to the Money Marketers, New York University,
New York, New York,
November 16, 1982.
first advertising campaign of the International Monetary Market
made necessity the underlying reason for the creation of currency
futures. Although the ad quoted Victor Hugo incorrectly, attributing
to him the statement that "necessity was the mother of invention," its
substance was right on the mark.
if the IMM was to succeed, if currency futures were to become
viable, if financial instruments were to become the well-spring
of new financial contracts, then clearly necessity would be
its singular common denominator. Of course, in 1972, necessity
had a personal side to it, as well. Some trader friends and
I were bearish on the British pound but powerless to do anything
about it. According to the Wall Street Journal—so was
Milton Friedman. He too needed a such a market in order to
express his financial opinion.
back ten years later, we could confidently state that history
proved us right. There was an inherent necessity for the creation
of a market designed to manage financial risk.
I will speak of change, of need, but mostly of "necessity, the
mother of invention". Victor Hugo succinctly expressed it in
1852 in his History of Crime: "A stand can be made
against invasion by an army; no stand can be made against invasion
by an idea." Hugo did not invent the thought, rather he inherited
it from a long line of literary stars beginning with the original
version Mater Artium Necessitas an undated anonymous
Latin saying of ancient Rome. The Latin poet, Pesius Flaccus,
was the first known author to use it in literature, circa 50
A.D. He put it, "the stomach is the teacher of the arts and
the dispenser of invention." The saying took one form or another
throughout the ensuing history of great literary thought until
some 1500 years later when Leonardo Da Vinci wrote, "Necessity
is the mistress and guardian of nature." William Shakespeare
in his Julius Caesar wrote, "Nature must obey necessity," and
the English dramatist, William Wycherly, in 1671, said it in
the form we know it today.
it is said, it is no less true. Necessity will produce the indicated
invention. Necessity will take many shapes and forms as will
the inventions it produces. Broadly speaking, there are two
causes for those irresistible ideas whose time has come: nature—the
demands as a consequence of natural needs; and social change—the
demands as a consequence of evolving changes in life style.
is a great example of an invention inspired by natural cause,
as are clothing and shelter and the outhouse. The needle is
known to have been used 20,000 years ago, and the button was
invented in ancient Greece. The modern need for rapid dress
and undress inspired the invention of the zipper in 1893. Of
course, some would argue that the zipper is a better example
of an invention inspired by social change rather than nature's
change—resulting in different customs, usages and life styles
of the human race—will inspire two types of invention. Those
in the scientific or technological realm and those in what would
euphemistically be labelled "the arts." Cumulatively speaking,
each new invention produces yet another social change and requires
still another responsive innovation. The wheel ranks with fire
as a most significant necessary invention and is a good example
of a science-related advancement inspired by social change.
Similarly, the telephone, the combustion engine and the railroad
are excellent examples of scientific responses to social changes
of civilization, as is the computer chip and the birth control
most dramatic social-inspired invention in the arts is not the
paint brush as Picasso might have argued, but rather the invention
of money. In its own way, money ranks with fire and the wheel
as one of the outstanding inventions in the entire history of
mankind, facilitating advancement in every aspect of civilization.
Banks, themselves, are a similar example as are investment and
bond houses, financial institutions of every kind, the Federal
Reserve System and social security. Society and its changed
demands caused each to be created.
is important, therefore, at this juncture in this rather over-simplified
discussion on inventions, to mention that "Those who do not see
the necessity, will not be the ones to invent the irresistible
idea." This corollary is true for both the sciences as well
as the arts. Perhaps the best example of a failure to understand
this truism are the U.S. railroads. Because they did not see
the changed necessity, they did not know to diversify into trucking
or airplanes. They paid dearly for this sin. How one avoids
this fate is a critical question, or should be, for every participant
of the financial and industrial world.
1904, Mary Parker Follet suggested one answer. She invented
what she called "the law of the situation." Her law required
every business to occasionally ask itself this question, "what
business am I really in?" Mary Parker Follet, the first known
management consultant in the United States, convinced a small
client of hers, a window shade manufacturer, that he was not
in the business of window covering treatment, but rather in the
light control business.
timely and realistic application of the Follet situation-law
may go a long way in correctly interpreting social change as
it relates to how well or what you are doing. Had the railroads
applied this law, the answer to the question might have been, "we
are in transportation, not merely in railroading." This answer,
I submit, suggests the expansion of services into other, and
more current, forms of transportation.
dramatic example of a timely application of the law of situation
will suffice. When in 1981, Sears Roebuck & Co., our nation's
largest retailer, saw that it was unable to grow in retailing,
it asked itself the question, "in what business am I?" The
answer must have been startling to some. It was, "I am a consumer
service organization." In that case, Sears was no longer limited
to retailing, and the results so far have been dramatic. Those
of us who cried foul, that Sears ought not be in trading, banking,
real estate or money market funds, missed the point. "Inventive
necessity" has only one rule: survival.
economic upheavals in the late 1960s and early 1970s that forever
changed the course of financial history were the requisite social
changes that brought about the invention of financial futures
in Chicago. The pressures dictating suspension of dollar convertibility,
the Smithsonian Agreement and the prompt abandonment of the Smithsonian
Agreement, were events that had been building for years. The
social changes these events produced required everyone in the
financial world to re-evaluate their position in the scheme of
things and to determine whether they ought to invent a change
to accommodate the new demands in order to survive.
the pork belly crapshooters of Chicago—as we were so fondly called—
applied the law of situation in timely fashion. To the question,
what business are you really in, we answered, "the business of
risk insurance." And to the question, what risks will we insure,
we answered "anything worth insuring." Thus we launched currency
futures on May 16, 1972, at the newly-created International Monetary
Market (IMM) division of the Chicago Mercantile Exchange.
events which thereafter unfolded created the most challenging
environment in the history of finance for every business entity
and its managers. Soaring inflation, soaring energy costs, changing
values between currencies, volatile interest rate movements and
extreme price swings of commodities all combined to create a
chaotic business climate fraught with danger and abundant with
opportunity. To a futures exchange that had asked the right question
of itself and was timely in its response, these conditions were
a heavenly blessing. We were like kids in a candy store. The
only question we needed to answer now was which candy to consume
first. The race was on.
what the IMM did was not merely to open a market in currency
futures, but rather to usher in the era of financial futures.
The phenomenal success of financial futures in the 1970s exemplified
the power and irresistibility of an idea whose time had come.
National futures market transaction volume increased from 14.5
million contracts in 1971 to 98.5 million a decade later, an
increase of 700 percent.
Chicago Mercantile Exchange was duly rewarded for having asked
the right question. During this decade, we experienced a phenomenal
growth rate; from a 1971 volume of 3.2 million contracts, we
ended 1981 with a record of 24.5 million transactions, an increase
of 800 percent. Significantly, IMM financial contracts represented
60 percent of that total. Third quarter volume figures at the
CME for 1982 already exceed its 1981 total. Those exchanges
that did not soon enough see the change or respond to the need
were left behind.
escalating uncertainties of present-day risk management demand
knowledge and prudent application of financial futures. These
markets today represent a business tool, an insurance vehicle,
and a profit center that can no longer be ignored by even the
most conservative financial institution. Not only has the world
of finance recognized this inescapable fact, so has the government
authority. Before our very eyes, walls of regulative prohibition
are crumbling in response to the demands of the new economic
era upon us. The Federal Reserve Board, the Federal Deposit Insurance
Corporation, the Comptroller of the Currency, and the Federal
Home Loan Bank Board have all adopted new policies which, in
effect, make certain futures market applications incidental to
banking and an adjunct to cash market activities. These policies
reflect recognition that financial futures markets are an established
tool of finance; that these markets can be utilized as a mechanism
to insure risk and enhance profit opportunities; and that they
offer a source of new revenue and opportunity to attract a wider
customer base and a means to expand services to existing financial
futures are no longer an American phenomenon. The demands for
them are global. Thus, London has opened the London International
Financial Futures Exchange (LIFFE), and Australia, Hong Kong,
Brazil, Canada and Malaysia all have their versions of similar
markets. The prospects are for more to come in such places as
Singapore and Bermuda and beyond. The immediate growth outlook
and applicability of financial futures to the present needs of
risk management are highly positive. Indeed, the day is fast
approaching when professional money managers, who do not use
futures markets as part of their operational procedures, will
be considered imprudent if not down right negligent. The reasons
become apparent to anyone who understands the potential myriad
of applicable uses these markets provide.
banks and their customers, the currency futures markets are complementary
to the interbank market and can perform the same functions without
tying up scarce resources of manpower and credit lines. Futures
markets virtually negate the need for credit evaluation of the
opposite party. Moreover, because of its unique clearinghouse
system, and because futures market dates do not move, positions
can be put on and later offset for the same maturity without
leaving outstanding, or necessitating duplicative, delivery procedures.
futures are now a very powerful tool for aggressive asset and
liability managers as well. Interest rate volatility and the
enormous growth of the U.S. Treasury's deficit have forced risk
takers and risk averters to look to the financial futures market
as a means of smoothing the swings in the marketplace. Borrowers,
lenders and investors in fixed income securities have found financial
futures a useful insurance policy against adverse interest rate
interest rate volatility forced commercial banks to lend money
on a variable or floating rate basis, it has resulted in the
transference of interest rate risk from the banks to the borrower.
This has made corporate decision-making very difficult and unpredictable.
Consequently, corporate treasurers, in increasing numbers, are
looking at the futures markets as a means of locking in a fixed
cost of money by creating a synthetic fixed rate loan (the combination
of a variable rate loan from a bank with a series of short sales
in the futures market).
treasurers who need to borrow money in the future are learning
to use financial futures to determine their cost of borrowing
and to lock in that cost. They then can plan their money management
strategy with greater certainty. The ability to plan without
worrying about adverse interest rate fluctuations increases the
company's flexibility in pricing its products and generating
futures have also increased the liquidity for portfolio managers
by enabling them to take advantage of market opportunities cash
positions may not always permit. How often have you heard, "if
only I didn't have to take a loss on this position, I could take
advantage of such and such an opportunity." With hedge protection,
it is often possible for a portfolio manager to get out of an "underwater" position.
interest rates over the past three years have forced money managers
to become more aggressive in capturing high rates of return.
A money manager who knows he will be receiving cash from dividends
or from a maturing investment can lock in current yields by an
anticipatory hedge using futures.
securities dealers and other money managers are now using futures
as a hedge to increase current and compounded yields on a cash
position. Even the U.S. Treasury department has openly testified
that interest rate futures have materially aided its securities
dealer community to fund government debt especially during this
period of increased federal financing requirements and shrinking
recent introduction of stock index contracts and their instantaneous
success is another clear example of the present demand for and
acceptance of financial futures. In less than six months of
life, these contracts have challenged all other highly successful
contracts for transaction volume leadership. They have already
produced a dramatic positive impact in the methodology of equity
fund managers are effectively arbitraging cash portfolios with
futures index contracts and money managers are learning to use
these markets and their broadening liquidity base as a means
of temporarily buying and selling the stock market before actually
doing so in the cash equity markets. Stock index futures have
been particularly helpful for a non-diversified portfolio which
is seeking overall market protection. Even equity underwriters
have utilized them to reduce the risk in an unsold stock position.
This new methodology of risk protection for underwriters may
enable many new companies, having no access to equity funding,
to raise capital. Moreover, market makers, specialists, block
traders and options traders have incorporated stock index trading
in the normal course of their business as a means of reducing
their risk exposure.
the foregoing represents broad general uses available through
the futures market, they do not spell out the many sophisticated
and intricate maneuvers and applications that experienced participants
have devised or are devising. Nor should one be fooled by the
phenomenal growth or growing acceptance of this marketplace.
Financial futures are still very much in their infancy, and their
utilization will expand with each new passing month and every
do the markets presently in existence represent the end to the
innovative process that produced them. Inventive necessity,
as it pertains to financial futures, is still on the upswing.
Competitive pressures among the exchanges are forcing new concepts
and contracts to be explored and instituted.
stock indexes and sub-index contracts are poised to be launched
as are a full array of options. Option contracts in themselves
may represent a field of market applicability as vast and potentially
explosive as its futures market counterpart. On the drawing boards
of the exchanges, both in the futures and securities sector as
well as in the minds of research staffers and economists, the
possibility of financial markets are being discussed which today
sound esoteric if not down right ridiculous. Contracts on the
prime rate, the fed-fund rate, the repo rate, as well as index
markets on consumer prices or freight rates and a full array
of energy futures are all being considered. While some of these
may never be launched and some will be unsuccessful, the inventive
process will go on.
is therefore prudent to conclude these remarks on a note of caution.
We are in the midst of a financial revolution requiring continuous
review of the situation and swift inventive response to the demands
of the times. Financial futures are today the fastest growing
sector of the financial world. But, it is also true that most
axioms have their own counter-axiom. In the case at hand, it
is that our positive reaction to inventive necessity has an inherent
danger. Sometimes our zeal directs us toward the wrong invention.
Sometimes, the applied invention is either too early or too late.
And in financial markets, timing is as important as being right.
The exchanges should be particularly mindful of these hazards.
If they ignore them and guess wrong, or are too early or too
late too many times, they may indeed find it difficult to recover.
example, the Chicago Mercantile Exchange failed in its attempt
to institute four-year and one-year Treasury bill contracts—the
wrong invention or one that was too early; the Amex failed in
its bid to become a financial futures exchange—it was too late;
the New York Futures Exchange almost mortally wounded itself
in attempting to reinvent that which was already invented; similarly,
the New York COMEX has expended funds in an all but a futile
attempt to duplicate successful market arenas elsewhere. This
would also have been the case of their avowed interest to create
a Pacific Coast Exchange. Of equal futility, was the idea of
an electronic link between the Chicago Board of Trade and the
New York Futures Exchange. One must also wonder about the need
for new futures contracts basically duplicating the purpose provided
by the ones already successfully trading.
potential exchanges, and the business community they serve or
intend to serve have the same failing as does the human race.
They are all too easily deluded by mass psychosis. Everyone
wants to get in on a good thing, even when it is too late or
unnecessary. The financial cemetery is crowded with brazen entrepreneurs
who bet their all on an imagined necessity whose time had already
passed or represented but a passing social madness.
I have often stated to the regulators of the Commodities Futures
Trading Commission, economic justification is ultimately determined
by the marketplace. If the time for the idea is at hand, it
will become irresistible.
by permission. Excerpted from Melamed on the Markets, by Leo
Melamed. John Wiley & Sons, 1993
to top of page | Return to
Index | Home Page