METAMORPHOSIS OF FUTURES AND OPTIONS
presented at the Chicago Mercantile Exchange Symposium on Financial
November 10, 1985.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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
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.
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
the many specific milestones on the road to the phenomenal success
and general acceptance of financial futures, there are several
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.
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.
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.
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.
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
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.
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
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.
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.
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.
by permission. Excerpted from Melamed on the Markets, by Leo
Melamed. John Wiley & Sons, 1993
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