MONETARY MARKET OF
THE CHICAGO MERCANTILE EXCHANGE
Essay in The Merits of
Flexible Exchange Rates: An Anthology
Few things are more symbolic
of flexible exchange rates than the International Monetary Market
(IMM) in Chicago. Indeed, the birth of this futures exchange on
May 16, 1972 is inextricably intertwined with the death of Bretton
Woods, occurring as it did but a few months after President Nixon
officially closed the gold window and ended the system of fixed
Yet, the IMM represented much
more than a new economic era or the successful introduction of currency
futures. In May of 1986, precisely fourteen years after its inception,
Merton H. Miller, Distinguished Service Professor of Finance at
the University of Chicago Graduate School of Business, bestowed
upon the IMM a supreme and unparalleled honorhe nominated
financial futures as "the most significant financial innovation
of the last twenty years."(1)
It is not my place to admit
or deny this distinction. Professor Miller and others of his distinguished
credentials are eminently more qualified than I to make such determinations.
Rather, I am best placed to reflect on the events surrounding the
birth of our currency markets, to recall some of the noteworthy
moments of the IMM's formative years and to answer questions about
who we were, and whether we knew what we were doing.
I dare say, if ever one needed
proof of the sagacity of "necessity is the mother of invention,"(2)
one need only review the economic disorders leading to and following
the creation of our new exchange. These events proved beyond anything
we could say that the IMM was an invention made necessary by the
dictates of the times.
The date most observers would
mark as the official onset of financial upheaval would be August
15, 1971. That day, President Nixon announced his economic emergency
package which included a wage and price freeze, a 10% import surcharge,
and the suspension of dollar convertibility into gold and other
reserve assets. Unquestionably, the closing of the gold window was
a seismic shock that unleashed financial reverberations that were
felt even a decade later.
It is unfair, however, to characterize
any one event as critical to the actual beginning.(3)
No one factor is responsible for the chain of events that culminated
in the financial tumult of the 1970s and early 1980s, except, of
course, the 1945 Bretton Woods Agreement itself.
In my humble opinion, Bretton
Woods was a short-term solution uniquely suited for post-World War
II reconstruction. If applied much beyond that, as it was, then
its basic and fundamental flawits rigiditywas destined
to become its undoing. A fixed exchange rate system could not forever
effectively cope with the continual change in currency value resulting
from the daily flows of political and economic stresses between
the member nations of Bretton Woods.
The different external and
internal interests of the participantstheir different rates
of economic growth; their different fiscal and monetary policies,
beholden to different forms of governments; their different work
force considerations; their different election timetables and political
pressuresall would combine to destroy a system dependent upon
a unified opinion regarding respective exchange values.
Milton Friedman knew this from
..., from the time Bretton
Woods became effective, it was inevitable it would break down...
It tried to achieve incompatible objectives: freedom of countries
to pursue an independent internal monetary policy; fixed exchange
rates; and relatively free international movement of goods and capital...As
one of the architects of Bretton Woods, Keynes tried to resolve
the incompatibility by providing for flexibility of exchange rates
through what he intended to be frequent and fairly easily achieved
changes in official parities. In practice, this hope was doomed
because maintaining the announced parity became a matter of prestige
and political controversy. Countries therefore held on to a parity
as long as they could, in the process letting minor problems grow
into major crises and then making large changes...(4)
By December 1971, when the
IMM was officially incorporated as an independent financial exchange,
it was obvious to some of us that the imbalances created and pent
up by fixed exchange rates were about to erupt. President Nixon's
economic measures were only one of those effects and were immediately
followed by a number of joint international actions and pious pronouncements
which, for the most part, turned out to be futile. These were followed
by a series of amendments and counter-measures that proved equally
useless and simply added to the general confusion.
The "Smithsonian Agreements"(5)
proposed currency realignments as well as dollar devaluation. These
attempts at a new foreign exchange value standard were doomed from
the outset since they were not much more than a reshaping of Bretton
Woods in a slightly more flexible form.
The Basle Agreement for the
European Economic Community (EEC) established the so-called "snake"
(6) for EEC currencies.
This regime was novel in that it allowed EEC currencies to jointly
float against the dollar while the movement between each currency
was restricted to a predetermined band. The concept has, of course,
survived to this day.
Nevertheless, there were an
unending series of currency revaluations and devaluations, entering
and leaving the snake, IMF agreements, amendments and inevitable
disagreementsall proving that the world was in serious difficulty.
The centerpiece of the unfolding
disarray occurred in 1973. In October of that year, the oil embargo,
oil price increases and the Arab-Israeli war set in motion economic
distortions that would dramatically change the world financial fabric
for a long time to come.
What followed was an era of
financial turmoil rarely equaled in modern history; turmoil that
tested the very foundations of western society: the U.S. dollar
plunged precipitously; U.S. unemployment reached in excess of 10%;
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%; interest rates
went even higher.
These events ensured that the
formula for successful invention based on necessity would be applicable
to the IMM. Indeed, if one could ordain 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, one
could not have bettered what actually happened.
Moreover, it seems our exchange
had embraced the single most effective remedy for the dramatic shocks
of the next decade and a half. Here is the International Monetary
Fund's assessment of floating exchange rates as published in its
Occasional Paper, July, 1984:
Given the events of the past
decade, it is easy to be impressed by the resiliency of the present
system...Indeed, in such an environment, managed floating might
well have been the only system that could have functioned continuously.
Similarly, an even stronger
statement was issued by the Group of Ten, as published June 21,
1985, "...it is questionable whether any less flexible system would
have survived the strains of the past decade..."
Can we claim that we anticipated
the exact nature of the turbulence that followed the IMM's creation?
Of course not. It was simply that, as traders with an ear to the
ground, we had heard the inner rumblings and knew there was trouble
ahead. Did we grasp the vast potential of the idea? I believe so.
This was the precise query pressed upon me by Milton Friedman when
he served as guest of honor at the occasion of the IMM's tenth anniversary.
Did we, he asked, actually envision the scope of our invention at
the time of its launch?
The answer was easy to locate.
It is to be found in the Annual Reports to the members of the Chicago
Mercantile Exchange (CME), the entity that spawned the IMM.
The 1972 Annual Report, the
first to speak officially of its offspring, was not at all bashful
in its assessment of what it had wrought:
The 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.(7)
One year later, the first International
Monetary Market Annual Report also focused on the era ushered in
by the new exchange:
The new era will afford us
the opportunity to expand our potential into other areas within
the monetary frame of reference. That was the essence of the philosophy
that fostered the IMM. Our new market was specifically designed
to encompass as many viable trading vehicles in the world of finance
as practicable. We must be willing and ready to explore all possibilities.(8)
Thus, while our grammatical
prowess may have been less than perfect, our eyesight was 20/20.
We were fully aware of the revolutionary nature of financial futures
and equally cognizant of their vast potential. Nor did we delude
ourselves about the difficulties that lay ahead.
"It's ludicrous to think that
foreign exchange can be entrusted to a bunch of pork belly crapshooters,"
proclaimed a prominent New York banker on the eve of the Merc's
launch of the IMM.
"The New Currency Market: Strictly
for Crapshooters," echoed Business Week, condemning us from
the start and preaching that "if you fancy yourself an international
money speculator but lack the resources...your day has come."(9)
Not what you would describe
as a friendly endorsement. Indeed, the world not only misread our
purpose, but our potential as well. In retrospect, the antagonism
stemmed from three factors: misunderstanding the depth and power
of financial forces pent up by twenty-five years of fixed exchange
rates, misreading the nature and value of the idea we had spawned,
and miscalculating who we were.
Of course, there were some
notable exceptions. For one, Milton Friedman, who not only provided
us with the intellectual courage to proceed undaunted by the sea
of skepticism about us, but also lent our concept his esteemed academic
credentials; without this help we could not possibly have defended
ourselves from the onslaught of official and unofficial negativism
Wrote Professor Friedman in
the position paper commissioned by the CME in the fall of 1971:
Changes in the international
financial structure will create a great expansion in the demand
for foreign cover. It is highly desirable that this demand be met
by as broad, as deep, as resilient a futures market in foreign currencies
as possible in order to facilitate foreign trade and investment.
Such a wider market is almost
certain to develop in response to the demand. The major open question
is where. The U.S. is a natural place and it is very much in the
interests of the U.S. that it should develop here.(10)
Those words and scores of subsequent
supporting actions by Friedman on behalf of the IMM were invaluable
in facilitating our birth, and indispensable in supporting our fragile
existence during our formative years.
To begin with, although CME
counsel assured us that we did not need governmental sanction to
proceed,(11) we thought
it prudent to acquaint the appropriate U.S. officials with our intentions.
We felt, correctly as it turned out, that there were compelling
reasons to touch base with our government (and later with other
governments): first, to give the IMM concept the proper level of
import and prominence; second, to gain, if possible, a positive
reaction that we might be able to use in promoting the idea; and
third, if the opposite were true, to control any negative fallout.
The first government official
to receive the Friedman paper formally was George P. Shultz, who
became U.S. Secretary of Treasury shortly after the launch of our
market. Mr. Shultz offered immediate and warm support. While he
gave the project long odds, he recognized its inherent values and
embraced Friedman's philosophical rationale. No doubt his own free
market views were in sync with those of his fellow Chicagoan.
In similar fashion, we paid
courtesy calls on Dr. Arthur Burns, Federal Reserve Board Chairman,
and Herbert Stein, Chairman of the Council of Economic Advisors.
In each instance, Friedman's paper had paved the way for a receptive
No sooner did currency futures
show signs of success, than we began to consider the next logical
step in the financial revolutiona futures contract on interest
rates. Toward this goal we were greatly assisted by the current
Chairman of the Council of Economic Advisors, Dr. Beryl W. Sprinkel,
who as Vice President and Economist of Harris Bank and Trust Co.,
served on the IMM's original Board of Directors.(12)
I recall vividly how, in 1975,
Dr. Sprinkel accompanied us to Chairman Burns to discuss our prospective
Treasury bill contract. It was a momentous occasion in our history;
by extending financial futures to interest rates, we would dramatically
expand our horizons. Moreover, this second meeting with Dr. Burns
was no longer a mere courtesy call. By then, as previously noted,
new futures contracts required CFTC approval. Chairman Burns loved
Of course, Treasury futures
faced one more hurdle, the United States Treasury. Its consent did
not occur until Milton Friedman wrote a letter explicitly recommending
the new contract to William E. Simon, U.S. Secretary of the Treasury
in 1975. Mr. Simon readily agreed.
Still another early and avid
supporter of our proposed T-bill market was the recently appointed
Federal Reserve Board Chairman, Alan Greenspan, who in 1975 was
Chairman of the Council of Economic Advisors. Dr. Greenspan unequivocally
embraced the concept. Indeed, I recall his immediate reaction as
he offered a litany of uses such a futures market could provide
the business community. His list included all the reasons why T-bill
futures were an instant success.
I recall also Herbert Stein's
cryptic comment upon learning of this new futures contract. Quipped
the former CEA Chairman, "I oppose little between two consenting
While positive reactions from
government officials were important, the contributions by members
of the business community who served on the early IMM boards were
equally meaningful. Not only did each of these gentlemen give us
advice and assistance, they provided our fledgling exchange with
the initial credibility it so desperately needed.
In addition to Beryl W. Sprinkel,
our IMM Boards(13)
included such distinguished names as Richard Lyng (currently serving
as U.S. Secretary of Agriculture); A. Robert Abboud, Vice Chairman,
First National Bank of Chicago; William J. McDonough, Executive
Vice President, First National Bank of Chicago; Robert Z. Aliber,
Associate Professor, University of Chicago; Henry Jarecki, Chairman,
Mocatta Metals, Inc.; and Fredrick W. Schantz, Vice President, American
National Bank and Trust Company of Chicago.
Of special significance were
two officers of the CME: Everette B. Harris, president of the exchange
and Mark J. Powers, its chief economist. Each of them, in their
own way, were instrumental in the IMM's ultimate success.
E.B. Harris had a vast store
of accumulated futures expertise as well as friends everywhere,
thereby providing invaluable advice and opening important doors
to give us the needed opportunities to preach the new gospel.
Mark Powers, on the other hand,
was a superb economist with a truly fertile mind. He instinctively
knew what the specifications of the new currency and T-bill contracts
should be; and, while those specifications have been changed over
time, they are still basically traded the way Powers wrote them.
Unfortunately, all these brave
soldiers represented but a handful compared with the armies who
viewed the idea of financial futures with disdain. It was to be
an uphill struggle for many years to come. Fortunately, its success
depended more on world events and our tenacity than on views of
individuals or the odds against us. Listen, if you will, to a candid
appraisal of who we were and why we were so underrated.(14)
Who were we?
We were a bunch of guys
who were hungry.
We were traders to whom
it did not matter-whether it was eggs or gold, bellies or the British
pound, turkeys or T-bills.
We were babes in the woods,
innocents, in a world we did not understand, too dumb to be scared.
We were audacious, brazen,
raucous pioneers-too unworldly to know we could not win.
That the odds against us
were too high;
That the banks would never trust us;
That the government would never let us;
That Chicago was the wrong place.
But we were fast learners as
well. While logic would dictate that unsophisticated belly, cattle
and hog traders could not long survive the treacherous waters of
foreign exchange when pitted against seasoned forex specialists,
the odds were shortened by the simple fact that we were using our
own money. That singular difference spelled a trading discipline
and a thirst for knowledge that became a winning combination for
those CME members who came to the IMM's currency pits.
And come they did, for they
represented the quintessential ingredient. Without traders who were
willing to brave the dangers of the new untested and illiquid markets,
we could never have succeeded. They came and stood there day after
day, learning and shouting, giving their time and money, infusing
the initial liquidity that ultimately lit the IMM torch.
And we made some very smart
moves, two of them decisive. The first was that the new currency
contracts were not simply added to the contracts already traded
at the CME. Rather, the IMM was created as a separate entity with
its own unique markets. This structure allowed us to build a "financial
futures" image somewhat less encumbered by the history and impressions
of age-old agricultural futures.
More importantly, it enabled
us to sell memberships at a much lower price to gain traders whose
activities would be limited to the contracts provided by the IMM.
The new members were thus captive of the currency pits, unable to
participate in the more active meat futures complex and forced to
generate business in their own arena. It was a crucial element in
our growth and became the model adopted by other exchanges when
the financial futures idea spread to our competitors.
The second critical component
at the outset was the so-called "Class B" arbitrage device. It was
a brand new approach to transaction-clearing requiring us to be
bold and imaginative.
In the early days, the banks
would not participate directly in our markets. This meant that FX
values at the IMM were not immediately connected to the real world
of the interbank market. To make this connection, we created a separate
class of clearing members whose sole function was to act as arbitrageurs
between a bank of their choice and the IMM. The Class B firms were
given special margin accommodations while the banks who dealt with
them were provided unique security guarantees. It worked. And, although
Class B arbitrage was destined to become obsolete as soon as the
banks realized that dealing directly with the IMM was safe and profitable,
the system was essential until then.
It is important to note that
while, at the outset, the major money center banks generally ignored
the events in Chicago, the Chicago banks did not. Their long-standing
relationship with futures markets was a profitable one and resulted
in a futures expertise within their walls. It, therefore, was easy
for them to grasp the concept of a futures market in currency.
It is well that this was the
case since we were in desperate need of their assistance. Happily,
the four major Chicago banks, Continental Illinois National Bank
& Trust Company of Chicago, First National Bank of Chicago,
Harris Bank and Trust Co. and American National Bank & Trust
Co. were very supportive of our IMM idea.
Indeed, the assistance of Continental,
then the largest of the Chicago banks and one with a world-wide
network, was critical. Continental agreed to act as the delivery
agent for the new currency contracts and helped devise a secure
world system for this purpose. Without a delivery mechanism, our
contracts had no chance.
In retrospect, in its formative
period, the IMM made few mistakesbut one of them was a whopper.
The instant success of its T-bill contract in 1976 made it clear
to the world that the IMM's idea represented a monumental new sphere
of business activity. As nothing before, this event served to enflame
the fires of competition.
Thus, the IMM and its larger
rival, the Chicago Board of Trade (CBOT), searched frantically for
the next new futures vehicle. It was destined to be in the interest
rate sector, but which instrument? The IMM chose incorrectly to
go after the middle range with a 4-year Treasury note contract;
the CBOT, for the long range with a 30-year Treasury bond contract.
Long-term bond futures became the most actively traded futures instrument,
mostly to the credit of Dr. Richard Sandor who spawned and championed
the concept for the CBOT.
However, there was a silver
lining. The IMM gained an insurmountable hold on the short-term
interest rate sector that led it to capture the Eurodollar contract.
Today, this 90-day interest rate contract represents the bellwether
for international short-term interest rates. It has become one of
the most actively traded instruments anywhere, and often maintains
the largest open interest for any futures contract.
Eurodollar futures were representative
of still another IMM innovation, one that dramatically expanded
the boundaries of the original concept. The IMM's notion to settle
this futures contract in terms of cash, rather than the traditional
method of physical delivery, was central to the future of futures.
To the credit of the CFTC, "cash settlement" was approved and paved
the way to uses never before thought possible for futures contracts.
Cash settlement became the gateway to the index markets.
As befits but often escapes
one who is first, the IMM ultimately captured the lion's share of
financial futures business as well as the most diverse complement
of financial instruments. Its success catapulted its parent, the
CME, from a lowly secondary position in domestic markets, to a primary
role in international finance.
The IMM served the CME in yet
another dimension: it infused the institution with a revolutionary
spirit, spawning a heritage of innovation and experimentation. This
is a quality rarely found in major financial organizations which,
as a rule, opt for the safety of "status quo."
The heritage lives. The latest
innovation of the Chicago Mercantile Exchange is a direct descendant
of the IMM revolution. On October 6, 1987, the CME membership overwhelmingly
approved a joint undertaking with Reuters Holdings PLC, the world's
largest communications organization, to create a global electronic
automated transaction system.
Called P-M-T (Post Market Trade),
it represents the first major attempt to link all of the world's
financial centers with a single futures trading system, one which
will utilize state-of-the-art technology, operate virtually over
the entire 24-hour trading day, and whose transactions will be cleared
by a single clearing entity.
The bold and revolutionary
concept is a comprehensive response to the demands of globalizationa
trend of world markets not lost on CME officials. Indeed, the CME
recognized that what Walter Wriston, chairman of Citicorp/Citibank
from 1970 to 1984, calls the "information standard" is the dominant
force of today's international financial system. It is the result
of the technological revolution of the last twenty years, enabling
information to travel at lightening speed and creating a global
marketplaceits trend and direction irreversible. The Chicago
Mercantile Exchange again was the first major futures institution
to accept this reality and react to its dictates.
Thus, the IMM spirit has remained
a permanent component of CME philosophy and the critical element
of its continued success. At the same time, the IMM made financial
futures an indispensable tool of risk management and gained Professor
Miller's coveted nomination. And, while it is untrue that the IMM
spawned flexible exchange rates, there is no denying that our currency
futures market is inexorably intertwined with its occurrence. Indeed,
we could not have prospered nor would the world have fared as well
if the IMM had not been a necessary by-product of the same economics
that ushered in the new era of flexible exchange rates.
Published in The Merits of
Flexible Exchange Rates: An Anthology
Financial Innovation: The Last Twenty
Years and the Next, Merton H. Miller, Graduate School of Business,
The University of Chicago, Selected Paper Number 63, May 1986.
A number of scholars have catalogued
the events which signaled the end of the fixed rate system. Events
cited range from the erratic monetary and fiscal policy in the United
States produced by the Vietnam War, the efforts of the Bank of England
in 1964 and 1967 to prop up an overvalued currency, similar Bundesbank
efforts, increasing demand for U.S. gold reserves, the August 15,
1971 termination of the gold window by President Nixon, the Smithsonian
Agreement, the oil shocks. See: Alfred E. Eckes, Jr., A Search
for Solvency, "Death of Bretton Woods," pp. 237-271, 1975; W.M.
Scammell, The International Economy Since 1945, "The Breakup
of the Dollar-Exchange System," pp. 179-201, 1983; Robert Solomon,
The International Monetary System, 1945-1976: An Insider's View,
There's No Such Thing as a Free Lunch,
International Economic Policy, Milton Friedman.
Its name stemmed from the place, the
Smithsonian Institution in Washington D.C., where, on December 17
and 18, 1971, the Group of Ten ministers met in an attempt to resolve
the international financial crisis.
A system established by the EEC countries
on April 24, 1972, for the narrowing of the margins of fluctuation
between EEC currencies to 2.25% in a tunnel (plus or minus 2.25%).
Original participating countries included Belgium, France, Germany,
Italy, Luxembourg and the Netherlands.
1972 International Monetary Market
Annual Report, Message from the Chairman, Leo Melamed.
1973 International Monetary Market
Annual Report, Message from the Chairman, Leo Melamed.
Business Week, April 22, 1972.
The Need for Futures Markets in Currencies,
Milton Friedman, 1971.
In 1972, there was no federal law or
agency from which we were required to receive approval before listing
a new futures contract. The federal statute creating the Commodity
Futures Trading Commission (CFTC) was not adopted by Congress until
One of the great
ironies of this event was that, over our vehement objections, the
new agency adopted a rule requiring "proof of economic justification,"
before a new futures contract would be approved. It is doubtful
whether in 1972 the IMM could have "proved" the economic need for
a futures market in foreign exchange. This is a classic example
of government meddling which results in suppression of market innovation.
Surely, only the marketplace itself can "prove" economic justification
of a financial product.
Beryl W. Sprinkel was named Chairman
of the Council of Economic Advisors by President Reagan on April
18, 1985. Prior to that, he served as Under Secretary of the Treasury
for Monetary Affairs from April 1981 to April 1985.
The first IMM Board of Directors included
the following: Leo Melamed, Chairman of the Board; John T. Geldermann,
First Vice Chairman; Carl E. Anderson, Second Vice Chairman,
Robert J. O'Brien, Secretary; Laurence M. Rosenberg, Treasurer;
A. Robert Abboud; Lloyd F. Arnold; Richard E. Boerke;
William E. Goldstandt; Henry G. Jarecki; Daniel R. Jesser;
Marlowe King; Barry J. Lind; Donald L. Minucciani; William C. Muno;
Fredrick W. Schantz; Beryl W. Sprinkel; Michael Weinberg, Jr.
From remarks by Leo Melamed on the occasion
of the Tenth Anniversary Celebration of the IMM, June 4, 1982.
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