BIRTH AND DEVELOPMENT OF FINANCIAL FUTURES
at the China Futures Seminar
Shen Zhen, Guangdong Province, China
April 25, 1996
is my very great pleasure to address you today on a subject that
is very close to my heart. My own personal involvement with futures
began many years ago when, as a law student, I gained part-time
employment for Merrill, Lynch, Pierce, Fenner & Bean as a
runner on the floor of the old Chicago Mercantile Exchange. Years
later, as Chairman of that institution, I began toying with an
idea that would lead us on the revolutionary path toward financial
futures. Indeed, the Chicago Mercantile Exchange and I have become
somewhat synonymous over the years as together we launched the
International Monetary Market (IMM) and pioneered the financial
the historical birth of financial futures can be traced to the
turbulent economic atmosphere of the late 1960s. While there
is no single action that stands out as the founding moment of
the International Monetary Market, certain events clearly played
a crucial role 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. By the late
1960s, the world's developed nations had recovered from the ravages
of World War II and as a result, the financial rules which had
been in place were no longer functioning properly and were causing
financial pressures and threatening upheaval in the world's economic
fabric. Central to these problems was the system of fixed exchange
rates, the Bretton Woods Agreement.
those days, Professor Milton Friedman was singular in his loud
and unabashed prediction about the demise of the Bretton Woods
system. Moreover, to the consternation of the world's central
bankers, Dr. Friedman proclaimed this eventuality to be a good
thing. His beliefs held an irresistible attraction for me. I,
too, had a vision. For I knew that if he were correct—and for
me, his unwavering belief in free market forces represented a
god-like logic which could not be questioned—then the time was
right to extend futures markets and take them from their narrow
agricultural base to the unlimited horizon of finance.
was then that I approached Dr. Friedman with an idea and a question,
one that set the course for the Merc and forever changed the
history of futures markets. I asked him whether he would endorse—when
Bretton Woods collapsed—the concept of futures contracts in foreign
exchange. Without hesitation, Dr. Milton Friedman embraced the
concept and 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
he needed to say in just 11 pages. His paper, entitled "The
Need for Futures Markets in Currencies," provided us with academic
authenticity of the highest magnitude to prove that our theory
was a viable necessity. As I often stated, "Professor Friedman
gave my idea the credibility without which the concept might
never have become a reality." For with Dr. Friedman's paper
in hand, I was 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. President Nixon's actions on August 15 in
closing the gold window in effect officially ended the era of
fixed exchange rates and sent a seismic shock in world financial
markets that would be felt for years to come.
Birth of Financial Futures
the entire history of financial futures in the United States
during the last 24 years—as they moved from their embryonic stages
of the early 1970s to their present dominant position in risk
management—should be of great interest to everyone here. But,
that would take too long. So instead, allow me to merely highlight
the important milestones of that history.
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. Remember,
the IMM was the first futures market expressly designed to trade
instruments of finance. We did not know, nor could we prove,
that our idea had merit. Indeed, we were in unchartered waters,
not cognizant of the reefs along the way and not certain there
was a safe shore at the other end. Today, financial futures
represent a singularly successful industry, one that is difficult
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
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. As the 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.
May 16, 1972, the International Monetary Market opened for business,
listing seven foreign currency futures contracts—British pounds,
Canadian dollars, Deutsche marks, French francs, Japanese yen,
Mexican pesos and Swiss francs. But, 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.
But I was determined and stubborn. Indeed, the eventual success
of the IMM came as a result of the stubborn determination of
its early protagonists. Of course, luck played its part. Indeed,
if I could have ordained the perfect backdrop for the creation
of a new financial futures exchange designed to help manage the
risk of currency and interest rate price movement, I could not
have done better than what actually happened. Within a year of
the IMM's birth, economic disarray ensued that would dramatically
change the world financial fabric for a long time to come. In
October 1973, the oil embargo, oil price increases, and the Arab-Israeli
War set in motion economic distortions and an era of financial
turmoil rarely equaled in modern history. Over the next several
years, the turmoil tested the very foundations of western society.
The U.S. dollar plunged precipitously, U.S. unemployment reached
in excess of 10 percent, oil prices skyrocketed to $39 a barrel,
the Dow Jones Industrial Average fell to 570, gold reached $800
an ounce, U.S. inflation climbed to an unprecedented peacetime
rate of 20 percent, and interest rates went even higher. These
economic repercussions ensured that the IMM was indeed an invention
based on the necessity of the times.
it Works with Currency Futures, the Sky's the Limit
my statement to the members in the 1972 Annual Report, the first
to speak officially of its offspring the IMM, I was not at all
bashful in its assessment of what we had initiated and the potential
opening of the International Monetary Market on May 16, 1972
was as revolutionary a step as the establishment of the first
organized commodity exchange when that event occurred. . .
We believe the IMM is larger in scope than currency futures
alone, and accordingly we hope to bring to our threshold many
other contracts and commodities that relate directly to monetary
matters and that would complement the economics of money futures.
private ownership of gold by U.S. citizens was legalized on December
31, 1974, the IMM quickly responded with a new financial futures
contract—gold—that same day. Gold 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. At the same time, enthusiasm for foreign
currency futures trading continued to build.
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.
next 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
Trade. In 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
was opened by Professor Milton Friedman on January 6, 1976 and
represented the most important stage in the revolution of futures
leg of the journey 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. Today, not only has
that skepticism vanished, but the Treasury Department and Federal
Reserve Board officials 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 years without the existence
of futures contracts.
transactions in foreign currency, gold, and interest rate 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.
Settlement - Eurodollars - Stock Index Futures
next major 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.
settlement was far from an easy concept to adopt. From time immemorial,
the settlement of a futures contract was through delivery of
the product. In fact, court precedent had established that the
difference between gambling and futures was that futures "contemplated" delivery.
But in truth, deliveries occurred only a tiny fraction of the
time. One was not supposed to use the futures market as a substitute
for normal market channels in obtaining a product.
delivery mechanism to settle futures contracts was intended solely
to stop would-be "cornerers" from driving prices beyond their
intrinsic values. The threat of delivery acted as an enforcer,
ensuring that prices of a futures contract and its cash market
equivalent converged at the date of maturation of the contract.
But while that was important in agriculture, it was unnecessary
in finance. No one was likely to corner the Deutsche mark. Indeed,
futures markets were used as an insurance policy, not to actually
take delivery. All a trader wanted was the difference—in cash—between
the value of the instrument at the time it was bought and the
time it was sold, or vice versa.
unlike CDs or T-bills, were intangible; they were just the rate
of interest. In other words, if the Merc was ever to have a Eurodollar
interest-rate contract, it would first have to have cash settlement.
But cash settlement was a new invention. The idea that on expiration
day there would simply be a variation on margin payment based
upon the final settlement price was untested. In the case of
the Eurodollar contract, the settlement price would be determined
on the last trading date by polling the London banks to determine
the average LIBOR or London Inter-Bank Offer Rate.
four years of discussions, we finally convinced the CFTC, our
federal regulator, to accept the concept of cash settlement.
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. This concept was
as revolutionary as the very introduction of financial futures.
It 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 contemplated—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 stock market risk. 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. Cash settlement of futures contracts overcame
these obstacles. In 1982, the Merc got into the stock index business
with a contract on the Standard & Poor's 500 stock price
index. The S&P 500 index 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 premiere
stock index futures contract.
long later, the CFTC lifted the 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 offered
market users an unending array of applications and therefore
represented a successful new dimension of futures markets.
Offset and GLOBEX
1984 I recognized that the information revolution had shrunk
the world and its markets. Globalization was upon us. This meant
that international competition in futures markets was going to
take center stage. If so, the Merc had to protect its markets
by extending them into Asia. Thus, financial futures took another
giant leap when a mutual offset system (MOS) 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 long or short position in a given futures contract at the Merc
could be offset by an equal and opposite transaction (short or
long) at the SIMEX, or vice versa. MOS represented an extremely
cost-efficient methodology for the global trading of futures
and was a very positive influence on the continued growth and
use of these markets.
mutual offset was only the stepping stone to electronic trade.
Once the computer brought on the telecommunications revolution,
we realized that we could extend our business day through screen-based
trading. GLOBEX—the automated global transaction system developed
by the CME and Reuters Holdings PLC—represented a move toward
automation in the transaction process. It touched 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. Indeed, all the landmarks
in futures markets have a single common denominator; each represent
a dramatic departure from status quo.
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.
foregoing brief history of futures markets provides a glimpse
into how we arrived at today's juncture. But such a history would
be incomplete without at least a few words about modern derivatives.
futures, launched in 1972, led to the first broad-based risk
management instruments and ushered in the Era of Financial Futures.
This innovation blazed the trail for much of what has since followed
in world capital markets. It established a need for new risk
management tools responsive to institutional money management
and it induced the introduction of risk management as a regime.
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
derivatives. Simple futures contracts in foreign exchange, Eurodollars,
and bonds evolved into complex swaps and swaptions, strips and
straps, collars and floors.
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. 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. Today, most derivatives
trading 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
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.
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.
products are, however, not without danger. By definition the
management of risk has inherent risk of its own. Procter & Gamble,
Orange County, Metallgesellschaft, Barings Bank, Daiwa Bank,
or similar debacles yet unknown are sober evidence that derivatives
can cause enormous losses. But that does not mean we need to
enact Draconian rules to prevent their use. The financial structure
of the world cannot exist without the use of derivatives. Instead,
we must be prudent and alert. We must set standards, benchmarks,
and especially internal controls. We must heed the lessons we
have learned and adopt the prescriptions that are warranted.
We must enforce the recommendations of such forums as the Group
of Thirty, The Windsor Declaration, and the FIA Global Task Force
on Financial Integrity. We must observe and learn and intensify
our education process. Risk management must implicitly include
1972, the IMM of the Chicago Mercantile Exchange was uniquely
alone in its attempt to deal in financial futures. Today, the
concept is sought and promoted by every U.S. exchange and many
financial centers the world over. The U.S. Futures Industry
Association reports volume statistics on 130 contracts at 41
worldwide futures exchanges, denominated in 17 currencies. The
total 1995 transactions worldwide is a staggering 1.5 billion
contracts traded with interest rate futures representing the
largest category with 40 contracts representing 57% of the global
trading volume. That statistic gains a better perspective when
you recognize that in 1971, on the eve of the birth of financial
futures, only 14.6 million contracts traded on U.S. futures exchanges
and that there were no foreign exchanges of any consequence.
Equally important is the undeniable trend that volume on non-U.S.
futures markets have overtaken U.S. futures exchanges. In 1993,
U.S. futures and options volume represented only half of the
total worldwide futures and options volume. In 1995, non-U.S.
exchanges made up 60% of all worldwide futures and options trading.
the last dozen years, new futures exchanges have opened in Argentina,
Australia, Austria, Belgium, Brazil, Canada, Chile, China, Denmark,
Finland, France, Germany, Hong Kong, Ireland, Italy, Japan, Malaysia,
Netherlands, New Zealand, Norway, Philippines, Singapore, South
Africa, South Korea, Spain, Sweden, Switzerland, and the U.K.,
and soon Mexico. There have even been overtures for assistance
in the development of such markets from some of the newly-freed
European communities such as Hungary and Czechoslovakia, and
even from Russia itself. Countries currently planning a futures
exchange include Costa Rica, India, Mexico, Nigeria, Peru, Panama,
Poland, Thailand, Turkey, Venezuela, and Vietnam.
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.
cannot be over-emphasized: Transformation in information technology
created a world economy. It will continue to foster more globalization,
greater interdependence, instantaneous informational flows, immediate
recognition of financial risks and opportunities, continuous
access to markets of choice, more sophisticated techniques, and
intensified competition. These are the unalterable trends of
the future. As a consequence, the management of risk is today
at the core of every prudent financial strategy—a reality that
will continue to have the greatest impact on the use and expansion
of futures and options markets as well as other forms of derivatives
markets, global and around-the-clock.
to top of page | Return to
Index | Home Page