A PRIMER ON FUTURES
Milton, Merton, Myron, Markets and Me
European Tour, November 2014
According to the Bank of International Settlements (BIS), the notional dollar value in 2013 of financial futures traded was an astounding one quadrillion, 886 trillion, 283 billion, and 4 million ($1,886,283.4 billion). Financial futures and options represented 81.3% of all futures contracts traded in 2013.
Here we are---after the crash of 2008, after derivatives were in some quarters blamed as one of the causes of the global meltdown---the use of futures markets and OTC financial derivatives as tools with which to efficiently manage risk is stronger than ever.
These instruments are used by the largest and most sophisticated financial institutions in the world—domestic and international banks, public and private pension funds, investment companies, mutual funds, hedge funds, energy providers, asset and liability managers, mortgage companies, swap dealers, and insurance companies. In other words, financial entities that face foreign exchange, interest rate, energy, agricultural, environmental or equities exposure use the OTC and our futures markets to hedge or manage their price risk.
The CME Group---as the largest and most diverse, exchange in the world featuring financial instruments---is clearly the biggest beneficiary of this trend. As the great boxer Muhammad Ali said, “It’s not bragging if it is true.” Allow me to offer a brief description of how some of that came about.
My very first lesson in economics occurred in Vilnius, today the capital of Lithuania. I was seven years old. Vilnius was the first stop in our escape after capture by the Nazis at the outset of World War II. One of my parents’ main concerns was that my education had been disrupted. My scheduled entry into first grade was indefinitely postponed. Right at the start of our two-year odyssey, as my parents with me at their side miraculously outwitted the Gestapo and KGB in a danger-filled escapade that spanned three continents, six languages, Japan, and happily concluded in the United States, my father became my private tutor. Early on he carefully demonstrated and explained about currencies, that their true value could only be determined by what they can buy in the marketplace. It was my first encounter with the logic of Milton Friedman and left an indelible impression.
Over the years, this lesson became fundamental to my understanding of the marketplace. It was fortified by attending classes at the University of Chicago. Not as a student, but I could not resist visiting the lectures of Milton Friedman, the 1976 Nobel Prize recipient in economic sciences. His 1962 book, Capitalism and Freedom, became my economic road map. His belief that economic freedom is a precondition for political freedom became my credo. His conviction in the free float for exchange rates validated my personal dream of a futures market for foreign exchange.
For the record, the best assessment of Milton Friedman’s influence in the world comes from Vaclav Klaus, the first Prime Minister of an independent Czech Republic from 1993 to 1998:
Reading and studying Milton Friedman’s works helped me and many of us to understand economic reality, to understand economics, to understand its methodology, the role of the market in society, the role of the state in a free market economy, the role of money in the economy. Surely there were other influential authors but there was no one comparable in intellectual and human integrity, in the firmness of stances and attitudes, in innovative boldness, in simplicity and clarity of exposition and in the scope and quality of important contributions both to economic theory and the theory of public policy.
Thirty years after my escape from the Nazis, I was in a position to make my dream a reality. As chairman of the Chicago Mercantile Exchange, today the CME Group, I directed the creation of the International Monetary Market, the IMM. It was to be an exchange created for the sole purpose of trading in financial instruments, the first of its kind---a revolutionary and controversial idea. It went live on May 16, 1972 with the launch of seven currencies.
Yes, that is the history. But as in many things, easier said than done. When I first suggested the idea to the CME board they laughed me out of the room. The idea that the CME---born a butter and egg board and now a pork belly exchange---would consider dealings in instruments of finance was so preposterous as to be viewed as a bad joke. Futures markets were considered the province of agriculture, not finance. That is how it was for centuries. Our big brother exchange down the road, the Chicago Board of Trade (CBOT), traded in grains. The CME was now trading in meats. Few joined me in the belief we could break this status quo. Nor that such a radical idea would ever work. Remember, I had no economics credentials; I was a lawyer by profession. The CME, I was admonished, would become a laughing stock of the trading world. It might ruin its reputation. Now there is a thought. The CME was known as a corrupt institution where corners and squeezes were commonplace. Its reputation could hardly go much lower.
Clearly, I was in need of a credible source to validate my idea. The choice was obvious. I mustered all my courage and arranged to meet with Milton Friedman. First, I beseeched him not to laugh at my idea. Then I timidly asked the great man what he thought about a futures market for currencies. His response was as immediate as it was positive. “It is a wonderful idea,” he instantly replied. “You must do it.” Stunned, I asked if he had considered the fact that this would be a break with tradition, bringing finance to the futures market. He responded, as I believed, that it should make no difference. Hardly believing my ears, I asked whether he would put his answer in writing. We settled on a “feasibility paper” at the price of $7,500. Today the CME Group is worth some $28 billion. Not a shabby trade.
Friedman’s paper was the perfect prescription. I used it everywhere as I crisscrossed the U.S. and the world with the financial futures concept. I used it with governmental officials, with bankers and financiers, with educators and economists, with journalists, with traders big and small, with market mavens everywhere. “Don’t believe me,” I preached, “read instead what the great economist, Milton Friedman, has to say.”
It worked. But it took time and persistence. I was battling, what Milton Friedman called, “The Tyranny of Status Quo.”
“It's ludicrous to think that foreign exchange can be entrusted to a bunch of pork belly crapshooters," proclaimed a prominent New York banker back in l972 on the eve of the Merc's launch of the International Monetary Market.
"The New Currency Market: Strictly for Crapshooters," echoed Business Week and wrote that "if you fancy yourself an international money speculator but lack the resources...your day has come!"
Twenty years after our launch, in 1990, Nobel Laureate in economics, Merton Miller, named financial futures “As the most significant innovation of the past two decades.” He marked the launch of currency futures, as the date that “Initiated the modern era of finance.” Not a bad endorsement.
Well, I got lucky. The timing, 1972, could not have been better. If ever one needed proof that "necessity is the mother of invention," one need only review the economic disorders leading to and following the creation of the IMM. What followed was an era of financial turmoil rarely equaled in modern history--- that is, until recently.
The U.S. dollar plunged precipitously; U.S. unemployment reached in excess of 10%; an Arab oil embargo which skyrocketed prices in crude oil to an unprecedented high of $39 a barrel; the Dow Jones Industrial Average fell to a new low of 570; gold reached a then unbelievable $800 an ounce; U.S. inflation climbed to an unprecedented peacetime rate of 20%; interest rates went even higher.
Another historical first that bolstered our initiative occurred about a year after the IMM launch. The CBOT created the Chicago Board Options Exchange (CBOE), an exchange for trading in listed equity options. The success of this idea was infinitely supported by the 1973 paper, published by Fischer Black and Myron Scholes with support by Robert Merton known throughout the world as the “Black-Scholes Model.” Both Scholes and Merton received the 1997 Nobel Prize in Economics. Fischer Black was ineligible because of his death in 1995.
The balance of CME history can be defined in two words: Innovation and Technology. We soon recognized that new advances in communications technology were bound to drastically change the manner and speed with which news and information would travel around the globe. Again we innovated. In 1987, the CME was the first futures exchange to announce our answer to the telecommunications revolution: Globex, an electronic transaction system.
This revolutionary transformation ultimately opened our markets to direct access from every corner of the planet. It was no small or easy undertaking. Again I was moving against the tyranny of status quo. Globex was bound to put the floor-broker out of business. But for me it was Globex or the termination of the CME. The following decade electronic trading platforms were launched by every futures exchange in the world. The impact on our growth is evidenced in the quantum leap in our annual transaction volume---from several million a year to our current average of 13 million a day. On October 15, 2014, we recorded 40 million transactions, a historic high.
By the 1990s, computer technology had evolved to materially change everything in life. Computer science enabled mankind to peer into the fundamental components of nature. In physical science, technology brought us to subatomic particles; in biological science, technology brought us to gene engineering; and in markets, computer technology brought forth derivatives. Financial engineers were able to disaggregate, repackage, and redistribute risks and their corresponding rewards, exchanging one set of risks and rewards for another that responded better to an investor's preferences. Financial derivatives evolved into a growing array of over the counter (OTC) financial instruments---not always with a happy outcome as the meltdown of 2008 bares witness.
Finally, as we all know, technological advances have materially speeded things up. In Globex the execution speed went from 2,500 milliseconds a decade ago to less than 3 milliseconds today. Moreover, advanced technology has dramatically altered the nature and definition of the “trader,” morphing the computer into an instrument that utilizes artificial intelligence and algorithms to direct the execution of the trade itself. So called HFTs were born. They apply advanced proprietary mathematical models in order to execute countless sophisticated trading strategies to capture even minute profits based on price correlations, price distortions, and value associations between markets. Their high speed enables them to act on profitable trading opportunities faster than humans can do. Some critics question the value of these latest advances and caution that perhaps they cause more harm than good.
In my opinion, HFTs represent but one more evolutionary step. They narrow the spread between bid and offer, improve market liquidity, contribute to market efficiency, and lower trading costs to small investors. They are part of the technological revolution which permeated every nook and cranny of our lives. It made everything faster. We are online with the world 24-7-365. We text, we twitter, we email, we Google, we Yahoo, we Facebook, we ipad, we iphone, we youtube, we Blackberry, we Android, and now we even Alibaba.
We cannot go back to the way it was.
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