BRIEF HISTORY OF FINANCIAL FUTURES
at the Seminar on Financial Futures
May 3, 1994
is my very great pleasure to address you this morning on a subject
that is very close to my heart. Indeed, the Chicago Mercantile
Exchange and I have become somewhat synonymous over the years
as together we engineered the financial futures revolution.
futures occasioned several milestones in their short history.
The first two milestones, both of a revolutionary nature, occurred
on the floor of the Chicago Mercantile Exchange. The first milestone
was their very creation. The departure by traditional futures
from their century old agricultural base and entrance into the
world of finance dramatically changed their direction and history.
By definition, no financial futures history could have ensued
without its conceptual inception. It is clear today that the
revolutionary concept sponsored by the CME in 1972 was destined
to change the world of finance and become an indispensable risk
management tool the world over.
financial futures revolution began, like most great ideas, with
a single concept: to give business and financial managers the
same risk transfer opportunities that their agribusiness counterparts
had been using successfully for more than 100 years. Like most
great ideas, however, its merit was not immediately and universally
recognized. The history of the International Monetary Market
and the start of financial futures trading is as much a story
of persistence, determination and conviction as it is one of
brilliance, insight or inevitability. To borrow from Thomas
Edison, the birth of the IMM was the result of both perspiration
fully comprehend the revolutionary impact of the International
Monetary Market on the history of futures markets, one must first
understand that, from its inception, the IMM represented both
a specific and general departure from traditional futures. Although
the IMM began life with foreign currency contracts—itself a revolutionary
departure from the theretofore agricultural base for futures—it
represented a much broader concept.
the then chairman of the Chicago Mercantile Exchange, I viewed
the IMM as a potential marketplace for a full range of financial
futures. Consequently, I led the institution in the creation
of an independent division specifically designed to exclusively
specialize in instruments of finance. This divisional concept
played an important role in the phenomenal success of the IMM
as did the ultimate success of its first financial vehicle, the
foreign currency contracts.
there is no single action that stands out as the founding moment
of the IMM, certain events clearly played crucial roles in the
new market's evolution from dream to reality. One of the most
important occurred on July 31, 1945 in a small resort town in
the mountains of New Hampshire. The Bretton Woods Agreement,
signed by President Truman and representatives of most Western
European nations, established a narrow band of fluctuations between
European currencies and the U.S. dollar. It was the breakdown
of these established relationships twenty-six years later, combined
with other economic developments, that brought the need for a
way to hedge currency fluctuation risk directly before the world
financial community. The problem was clear. So was the solution.
the behest of the CME, Dr. Milton Friedman authored a study in
December 1971 which became the intellectual foundation for the
birth of currency futures. It was not a major treatise, hundreds
of pages long with footnotes and a bibliography. The world-renowned
economist stated all that he needed in just eleven pages. His
paper, entitled "The Need for Futures Markets in Currencies," provided
the CME administration with academic authenticity of the highest
magnitude to prove that their theory was a viable necessity.
As I often stated, "Professor Friedman gave our idea the credibility
without which the concept might never have become a reality."
For with Dr. Friedman's paper in hand, we were able to convince
government officials, bank presidents and the CME brokerage community
that the idea had merit.
Woods is now dead," Dr. Friedman wrote. He looked at the
series of monetary crises that had shaken the world's economies
that year and tried to peer into the future. He saw two things
clearly: Although central banks were to set official exchange
rates, a much wider range of fluctuations would be permitted;
and official exchange rates would be less rigid and would be
changed in response to much less pressure. "The President's action
(President Nixon) on August 15 in closing the gold window was
simply a public announcement of the change that had really occurred
when the two-tier system was established in early 1968," he observed. "No
one can be sure just what kind of a system will develop in coming
years— whether the world will continue on a dollar standard or
whether a substitute international standard will emerge."
a result of Professor Friedman's strong support, the determination
of the Exchange leaders, its Board of Governors and its rank
and file members, the IMM was chartered by the State of Illinois
in December of 1971. It opened its currency contracts for trading
on May 16, 1972.
hardly anyone recognized that event as significant back in 1972.
Indeed, hardly anyone believed it to be of any consequence at
all, and few gave it any chance of success. Pundits and critics
mocked the idea, regarding it as no more than a joke or, at best,
a quixotic impossible dream. Some simply thought it ludicrous
that a "bunch of pork belly crapshooters" would dare contemplate
treading on the hallowed ground of foreign exchange. But succeed
we did. The reason? Quite simple! Victor Hugo explained it when
he told us that no general was smart enough and no army strong
enough to suppress an idea whose time had come. In fact, a New
York foreign exchange expert was widely quoted a few months after
Dr. Friedman delivered his paper: "I'm amazed that a bunch of
crapshooters in pork bellies have the temerity to think that
they can beat some of the world's most sophisticated traders
at their own game."
this missed the point. The IMM was not out to beat anybody.
Instead, as traders around the world would learn, the new market
was to become an important adjunct and alternative to the world's
interbank market. It offered money managers and foreign exchange
traders an avenue to transfer their inherent risks unto the speculative
world which, in turn, welcomed the opportunity. It represented
a new mechanism that grew out of necessity and became mandatory
in response to the new financial era which had dawned.
as noted before, success did not come easy. The IMM's currency
contracts endured a painful process of acceptance by the U.S. brokerage
community and the world's banking establishment. Its eventual
approbation came as a result of the stubborn determination of
its early protagonists. Only a visionary few could have known
at the time just how important, and how popular, these new contracts
would become. The phenomenal growth of the IMM and financial
futures through a decade of international tension, high inflation,
oil embargos and stagnant economies, stands as a tribute to the
abilities, energy and patience of its founders.
concept of a centralized market for transferring foreign currency
risk gained momentum in 1971 when the dollar was devalued and
member countries of the International Monetary Fund agreed to
widen the original one percent parity to a 2-l/4 percent par
value level. This move was one of a series of steps leading
up to the eventual collapse of the Bretton Woods Agreement which,
in turn, ushered in an era of considerable risk in currency price
fluctuation— risks which could be limited if there were a viable
market for currency futures trading.
noted, on May 16, 1972, the International Monetary Market opened
for business, listing eight foreign currency futures contracts—British
Pounds, Canadian Dollars, Deutsche Marks, Dutch Guilders, French
Francs, Japanese Yen, Mexican Pesos and Swiss Francs. For the
first time, the economic benefits of risk transfer and price
discovery that were indigenous to futures became available to
those outside the agricultural sector. Trading on the new exchange
began cautiously. But, within two years, volume started to build
momentum almost tripling, from 144,928 contracts traded in 1972
to 417,310 in 1973.
on, IMM officials saw an opportunity to encourage the growth
of the fledgling foreign currency futures market by allowing
firms to become Class "B" clearing members. Designed to facilitate
foreign exchange arbitrage between the interbank market and the
futures market, these new members not only succeeded in forging
a close link between the two markets, but also helped gain widespread
acceptance of foreign currency futures as alternative trading
instruments for cash market participants.
private ownership of gold by U.S. citizens was legalized on December
31, 1974, the IMM quickly responded with a new financial futures
contract. The Exchange introduced trading in gold futures that
same day. It represented the first expansion of IMM contracts
into a second type of financial instrument and emphasized the
exclusive specialty of the IMM Division.
futures, unlike the currency contracts, became an instant success
because of the flexibility and protection they provided to gold
bullion dealers, institutional traders and the general public
within which there was a pent-up demand of tremendous proportion
for this metal. By 1981, gold contracts were being traded briskly
by individuals and institutions throughout the world. In just
seven years, volume had grown to exceed 2.5 million contracts
the same time, enthusiasm for foreign currency futures trading
continued to build. More than 959,000 contracts changed hands
during 1974 and 1975 firmly establishing the IMM as an important
part of the global exchange network.
the IMM concept was much broader than currency and gold. The
revolution it had ignited was now fast becoming an accepted reality.
World events had proved that futures provided a necessary new
tool in financial arenas and that their potential was therefore
vast. Thus, the metamorphosis of futures markets had reached
a threshold from which vistas never before imagined could be
contemplated. The IMM, as well as other exchanges, were now
preparing to expand the original idea and capitalize on what
was bound to become the new era in futures.
Growing Rate of Interest
second major milestone in the history of financial futures occurred
with their extension to interest rates. It was, of course, a
logical next step and began in the mid-1970s with the introduction
of contracts on U.S. government securities—Treasury bills at
the Merc and GNMAs and Treasury bonds at the Chicago Board of
the face of soaring inflation and volatile interest rates, the
IMM prepared for its entrance into a vehicle of finance which
would become one of the most important contributions to the national
economy. Trading in U.S. Treasury bill futures began in January
1976 and represented the most important stage in the revolution
of futures markets which began with the currency contracts.
It also epitomized the broad scope of the IMM as the specialized
financial futures division envisioned by its founders.
should note that this leg of the journey was one that was not
easy. The U.S. government's two major financial institutions—the
Treasury Department and the Federal Reserve Board—were very concerned
about the effect of such futures contracts on their official
operations. Their skepticism has not only vanished, but today,
most Treasury Department officials will acknowledge that the
U.S. Treasury securities market could not, in the face of a veritable
torrent of borrowing, have functioned so smoothly over the past
few years without the existence of futures contracts. Equally,
the Federal Reserve has recognized the good that interest rate
futures can do for banks and has not only permitted banks to
use futures to manage risk but has approved petitions by several
banks to become directly involved in the futures business.
bill futures in their first five years grew to become the largest
contract of any on the CME or IMM with more than 5.6 million
transactions in 1981. Moreover, they were an indispensable hedge
vehicle for money managers and government dealers whose overwhelming
acceptance of this contract prompted Exchange officials to pursue
additional interest rate futures.
transactions in foreign currency, gold and interest futures continued
to grow worldwide, the Exchange sought to extend the scope of
services that could be offered from its home base in Chicago
and make itself more readily accessible to market participants
from around the world. In 1980, the IMM opened offices in New
York and London making possible direct, person- to-person communications
with Exchange officials and a continuous educational and informational
flow to new prospective market users in major money centers throughout
North America and Europe.
third milestone—cash settlement—came in 1981. The Merc's Eurodollar
contract became the first to settle by way of payment in cash
rather than by delivery of the instrument itself. Once financial
futures shed the requirement of physical delivery, the curtain
was opened to instruments and concepts previously unthinkable.
Cash settlement represented the gateway to index products and
seemingly limitless potential.
third major stage in the development of these futures markets
was as revolutionary as their very introduction in the first
place. It again represented a complete departure from past and
accepted ideologies and forever changed their direction. It
called for the settlement of futures contracts in cash rather
than in delivery of the actual instrument of trade. The new
system thus enabled us to create markets in instruments never
before first by way of Eurodollar futures, a contract on LIBOR
time deposit rates and then later with the introduction of our
stock index futures.
years we had nurtured the dream of creating a futures contract
that would allow people to hedge against risk in the stock market.
It was an impossible dream, however, since we could find no way
to make delivery of the actual product. Delivery of stocks was
out of the question because of the complexity it represented
and the expense involved.
settlement of futures contracts, however, overcame these obstacles
and thus in 1982 the Merc got into the stock index business with
a contract on the Standard and Poor's 500 index of stock prices.
The S&P 500 is the standard against which every manager of
a stock portfolio, whether for a pension fund or an insurance
company, measures his performance. Therefore, it was no surprise
to us that S&P futures soon became the premier stock index
contract, one that today has captured over 75 percent of the
business in this market sector.
next important development in our markets was brought about by
the lifting of a 50-year prohibition against the trading of options
on commodities. Thus we were able to expand vertically on markets
that had their genesis in futures contracts. We found that options
in conjunction with futures contracts offer market users an unending
array of applications and therefore give us every reason to feel
that these instruments represent a new successful dimension of
financial futures took another giant leap in 1984 when a mutual
offset system was successfully innovated between two different
exchanges in two different time zones. The Singapore International
Monetary Exchange (SIMEX) and the CME connection was as revolutionary
a step in the development of futures as any I have cited. It
represents a system whereby a position (long or short) in a given
futures contract at the Merc can be offset by an equal and opposite
transaction (buy or sell) at the SIMEX or vice versa. Obviously,
such a system of mutual offset represents an extremely cost-efficient
methodology for global trading of futures and will no doubt be
a very positive influence on the continued growth and use of
milestone for financial futures, inspired by the telecommunications
revolution, was also led by the CME. For all the landmarks have
a single common denominator; each represent a dramatic departure
from status quo. GLOBEX—the automated global transaction
system developed by the CME and Reuters Holdings PLC—represents
a move toward automation in the transaction process. It touches
the very nerve center of status quo in our industry and has incurred
the criticism of those who would oppose any movement toward change
in automation or adoption of technological advancements.
unequivocal truth is that the world of futures is dynamic and
continuously evolving. Complacency is the enemy; innovation and
change are at the very heart of our success. As our markets'
applicability extended to new products, new techniques and new
users, as our markets became the standard tools for risk management,
the changes we engendered were dramatic and revolutionary.
brief history of financial futures, hopefully, has given you
a general idea of their development and will enable us now to
take a closer look at these markets themselves. Clearly, the
mechanics of futures trading as well as the nature of contract
specifications is every bit as interesting as what is traded.
most striking thing about futures noticed immediately is that
the units of trade of a given contract are all the same. In
other words, rather than being personalized as in the commercial
world, futures contracts are standardized. Indeed, while in
the spot market you can buy or sell U.S. Treasury bills with
maturities ranging from a few days to a year, in futures you
can only trade in units of $1 million of U.S. Treasury bills
with exactly 13 weeks to maturity.
futures contracts can be settled only at a limited number of
set times during the year. In the case of the Treasury bill
contract, delivery can take place only in March, June, September
or December. In the spot market, of course, delivery can be
made at any time that is acceptable to both sides of the transaction.
first glance, one may consider such a high degree of standardization
to be very restrictive. Actually, this is the very element of
futures that gives them their wide appeal. Even though a futures
contract may seldom offer the precise specifications needed in
a prospective commercial transaction or hedge, it serves as a
model for a wide range of commercial needs and uses. Their standardization
thus allows a wide range of people who face risk in a wide range
of specific commodities to focus their attention on a single
market—the market for the futures contract. The result of that
focus is a concentration of liquidity. And, it is the liquidity
that you can find in a futures market together with the resulting
low costs of buying and selling that endow them with their primary
way we trade is another important reason for the success of futures
markets. First, all trading is done by open outcry in a competitive
arena. If you wish to buy or sell, you must shout the price
for everyone surrounding you to hear. Second, our markets are
open to anyone. We do not keep people out of the market because
we do not know them—nor do we ask their commercial reason for
trading. As a result, complete strangers, from commercial and
investment worlds, who might otherwise never have done business
together, are given access to a trading arena allowing them to
transfer or assume risk. This is an important virtue of futures
markets which should be obvious and a point to which I would
like to return shortly.
Success of Financial Futures
futures have been so extraordinarily successful since their creation
because they are especially useful for managing risk, and they
do not allow embarrassing losses to be swept under the carpet.
Consider these in turn.
consider the efficiencies. Everyone who does business in financial
markets finds his business to be a complex combination of performing
services and taking risks. Take, for example, the government
securities market in the United States. In our country, the
job of buying and distributing the government securities sold
weekly by the U.S. Treasury has fallen quite naturally to a
relatively small group of government securities dealers. Their
chief function, of course, is to distribute these securities
to their ultimate investors.
doing this job, however, each dealer finds it worthwhile to make
a market in these securities, and this function—together with
the task of buying and distributing the securities—requires a
dealer to hold large quantities of bills, notes and bonds. And,
of course, having to hold a position exposes the dealer to risk.
How does the dealer cope with the inherent risk of his profession?
Well, before the advent of interest rate futures, he had two
options—he could limit the size of his position, or he could
take an offsetting position in the forward markets.
first approach to managing risk interferes with his function
as an underwriter. If he is concerned with interest rate risk,
he bids less aggressively in Treasury auctions and requires higher
bid/ask spreads to compensate him for making a market—the higher
resulting costs are then necessarily passed on to the consumer.
second approach to managing risk, trading in the forward market,
is costly, cumbersome and has the undesirable effect of blowing
up the size of his balance sheet. Since forward trades are made
between specific individuals, the dealer who sells into the forward
market and later buys in the forward market most often will have
two positions on the books—a short position resulting from the
first trade, and a long position resulting from the second.
As you can imagine, enough of these trades can produce bloated
balance sheets fraught with credit risk.
contrast, opposite trades done in the futures market are completely
offsetting. Since they are all fungible, it does not matter
which obligation is offset with which trade. That is, a short
sale followed by a purchase, or vice versa, will leave the dealer
with no position at all. He will be out of the market altogether
rather than having to carry the burden of a complex network of
short and long positions in the forward market.
with financial futures, the government securities dealer is armed
with a superb risk management tool that allows him to hold as
large a position as he thinks is necessary for him to compete
effectively in doing his job.
same is true for banks. The main function of a bank is to provide
transactions services and to be an intermediary between lenders
and borrowers. In the past, however, these jobs also required
a bank to undertake the risk exposure to changes in interest
rates. Depositors seldom want to lend at the same maturities
at which borrowers would like to borrow. Faced with such risk,
a bank would demand compensation in the form of a lower rate
paid to lenders and a higher rate charged to borrowers.
however, banks can balance their risk exposure efficiently by
taking positions in futures markets. There is no longer any
need to impose on their clients the costs of bearing interest
rate risk. As a result, banks are able to perform their primary
natural question, of course, is how much all of this matters.
On this score, I can assure you that futures markets matter a
great deal. Our interest rate futures markets close at 2:00
PM Chicago time, 3:00 PM New York time. This, however, does
not mean trading in government securities ends at that time --
it does not. But, the trading that continues after our market
closes is done at bid/ask spreads that can be twice as wide as
those available while our markets are open. By the same token,
the trades done without our markets are considerably smaller
in size. The reason, of course, is that a commercial trader
is far less willing to take on a position he cannot immediately
hedge in the futures market.
difference this makes to the public good is quite obvious. The
bid/ask spreads available when the futures markets are closed
are those you would see all the time if there were no futures
markets. And, the cost of these larger bid/ask spreads would
be borne either by the taxpayer (who would have to pay the higher
borrowing cost associated with the lower bid) or by the investor
(who would get the lower return associated with the higher offer).
All in all, it is quite clear that financial futures have been
of significant benefit to the U.S. debt markets and thereby to
the American public.
should note that the corporate sector also reaps substantial
savings from our markets. The investment banking firms who underwrite
corporate bond issues hedge their risk in futures markets. Because
they can do so, they are willing to bid more aggressively for
the right to underwrite corporate bonds. The result of more
aggressive bidding is a lower cost of for the corporate borrower.
aspect of the efficiencies permitted by futures contracts stems
from their use as a temporary substitute for doing a trade in
the cash market where transactions costs can be quite substantial.
Consider, for example, the problem faced by someone who manages
a portfolio of stocks but who is worried about a decline in the
general stock market.
the advent of stock index futures contracts, the only way to
deal with the risk of a decline in the stock market was to sell
stocks out of the portfolio. Anyone who runs a portfolio hates
to do this for two reasons. First, to sell a stock and later
buy it back is expensive in terms of market impact and brokerage
commissions. Second, and possibly worse, is that the portfolio
manager selected those stocks for a reason -- he believed those
stocks would yield higher rates of return than other stocks available
in the marketplace.
portfolio manager's dilemma is that he wants to sell the market
but keep his stocks. This dilemma is resolved by the stock index
futures contract. Using the S&P 500 futures contract, the
portfolio manager—if concerned about a decline in the stock market—can
retain his stocks while selling the stock index futures. The
transaction costs of this approach are demonstrably lower than
the costs of actually selling the stocks and buying them back
again. And, of course, the productivity of the fund manager's
research department is enhanced if the stocks in the portfolio
outperform the market, enabling the fund manager to reap those
rewards even if the stock market does decline.
last point I would like to make concerns a property of futures
markets appreciated by all too few. Recall that we require everyone
to settle their losses at the end of every day. This practice
is called mark-to-market, and if a trader fails to make good
his losses (no one ever turns down gains), his position is closed
out and he is not allowed to trade.
all gains and losses to be settled each day has the striking
salutary effect of requiring those who sustain losses to recognize
them the instant they occur. It is impossible to let losses
ride or to sweep them under the carpet. The importance of this
feature for banks and other financial institutions should be
clear. The failures of Herstatt Bank in Germany and Franklin
National Bank in this country were in large part the result of
trading losses hidden either from management or from the public
eye, or both.
banks in Japan have not been immune from such problems. Fuji
Bank, for example, recently sustained major losses due to unauthorized
trades -- and the losses were compounded because they were kept
hidden from management's view. Such a thing almost certainly
could not happen with futures.
trader might make an unauthorized trade but, if he were to sustain
a loss, we would require the loss to be made good the next morning.
As a result, the comptroller of the bank who must cover the loss,
knows immediately about the trades. As a result, the position
cannot be tucked away in a drawer or under a blotter and the
losses cannot be allowed to run. In this way, futures contracts
provide an exceptionally effective management tool for those
whose job it is to monitor the financial integrity of their companies.
and anecdotal references notwithstanding, it fair to say that
the modern concept of financial derivatives as tools in business
dates back only about twenty years. The process was initiated
by the financial futures revolution in the early 1970s when the
International Monetary Market was launched at the Chicago Mercantile
Exchange with the express intent of developing futures trade
in financial products. This innovation created the first broad-based
risk management instruments and ushered in the Era of Financial
Futures. Thereafter, evolutionary forces in finance, global markets,
and world economies—coupled with advancements in computer technology—transformed
these relatively simple tools into the present genre of complex
backdrop to this metamorphosis was modern academic theory which
fostered the philosophy of risk management as a necessary business
regime. General acceptance of this principle spurred the idea
of breaking down risk into its basic components. Consequently,
an infinite number of financial derivative contracts are being
created whose values depend on the value of one or more underlying
assets or indices of asset values. The primary purpose of these
instruments is not to borrow or lend funds but to transfer price
risks associated with fluctuations in asset values.
the most powerful force affecting the growth of derivatives has
been technology. High-capacity computing and telecommunications
have not only prompted off-exchange and screen-based trading,
but have permitted the creation of complicated new products at
a low cost. Financial engineers comb world markets looking for
inefficiencies, volatility, and investors' dilemmas, using their
computers to create models and products to solve the perceived
problems. It is believed that a new derivative instrument is
invented weekly. In what Forbes calls the "age of digital
capitalism," formerly impossible tasks such as breaking up a
Fannie Mae mortgage pool into 36 tranches of different maturities
is now something that can be done on a routine basis.(1) In
other words, mathematicians, physicists, scientists and "quants" are
replacing economists and account executives.
majority of such contracts can be placed into one of four categories:
foreign exchange, interest rate, commodity, and equity—reflecting
the most common forms of financial risk. The bulk of derivatives
trading presently is in interest-rate and foreign exchange swaps,
but it is rapidly expanding into equity, commodity, and insurance
markets. Indeed, with modern high-speed computer competence,
the range and possibilities of derivatives is limited only by
the imagination of financial engineers and the demand of market
participants. Virtually any income stream can now be exchanged
for any other income stream. These inventions cover the full
gamut of financial risk and their esoteric acronyms are represented
by the entire alphabet.
a macro-economic sense, derivatives have played a major role
in increasing the liquidity in capital markets and in developing
more efficient global intermediation processes. By acting as
a catalyst for the integration of various markets, these instruments
serve to foster rapid growth in international trade and capital
flows, allowing excess savings in one market to be channelled
into another. This process offers assistance to emerging capital
centers by funneling investment of savings from mature industrialized
countries into higher yielding opportunities in developing nations.
live in a world where financial derivatives are used to protect
against interest rate and exchange rate exposure, to manage assets
and liabilities, to enhance equity and fixed income portfolio
performance, and protect against commodity price rises or mortgage
interest expenses. As a consequence of their application, risks
are reduced and profit is increased over a wide range of financial
enterprises and in various ways—from businesses whose efficiency
is enhanced, to banks whose depositors and borrowers are benefited;
from investment managers who increase their performance for clients,
to farmers who protect their crops; and from commercial users
of energy, to retail users of mortgages.
reflecting on the dramatic changes that have transpired in global
markets over the past two decades, one overriding principle must
be remembered: In our global market environment—an environment
driven by instantaneous information flows and sophisticated technology—financial
risk is ubiquitous and unending. Its management will continue
to be the fundamental goal of investors and money managers. Futures,
options, and other forms of derivatives provide the ability to
identify, price and transfer existing risks. These instruments
have become the premier tools of risk management and will continue
to function as such for the foreseeable future.
Lenzer and William Heuslein, "The Age of Digital Capitalism", Forbes, 29
March 1993, 62-66, 71-72
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