THE METAMORPHOSIS OF FUTURES AND OPTIONS

Essay presented at the Chicago Mercantile Exchange Symposium on Financial Futures,
London, England,
November 10, 1985.

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Financial futures were on a roll by the mid-1980s. Consistent contract successes brought us favorable notoriety. Innovative expansion became our trademark and with it came respectability. It was a heady elixir, but I knew it could be temporary. I knew we would not become a permanent member of the financial establishment until we proved that we were not simply a passing fancy or a momentary blip in the financial sky.

Permanent strength for financial futures could be found by establishing first, that financial futures were a necessary tool in modern risk management and second, that they are the consequence of a long evolutionary process. In other words, that these instruments were not merely a passing fad but an outgrowth of financial history—part of its establishment.

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It is no simple task to pinpoint with any degree of exactitude the precise moment when the idea of futures and options was born. While it would be most flattering to suggest that it all began with the opening of the International Monetary Market (IMM) of the Chicago Mercantile Exchange (CME), and while this occasion does represent a momentous turning point in the history and metamorphosis of futures, it was not where or when the process was conceived. Nor was its inception the 1971 announcement by President Nixon of a suspension of dollar convertibility into gold; nor the 1945 Bretton Woods agreement establishing a system of fixed exchange rates; nor even the French Commercial Code of 1807 which paved the way for international codification of commercial transactions. Such events, while each significant from an historical view, were mere milestones in the evolution of international commerce and thus of futures markets as well.

Indeed, the idea of establishing forward availability of product as well as its future price was conceived at the dawn of mankind, perhaps at that inspirational moment just after Eve bit into the proverbial apple and then frantically sought to make a futures contract with Adam. Clearly, the first recorded application of futures is Biblical, when Joseph outlined to the Pharaoh his plan for forward buy hedges in grain to protect the land of Egypt from the coming seven years of famine.

Ancient records are replete with proof that markets, utilizing elements of modern futures exchanges, were in existence throughout man's early history and in every corner of civilization. Sumerian documents, circa 3,000 B.C., reveal a systematic use of credit based on loans of grain by volume, and loans of metal by weight.  Ancient records found in China, Egypt, Austria, and India are replete with rules and regulations pertaining to active commodity markets.  In the city-states of Greece, market laws were in place to prevent manipulation. During the Roman period, there were nineteen trading markets in Rome called Fora Vedalia that specialized in distribution of specific commodities, many of them brought from far corners of the earth by caravans. There were a host of medieval European seasonal festivals, the actual precursors to our modern exchanges, which evolved into important year-round markets, incorporating such features as self-regulation, business conduct, guarantee of contract fulfillment and mutual trust among merchants.

In the sixteenth century, in two opposite parts of the world, two similar techniques were created to deal with inherent risks of production and delivery:  In London, the great commercial insurance syndicate of Edward Lloyd was born; In Osaka, Japan, the first rice futures exchange was founded.  Later, as a result of increased international trade spurred by the industrial revolution, a system of to arrive forward purchasing became commonplace throughout the then commercial world.

The advent of the transatlantic cable in 1866, prompted John Rew, a Liverpool cotton merchant, to conceive of a method to limit price risk.  He encouraged his American correspondents to report their purchases by cable, providing him an opportunity to sell the cotton before its arrival.  The idea was the precursor to modern hedging techniques.

Of course, by then the Chicago Board of Trade had already been created, the New York Board of Cotton Brokers was being organized and the Chicago Butter and Egg Board (the original name of the Chicago Mercantile Exchange) was not far from birth.

It is clear that no single person, place, or thing can be accredited or faulted with fathering or mothering the idea of futures and options.  From its very beginning, the technique knew no national boundaries and—in one form or another—was utilized throughout the ages in every corner of the globe.  Its evolution was as dramatic and different as any in the history of mankind; its metamorphosis dynamic and revolutionary; and its business applications ever changing and adapting as necessity demanded.

Of course, few would argue that futures and options have recently attained a level of prominence, stature, and respectability without parallel in their long history. Moreover, as a consequence of their latest endeavors, they have attracted a magnitude of utilization and achieved a measure of internationalization rivaling any aspect of commerce and industry.

Nor would historians argue with the contention that the modern era of futures was ushered in on May 16, 1972, with the birth of the International Monetary Market in Chicago.  Clearly, this occasion marked the moment when futures and options formally broke with their historically agricultural past and took their first meaningful step into the world of finance. This occasion did not happen in a vacuum, nor by virtue of any single thought process.  The causes and events that led the CME to produce the IMM were as many as they were historic. 

In 1945, after the Second World War had completely ravaged every aspect of international commerce and trade, the western world looked to the U.S. for its reconstruction. The American financial system was the sole survivor of the free world's economic fabric. As the primary building block on whose foundation financial recovery was to be built, the western nations chose a system of fixed exchange rates wholly dependent on the strength of the U.S. dollar. 

The Bretton Woods system was instituted and required all participating member nations to maintain exchange rates of their currencies within one percent of the declared par value in terms of U.S. dollars.  Par was to be established at an annual conference by the International Monetary Fund and based on internal financial conditions of the participating sovereignties. This fixed exchange rate system functioned famously well for many years. First, because of U.S. determination to make it work. Second, because, except for the U.S., the other participating nations were in the midst of an internal economic revitalization. Third, because of U.S. willingness to maintain the gold content of the dollar, and to buy or sell gold at $32 an ounce in transactions with foreign authorities. For most of the next two decades, with the fixed system in place, the world enjoyed a period of monetary stability. World currencies were linked to a unit of constant value.  The limited built-in variation mechanism was sufficient in most instances for the divergences in relative foreign exchange values and minor adjustments that were encountered. Any major adjustment caused by fundamental changes in the foreign exchange value of member nations could be accounted for periodically by the finance ministers.

Unfortunately, the basic and fundamental flaw of fixed exchange rates— its rigidity—eventually began to have a cumulative effect.  The system that served so well during conditions of internal reconstruction was highly inadequate once that process was complete.  Because every one of the system's members achieved a different level of economic competence—each at a different rate of growth with widely divergent expectations and limitations—and because each operated under significantly different fiscal and monetary policies as well as within substantially different forms of government, their respective values could not forever be ordained by committee nor adjusted every year or so. The daily flow of political and economic events, the constant competitive stresses between member nations, the emerging demands of the Third World and the non-ceasing tug of war between East and West, all combined to continuously change the supply-demand statistics that governed relative currency values.  Consequently, beginning in the mid-1960s, even while the world was enjoying unprecedented prosperity, it began to suffer a constant and consistent erosion of the effectiveness of the exchange rate system on which it depended.  Revaluations and devaluations began to occur at a faster and faster pace, each of a larger magnitude than the one before. 

At the same time, the dollar circulation outside the U.S., which had been rising at an alarming rate, had reached a level causing the system's gold accountability to come into question.  The widening gulf between dollars in circulation and the gold reserves backing them made it obvious that the official price for the precious metal was unrealistic.  Eventually, foreign demands on Fort Knox for dollar conversion into gold, coupled with a growing U.S. trade deficit, resulted in unbearable pressures on the system's integrity. Indeed, by the time the decade was drawing to a close, confidence in U.S. strength and viability had eroded to a point of near crisis proportions.

A round of hastily conceived stop-gap measures were instituted in a futile attempt to save the system.  First, an EMU (European Monetary Unit) was sponsored in December of 1969 and later a similar SDR (Special Drawing Right) unit in its place.  Then, in February of 1970, an agreement was reached setting up a system of short-term monetary support among the EEC (European Economic Community) nations.  In March, a decision was made to set-up machinery for medium-term financial assistance.  But these measures and others could not countermand the inevitable.

On May 10, 1971, the first official crack in the fixed rate system occurred when the German Mark and Dutch Guilder floated.  A few months later, on August 15, 1971, the lynch-pin of the system became unhinged, the dollar went off the gold standard.  President Nixon announced the de facto demise of fixed rates by stopping dollar convertibility into gold.  Almost at once, the EEC nations declared that they would organize their own system of exchange rates.  Then followed a series of Group of 10 pronouncements about new currency realignments (the so-called Smithsonian Agreements), each of which involved a de facto dollar devaluation.  All of these maneuvers, however, were inherently flawed and doomed to failure.  As Professor Milton Friedman had warned, the world financial system could function only in an environment of free float where the values of foreign exchange fluctuated in an open market based on conditions of supply and demand.

The foregoing was the global economic backdrop that spurred us in Chicago to bring the IMM to life.  The long journey of futures, beginning with Joseph in grains, had now reached the doorstep of its business counterpart— finance.  The IMM represented the dawn of a new era for futures and options, one that only recently entered its latest phase—internationalization. 

The formative years of financial futures were difficult.  The concept was unfamiliar to and distrusted by the very institutions it meant to serve.  Futures markets had historically earned a reputation as high-risk arenas for gamblers and speculators who performed squeezes and corners. Its mechanism was considered unsafe, its participants unholy (or worse), its application misunderstood, its benefits dubious at best.  Clearly, if these esoteric instruments had any value at all, they would have the decency to move their domicile to New York.  Deeply-rooted beliefs and philosophies die hard. 

Defying all expert predictions, the IMM did not perish; rather it showed some healthy life signs.  Admittedly, it had a great deal of valuable help.  The economic pressures that caused the upheavals of the early seventies continued to reverberate through the world's financial structure and resulted in as chaotic a financial epoch as any in the modern history of the world. The era was made to order for a fledgling exchange designed to function by virtue of free market forces.  The IMM was the classic prototype of an invention spawned by necessity. Although few knew it at that precise moment, the world had just entered the most volatile chapter of recorded financial history.  Price swings for commodities, oil, and metals were about to enter a phase of unprecedented velocity, interest rates were about to begin a climb destined to bring them to record highs, and inflation was about to ascend to levels that would threaten the very foundations of the western world. For an enterprise such as ours— whose activities were particularly well-suited for upheaval, chaos, pestilence, famine, or worse—the new era was perfect.  From anchovies that lost their way to Peru, to secret grain sales to Russia, to oil cartels, to oil embargoes, to war, or to astounding ineptitude of world leaders who seemed in a race to outdo each others' blunders, futures markets became the beneficiaries of a most bizarre set of eventualities that ensured its success. These eventualities sent money managers and investors desperately scrambling for a means to protect their assets from risk or to take advantage of the opportunities.

Indeed, the uncharted, confused and convoluted sea of economics that was released in the seventies was far too much for the limited comprehension capabilities of the ruling political bodies of the free world.  It seemed almost as if every head of state, central banker, or finance minister was doing his very best to advance the raison de' etre of the International Monetary Market in Chicago.  Virtually every governmental decision or proclamation during the balance of this decade served to further exacerbate the turbulent global state of affairs and erode whatever confidence remained in the wisdom of the official world.  The only institution that still seemed to make sense was the free market itself.

Of the many specific milestones on the road to the phenomenal success and general acceptance of financial futures, there are several worth mentioning.

First, of course, the fact that every major currency listed for trade on the IMM was soon floated against the dollar.  Since the very essence of the IMM was dependent on price movement resulting from free market flows, our exchange had no chance without the eventuality of flexible or floating exchange rates. As we anticipated, every major nation in quick rotation, accommodated this need.

The introduction of the next generation of financial futures—interest rate markets—represented the second milestone.  These futures contracts had no counterpart in the interbank market (as did their currency forbearers) and therefore, immediately drew dealers from the government securities sector.  Here was a mechanism that offered a means to transfer price risk never before possible.  Thus, the GNMA, the 90-day T-bill and U.S. T-bond contracts, and later the Certificate of Deposit and the Eurodollar contracts became virtually instant successes and served as a signal to the entire world that the IMM was on to something really big.

Third, the IMM's financial integrity was not widely understood or accepted until the occurrence of the 1976 devaluation of the Mexican Peso. This event caused a enormous disturbance in world banking circles and stopped the forward pricing for the Mexican currency everywhere except on the IMM.  Indeed, the world took note that throughout this period of turmoil our futures market stayed open and continued to provide forward prices on the Peso.  Most important, the banking world acknowledged that the IMM had no financial difficulty in settling the huge losses suffered by the unfortunate longs.

As important as the introduction of new interest rate markets were toward futures acceptability, so was the mercurial rise of transaction volume that accompanied them.  In 1970, on the eve of the financial futures revolution, U.S. futures volume stood at 13.6 million transactions.  A decade later, the volume had risen to 92.1 million contracts, a phenomenal 579% increase.  By the end of 1984, the total U.S. futures volume stood at 159.3 million contracts of which 51.4% was attributable to the financial sector. 

Success begets respectability which begets success.  As these markets grew, they attracted trade not only from within the U.S. but from non-U.S. financial centers as well.  Europe was the first off-shore sector to take note of the Chicago phenomenon.  The major money center banks of London, Zurich, Geneva, and Frankfort began sending teams of interested officials to gain insight into these new markets.  Not much later, their business began to flow to Chicago. Soon thereafter, the London business community began thinking about their own financial futures—LIFFE was on their mind.

Success begets respectability which begets success.  Our futures market membership scrolls began to swell with those blue-blooded names representing the very high priests of the temples of finance, those very firms who shunned us at the beginning: Goldman Sachs, Phibro-Salomon, Morgan Stanley, J.P. Morgan, Mercantile House, Bank of America, Citicorp, Chase Manhattan, Manufacturers Hanover, and on and on.  And they were all welcome; our members were not intimidated by the competition these big names represented.

One cannot, however, speak of milestones without mentioning cash- settlement.  Once this revolutionary innovation for settling delivery obligations replaced the time-honored physical delivery methodology, the limitations for futures markets were dramatically removed.  Cash-settlement ushered in a new era for futures, and with it, the third generation of futures contracts—index markets.  It also breathed life into a restructured option market thus creating a vastly expanded universe of users and uses for futures.  The product possibilities now became limited only by one's own imagination.

Success begets respectability which begets success.  Financial futures had become not only one of the most successful business inventions of this age, they had become the most sought after and copied.  There was a period in the early eighties when one could hardly open a newspaper without encountering an item about a new soon-to-be-opened financial futures exchange somewhere in the world.  It seemed as if virtually every center or would-be center of finance was moving in this direction.  If you were to believe what you read, there would soon be a financial futures market in London, Amsterdam, Montreal, Vancouver, Brussels, Sydney, New Zealand, Toronto, Kuala Lumpur, Bermuda, Singapore, Hong Kong, Paris, Zurich, Rio, Tokyo, not to forget Philadelphia and New York. Many of them tried, some failed, some succeeded.  But throughout, the process and its attendant notoriety added to the overall respectability of this new risk transfer mechanism.  Futures had become an integral part of risk management and virtually every major bank, financial institution, investment house, brokerage concern, fund, and portfolio manager had to make the connection. 

Internationalization led us to the last and most current milestone in the metamorphosis of these markets—the era of linkages between exchanges.  The world had become so small that a bank in South East Asia was as near as your downtown counterpart and an event in Abu Dhabi was as close as your nearest telephone.  Such a world demanded a cost-efficient methodology for assuming and offsetting market positions around the clock.  Futures and options markets were first to respond to this necessity.  Proudly, the Chicago Mercantile Exchange was once again in the forefront of the movement.  Its mutual offset system with the Singapore Monetary Exchange (SIMEX), has become a model for others to follow.

Without a doubt, linkage—the latest frontier of futures and options—demonstrates the unparalleled ability of our industry to keep current with business demands and respond to them in a rapid and innovative fashion. We stand ready to face the future and the next milestone.

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

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