, a contract in pork bellies which has become one of the most-actively traded of all futures contracts. Next, we introduced the first futures contract ever based on a non-storable commodity, that is, live cattle. This has become--and is now--the largest contract on the exchange.

But, let me move on to the development of the financial futures.

I believe it is necessary to emphasize to you that, as a function of the unique circumstances of the United States on the North American continent, there has long been a certain remoteness from the financial realities of Europe and the U.K. As one example, consider currencies.

In the United States, unlike any or all of the countries represented here, there is no long history of currency trading. Facilities did not exist for Americans to trade currencies, or to even convert currencies, in the manner to which you have been accustomed for centuries. With the value of the dollar fixed and supported by the government, there was, in fact, little need and no incentive for Americans to concern themselves with currencies.

In 1971, however, the pressures upon the dollar became basically unsustainable and the President of the United States, by executive order, acted to float the dollar, allowing its value to fluctuate in relation to other
currencies. That was, and remains, an event of great consequence in the
United States. At the Chicago Mercantile Exchange, the floating of the dollar gave encouragement to a rather daring venture: the start, in 1972, of the International Monetary Market, offering futures contracts in eight major currencies.

In a nation wholly without experience in currencies, the start-up of currency trading was excruciatingly slow. As recently as 1975, the total volume of currency futures trading amounted to less than 200,000 contracts. Today, currencies are providing some 45 percent of the volume on the International Monetary Market, and in August of this year, the onemonth volume in currency futures ran 38 percent ahead of the full-year volume in 1975.

In addition to the national inexperience in the realm of currencies, the United States entered the 1970's under the 40-year-old moratorium against ownership of gold by private citizens. After debating this prohibition, Congress decided to permit gold ownership once again, beginning on the last day of 1974.

Anticipating the likelihood that strong public interest would develop in gold ownership, most of the exchanges developed and on December 31, 1974, offered, futures contracts in gold. Slightly more than 6,000 contracts were traded in that one-day trading year. Over the next two years, trading hovered in the range of 800,000-900,000 contracts. As the decade came to an end, the uncertain conditions in the world sent gold prices and gold futures trading soaring. In 1979, more than 10 million gold futures contracts were traded, a volume exceeding all the trades in the previous years of the contract's existence.

By this time, the evidence was clear -- financial instrument futures were vehicles with high potential for futures exchanges. Thus, the Chicago Board of Trade prepared for its entrance into this field. By 1976, both the CBT and the IMM had again broken new ground by entering into the field of interest rate futures. First came the CBT with its GNMA futures contract, and shortly thereafter, the IMM with its 13-week Treasury bill futures contract. The interest rate futures have subsequently been expanded to offer both one-year Treasury bills and four-year Treasury notes. Again, the start was slow, yet, again, the decade ended with these contracts surging. The three-month Treasury bill which traded only 110,000 contracts the first year, closed the decade in 1979 with a volume of 1.9 million contracts, the third most active contract on the Chicago Mercantile Exchange.

V.

Now, for the primary questions: Why have we done what we have done, and why has it worked?

In answer to the first question, let me say this. At the start of our venture into financial futures, we recognized, as did other of our sister exchanges, that the changing economic realities of the 1970s were creating (or likely to create) conditions of uncertainty and risk for the business and banking communities very similar to those on the agricultural sector. Instabilities were evident in many directions -- and remember, if you will, this was before the advent of oil pricing by OPEC. While it was technically possible for managers outside of agriculture to utilize agricultural futures for money management purposes, we knew that simply would not happen.

Corporate treasurers, pension fund managers, finance companies, state and municipal comptrollers, finance officers of multinational corporations, the whole array of financial decision-makers in the business sector, simply were not likely to begin putting their funds into futures based on live cattle, pork bellies or frozen turkeys, commodities about which they were both richly inexperienced and wholly disinterested. The limitation on use of the futures markets was, we felt, a self-limitation imposed by the markets themselves. Under the influence of our agricultural origins, we simply were not offering futures denominated in instruments understood by corporate America.

If we were to open, or perhaps to unlock, the vast resources of the corporate world, we had to offer futures based on instruments comprehensible to and trusted by corporate financial decision-makers. This meant, as I have suggested earlier, that we should take the instrument of the futures contract and underlie it with the various financial instruments such as Treasury bills, currencies and metals.

The results have been, to an extent, beyond our expectations. We did not initially foresee that the interest and response to these financial futures would be worldwide rather than strictly national. Neither did we, nor could we, anticipate fully the escalating uncertainties, economic and political, which have dominated financial planning and action during the last few years of the 1970s and these months of the 1980s. As the farmers of the midwest like to say, though, even a blind hog finds an acorn now and then.

Whether by accident or design, and it makes no material difference which it may have been, the fact is that the futures exchanges of the United States were fortuitously in position to offer a wide portfolio of financial futures precisely at the time when those futures were most needed, and most welcomed, by a new clientele in the financial community.

VI.

But, let me return to the second part of the question which I posed a few minutes ago. Why has what we have done worked? That is, why has the offering of financial futures succeeded on such an impressive scale?

The question is subject to many different answers. In my own view, though, a part (a very large part) of the answer lies on or with the perspective which I emphasized at the beginning of my remarks -- the age and experience of the futures markets.

As a function of that long history, the futures exchanges in the United States have accumulated an impressive record of self- governance aimed at assuring the absolute integrity of the operations of the markets.

In speaking of this, let me emphasize that I do not intend to deal in pieties or moralizing toward other financial institutions. Rather, I only speak in the most pragmatic terms. Since the futures exchanges are, as I mentioned, simply facilities -- places provided for convenient and easy trading -- the individual members of such exchanges have the highest order of self-interest in guarding and protecting the integrity of those markets. Should a single member default or cause a loss to customers, the entire membership would suffer severely.

As a consequence of these realities, the futures exchanges of the United States have established for themselves, wholly and without government intervention, remarkable provisions for self-governance and self-policing, as well as equally remarkable provisions for customer protection. As a
consequence, over the long history of these exchanges, not one dollar of any public customer's funds has ever been lost as a result of the insolvency of any clearing member. At the Chicago Mercantile Exchange, resources totalling in excess of $2.5 billion exist to assure against customer loss.

It is not possible, of course, for exchanges to prevent loss resulting from customer poor judgment of the market. Nonetheless, all the futures exchanges, drawing upon long experience, have in place certain provisions and regulations aimed at limiting, if not absolutely preventing, losses.

The exchanges establish daily limits on the movement of contract prices. This functions to brake extreme fluctuations of price which may be ruinous to customers. Similarly, when customers enter the futures markets, they may establish a variety of standing orders which serve to limit their adverse exposure. Limit orders or stop orders or any number of other variations, all function to fix automatic parameters on the market position. The exchanges further reinforce this protection by keeping precise account of the time at which price changes occur. Orders from customers are time-stamped at each step of receipt and execution. If, after an order is received, the market moves through the price set by the customer, and the order is not executed, the customer is subject to indemnification.

Once a customer acquires a futures contract, the clearinghouse of the exchange becomes the opposite party -- the seller for every buyer, the buyer for every seller. This eliminates the concern typically present in other types of markets about the ability of the opposite party to perform.

Perhaps, most important of all, for those not acquainted with or experienced in futures markets, the risk of a futures market customer is limited to a single day's market fluctuation. All accounts are kept current on a daily cash basis. If price movements yield a profit, that profit is payable daily; if price movements are adverse, the loss must be deducted immediately, or at least prior to the start of the next trading day.

These provisions are complex and thorough. As I suggested earlier, they reflect the age and experience of the futures markets. Compelled as they are by the self-interest of protecting their reputations for total integrity, the markets are aggressively jealous of their repute among customers. The net result is a rare level of assurance to customers.

With all due respect to our friends in the banking community, I know of no other sector of the financial community which takes such extensive interest or such an active role in protecting customers from loss as in the futures markets.

The point of this, in the context of my presentation, is that the phenomenal success of the financial futures contracts lies, at least in part, with the fact that these old, mature and fully-developed markets in the United States are markets which can be, on the record, fully trusted.

This is a matter of highest importance to those of you attending this conference. The bright promise of financial futures necessarily entails your dealing with markets not only distant from you but also markets totally unfamiliar to you. Certainly, as prudent and cautious managers, you have questions about the trust-worthiness of those markets. By what I am saying here, I hope I may bring you a measure of reassurance that the futures markets are something to be relied upon.

VII.

As I previously mentioned, financial futures represent the leading edge of a new era of international finance. The instruments themselves were created expressly to serve the kind of economic climate we all presently are facing. The application of financial futures to the challenges now facing financial managers afford opportunity for achieving stability and certainty in an era of risk and uncertainty.

Thus, I trust that in these sessions, and perhaps in other sessions outside these settings, you will pursue your desire to understand financial futures and that together we all realize benefit and gain from this meeting.

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