Historical Research: Inventing Financial Futures
How new financial markets emerged
turmoil in the early 1970s.
By Kenneth Silber
Published in the 11/1/2009 Issue of Research Magazine.
In November 1967, University of Chicago economist Milton Friedman
was turned down for a loan, a rejection that ended up changing
the course of financial history.
The problem was that he wanted to borrow in British pounds.
He expected the pound to be devalued as a consequence of Britain's
big-spending government policies, and then he could repay the
loan at a low cost in dollars.
Chicago bankers, to Friedman's surprise, declined to perform
the transaction, stating that the economics professor did not
have a proper commercial interest in exchanging currency. Foreign-exchange
speculation, it turned out, was discouraged by the Federal Reserve
and the Bank of England.
However, Friedman, though not yet the Nobel Prize winner he'd
become less than a decade later, was an economist already known
for his free-market views and one with the prominent public platform
of a regular column in Newsweek. He subsequently used that column
to complain that currency trading was hampered by unjustified
Those writings got the attention of Leo Melamed, a Chicago Mercantile
Exchange board member who became its chairman in 1969. Drawing
on Friedman's ideas and support, Melamed in the coming years
would pioneer the expansion of futures trading from its traditional
bailiwick of agricultural products into the realm of exchange
rates, interest rates and other financial variables. The 1970s
would see the birth of financial futures, a vast new frontier
for the financial services industry.
Ending Bretton Woods
Currency futures, the first type of financial futures to be
introduced, emerged against the backdrop of the unraveling of
the Bretton Woods system of fixed exchange rates, named for the
New Hampshire town where it was set up at an international conference
in July 1945. The system was under growing strain by the late
1960s, with major currencies pushing against the narrow bands
in which they were supposed to fluctuate.
the system's linchpin, was increasingly overvalued, as U.S.
inflation edged up as a result of heightened federal spending
on the Vietnam War and Great Society. Policymakers first tried
to tinker with Bretton Woods to make the fixed rates more flexible.
Then, on Aug. 15, 1971, the Nixon administration closed the "gold window" at
which foreign central banks had been allowed to exchange greenbacks
for gold at $35 an ounce. This step opened the way for floating
Floating exchange rates were a policy regime that Friedman had
long favored, as they could adjust to changing trade and capital
flows without requiring government intervention. However, other
free-market economists took a different view, believing fixed
rates, especially with a link to gold, were preferable because
they limited government printing and spending of money. That
debate echoes on today.
But in the early 1970s, the world was moving, however uncertainly,
to floating exchange rates. And that meant that companies and
investors had a greater interest than ever in guarding against
- or profiting from - currency fluctuations, which would now
be constant as opposed to the occasional adjustments that had
characterized Bretton Woods. Currency exchange, once a quiet
service provided by banks through over-the-counter forward contracts,
was about to become something much more open and noisy.
Trading in the Pits
Back in Chicago, Melamed was contemplating whether the commodity
exchange he headed could play a role in the prospective currency
market. This would be a radical departure. The Chicago Merc had
gotten its start trading contracts on butter and eggs, before
branching out into live cattle, frozen pork bellies and other
agricultural futures. The idea of trading purely financial items
in the pits was unfamiliar, to say the least.
been inspired by Friedman's calls for free-market reforms -
even sneaking into a University of Chicago classroom to hear
the economist lecture at one point. The two had breakfast at
New York's Waldorf Astoria on Nov. 13, 1971. "Is there
any reason foreign currency might not work in futures markets?" Melamed
"None I can think of," Friedman
To the contrary,
the professor said it was a "wonderful
idea" and encouraged Melamed to implement it. But the Merc
executive, worried about the skepticism likely to greet such
an unusual innovation, asked Friedman to put something in writing
on the subject.
"You know I am a capitalist?" Friedman inquired. The
two agreed on $7,500 for a feasibility study, which was titled "The
Need for Futures Markets in Currencies."
Melamed was right to think he could use some help in overcoming
doubts about the initiative. Futures trading had been used for
agricultural goods since the 19th century, and some in the business
were wary of trying to transplant it elsewhere. Meanwhile, there
were some financial types who regarded the Chicago trading pits
"It's ludicrous to think that foreign exchange can be entrusted
to a bunch of pork belly crapshooters," said one New York
banker just before the opening of the Merc's International Monetary
Market in May 1972. Business Week ran an article titled "The
New Currency Market: Strictly for Crapshooters," saying
the market would have great appeal "if you fancy yourself
an international money speculator but lack the resources."
paper in hand, Melamed was able to convince bankers, brokers
and government officials that currency futures had merit. Shortly
after the IMM began trading, Melamed visited Treasury Secretary
George P. Shultz, to whom he had sent the economist's study.
Shultz, after listening to Melamed's pitch for the new market,
said: "Listen, Mr. Melamed. If it's
good enough for Milton, it is good enough for me."
The IMM's first currency futures included British pounds, Canadian
dollars, Deutsche marks, French francs, Japanese yen, Mexican
pesos and Swiss francs. Trading was cautious at first, but volume
gradually built up, rising from 417,310 contracts in 1973, the
market's first full year, to 643,000 in 1975. The market's credibility
was enhanced in September 1975, when trading continued in Chicago
during a Mexican peso crisis even as interbank forward activity
in that currency ground to an unseemly halt.
As currency futures grew in acceptance, interest grew in having
instruments to manage exposure to interest rates, which had become
more volatile amid heightened inflation. The Chicago Board of
Trade was the first to jump in, launching a contract for Ginnie
Mae securities in October 1975. The IMM soon rolled out Treasury
bill futures, with Friedman ringing the opening bell as trading
commenced on January 6, 1976.
Initially, officials at the Treasury and the Fed were worried
that futures contracts could have a disruptive impact on markets
for government debt. The T-bill contract required regulatory
approval (the Commodity Futures Trading Commission had been set
up in 1974) and this was forthcoming only after Friedman placed
a phone call to Treasury Secretary William Simon to allay concerns
about the contract's effects.
Soon enough, it became clear that futures trading enhanced the
liquidity of government debt markets, making them function more
rather than less smoothly, besides giving banks and companies
needed tools to hedge against rate swings. The Board of Trade
came out with futures for Treasury bonds in 1977 and for Treasury
notes in 1981.
By the early
1980s, financial futures were spreading into new fields. The
IMM launched contracts for bank CDs and Eurodollars in 1981.
The next year, stock index futures were added to the toolkit
of investors and financial managers, as the Chicago Mercantile
Exchange launched a contract for the S&P 500, the New York
Futures Exchange launched one for the NYSE Composite index and
the Kansas City Board of Trade unveiled its Value Line futures
contract. More index futures would follow.
Over the subsequent decades, the financial futures industry
boomed, with new contracts proliferating and exchanges being
set up around the world. In the same period, though, over-the-counter
derivatives expanded at an even faster clip than exchange-traded
The recent financial crisis has brought heightened scrutiny
of collateralized debt obligations and other over-the-counter
In an ironic
historical twist, the financial futures markets - once derided
as being "strictly for crapshooters" -
now are quite often seen as models of prudent regulation and
transparency. Indeed, there is a growing push to bring much over-the-counter
trading onto exchanges such as those pioneered by Melamed and
Friedman those decades ago.
A Trader's Education
Leo Melamed received some lessons in currency trading long before
he pressed for his vision of financial futures as chairman of
the Chicago Mercantile Exchange.
Born in Poland
in 1932 with the family name Melamdovich, the 7-year-old Leo
was fleeing with his family from the Nazis when they arrived
in the Lithuanian city of Vilnius. His father, Isaac Melamdovich,
a math teacher, showed him a Polish zloty and a Lithuanian
lit, and asked if he knew what these were. "Money," the
His father then explained the value of these two currencies
- that despite the official one-to-one exchange rate, buying
a loaf of bread took two zlotys but only one lit.
The family received a life-saving visa to Japan from Chiune
Sugihara, the Japanese consul general to Lithuania, who at risk
to himself and his own family issued such papers to thousands
of Jewish refugees.
In Tokyo in 1941, Leo received another lesson in currency trading.
When Jewish families in Japan received an exit visa, they would
deposit yen in a bank and receive dollars (or the currencies
of countries where they were traveling) back at the official
rate. They would then hand that money to the community's refugee
committee, which sold it on the black market for a higher quantity
The profits from such transactions enabled the community to
support the existing families as well as new refugees.
arrived in Chicago in the spring of 1941 and took the name
Melamed. Leo went to law school and, seeking work as a law
clerk, answered a help-wanted ad that changed his career. The
employer was Merrill, Lynch, Pierce, Fenner & Bean, which
Melamed assumed was a law firm seeking a "runner" to
bring papers to court. The future lawyer and trader got the job
of working as a runner in commodity futures markets.
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