NECESSITY

Presented to the Money Marketers, New York University,
New York, New York,
November 16, 1982.

The first advertising campaign of the International Monetary Market made necessity the underlying reason for the creation of currency futures. Although the ad quoted Victor Hugo incorrectly, attributing to him the statement that "necessity was the mother of invention," its substance was right on the mark.

Indeed, if the IMM was to succeed, if currency futures were to become viable, if financial instruments were to become the well-spring of new financial contracts, then clearly necessity would be its singular common denominator. Of course, in 1972, necessity had a personal side to it, as well. Some trader friends and I were bearish on the British pound but powerless to do anything about it. According to the Wall Street Journal—so was Milton Friedman. He too needed a such a market in order to express his financial opinion.

Looking back ten years later, we could confidently state that history proved us right. There was an inherent necessity for the creation of a market designed to manage financial risk.

Today, I will speak of change, of need, but mostly of "necessity, the mother of invention". Victor Hugo succinctly expressed it in 1852 in his History of Crime: "A stand can be made against invasion by an army; no stand can be made against invasion by an idea."  Hugo did not invent the thought, rather he inherited it from a long line of literary stars beginning with the original version Mater Artium Necessitas an undated anonymous Latin saying of ancient Rome. The Latin poet, Pesius Flaccus, was the first known author to use it in literature, circa 50 A.D.  He put it, "the stomach is the teacher of the arts and the dispenser of invention."  The saying took one form or another throughout the ensuing history of great literary thought until some 1500 years later when Leonardo Da Vinci wrote, "Necessity is the mistress and guardian of nature."  William Shakespeare in his Julius Caesar wrote, "Nature must obey necessity," and the English dramatist, William Wycherly, in 1671, said it in the form we know it today.

However it is said, it is no less true.  Necessity will produce the indicated invention.  Necessity will take many shapes and forms as will the inventions it produces.  Broadly speaking, there are two causes for those irresistible ideas whose time has come:  nature—the demands as a consequence of natural needs; and social change—the demands as a consequence of evolving changes in life style.

Fire is a great example of an invention inspired by natural cause, as are clothing and shelter and the outhouse.  The needle is known to have been used 20,000 years ago, and the button was invented in ancient Greece.  The modern need for rapid dress and undress inspired the invention of the zipper in 1893.  Of course, some would argue that the zipper is a better example of an invention inspired by social change rather than nature's demands.

Social change—resulting in different customs, usages and life styles of the human race—will inspire two types of invention.  Those in the scientific or technological realm and those in what would euphemistically be labelled "the arts." Cumulatively speaking, each new invention produces yet another social change and requires still another responsive innovation.  The wheel ranks with fire as a most significant necessary invention and is a good example of a science-related advancement inspired by social change.  Similarly, the telephone, the combustion engine and the railroad are excellent examples of scientific responses to social changes of civilization, as is the computer chip and the birth control pill.

The most dramatic social-inspired invention in the arts is not the paint brush as Picasso might have argued, but rather the invention of money.  In its own way, money ranks with fire and the wheel as one of the outstanding inventions in the entire history of mankind, facilitating advancement in every aspect of civilization. Banks, themselves, are a similar example as are investment and bond houses, financial institutions of every kind, the Federal Reserve System and social security.  Society and its changed demands caused each to be created.

It is important, therefore, at this juncture in this rather over-simplified discussion on inventions, to mention that "Those who do not see the necessity, will not be the ones to invent the irresistible idea."  This corollary is true for both the sciences as well as the arts. Perhaps the best example of a failure to understand this truism are the U.S. railroads.  Because they did not see the changed necessity, they did not know to diversify into trucking or airplanes.  They paid dearly for this sin. How one avoids this fate is a critical question, or should be, for every participant of the financial and industrial world.

In 1904, Mary Parker Follet suggested one answer.  She invented what she called "the law of the situation."  Her law required every business to occasionally ask itself this question, "what business am I really in?"  Mary Parker Follet, the first known management consultant in the United States, convinced a small client of hers, a window shade manufacturer, that he was not in the business of window covering treatment, but rather in the light control business.

The timely and realistic application of the Follet situation-law may go a long way in correctly interpreting social change as it relates to how well or what you are doing. Had the railroads applied this law, the answer to the question might have been, "we are in transportation, not merely in railroading."  This answer, I submit, suggests the expansion of services into other, and more current, forms of transportation.

One dramatic example of a timely application of the law of situation will suffice.  When in 1981, Sears Roebuck & Co., our nation's largest retailer, saw that it was unable to grow in retailing, it asked itself the question, "in what business am I?"  The answer must have been startling to some.  It was, "I am a consumer service organization."  In that case, Sears was no longer limited to retailing, and the results so far have been dramatic.  Those of us who cried foul, that Sears ought not be in trading, banking, real estate or money market funds, missed the point. "Inventive necessity" has only one rule: survival.

The economic upheavals in the late 1960s and early 1970s that forever changed the course of financial history were the requisite social changes that brought about the invention of financial futures in Chicago.  The pressures dictating suspension of dollar convertibility, the Smithsonian Agreement and the prompt abandonment of the Smithsonian Agreement, were events that had been building for years.  The social changes these events produced required everyone in the financial world to re-evaluate their position in the scheme of things and to determine whether they ought to invent a change to accommodate the new demands in order to survive.

We, the pork belly crapshooters of Chicago—as we were so fondly called— applied the law of situation in timely fashion.  To the question, what business are you really in, we answered, "the business of risk insurance."  And to the question, what risks will we insure, we answered "anything worth insuring." Thus we launched currency futures on May 16, 1972, at the newly-created International Monetary Market (IMM) division of the Chicago Mercantile Exchange.

World events which thereafter unfolded created the most challenging environment in the history of finance for every business entity and its managers.  Soaring inflation, soaring energy costs, changing values between currencies, volatile interest rate movements and extreme price swings of commodities all combined to create a chaotic business climate fraught with danger and abundant with opportunity. To a futures exchange that had asked the right question of itself and was timely in its response, these conditions were a heavenly blessing.  We were like kids in a candy store.  The only question we needed to answer now was which candy to consume first.  The race was on.

For what the IMM did was not merely to open a market in currency futures, but rather to usher in the era of financial futures.  The phenomenal success of financial futures in the 1970s exemplified the power and irresistibility of an idea whose time had come. National futures market transaction volume increased from 14.5 million contracts in 1971 to 98.5 million a decade later, an increase of 700 percent. 

The Chicago Mercantile Exchange was duly rewarded for having asked the right question. During this decade, we experienced a phenomenal growth rate; from a 1971 volume of 3.2 million contracts, we ended 1981 with a record of 24.5 million transactions, an increase of 800 percent.  Significantly, IMM financial contracts represented 60 percent of that total.  Third quarter volume figures at the CME for 1982 already exceed its 1981 total.  Those exchanges that did not soon enough see the change or respond to the need were left behind. 

The escalating uncertainties of present-day risk management demand knowledge and prudent application of financial futures.  These markets today represent a business tool, an insurance vehicle, and a profit center that can no longer be ignored by even the most conservative financial institution. Not only has the world of finance recognized this inescapable fact, so has the government authority.  Before our very eyes, walls of regulative prohibition are crumbling in response to the demands of the new economic era upon us. The Federal Reserve Board, the Federal Deposit Insurance Corporation, the Comptroller of the Currency, and the Federal Home Loan Bank Board have all adopted new policies which, in effect, make certain futures market applications incidental to banking and an adjunct to cash market activities.  These policies reflect recognition that financial futures markets are an established tool of finance; that these markets can be utilized as a mechanism to insure risk and enhance profit opportunities; and that they offer a source of new revenue and opportunity to attract a wider customer base and a means to expand services to existing financial clients.

Financial futures are no longer an American phenomenon.  The demands for them are global.  Thus, London has opened the London International Financial Futures Exchange (LIFFE), and Australia, Hong Kong, Brazil, Canada and Malaysia all have their versions of similar markets.  The prospects are for more to come in such places as Singapore and Bermuda and beyond. The immediate growth outlook and applicability of financial futures to the present needs of risk management are highly positive.  Indeed, the day is fast approaching when professional money managers, who do not use futures markets as part of their operational procedures, will be considered imprudent if not down right negligent.  The reasons become apparent to anyone who understands the potential myriad of applicable uses these markets provide.

For banks and their customers, the currency futures markets are complementary to the interbank market and can perform the same functions without tying up scarce resources of manpower and credit lines.  Futures markets virtually negate the need for credit evaluation of the opposite party.  Moreover, because of its unique clearinghouse system, and because futures market dates do not move, positions can be put on and later offset for the same maturity without leaving outstanding, or necessitating duplicative, delivery procedures.

Financial futures are now a very powerful tool for aggressive asset and liability managers as well.  Interest rate volatility and the enormous growth of the U.S. Treasury's deficit have forced risk takers and risk averters to look to the financial futures market as a means of smoothing the swings in the marketplace.  Borrowers, lenders and investors in fixed income securities have found financial futures a useful insurance policy against adverse interest rate variations.

Because interest rate volatility forced commercial banks to lend money on a variable or floating rate basis, it has resulted in the transference of interest rate risk from the banks to the borrower.  This has made corporate decision-making very difficult and unpredictable.  Consequently, corporate treasurers, in increasing numbers, are looking at the futures markets as a means of locking in a fixed cost of money by creating a synthetic fixed rate loan (the combination of a variable rate loan from a bank with a series of short sales in the futures market).

Institutional treasurers who need to borrow money in the future are learning to use financial futures to determine their cost of borrowing and to lock in that cost.  They then can plan their money management strategy with greater certainty.  The ability to plan without worrying about adverse interest rate fluctuations increases the company's flexibility in pricing its products and generating new business.

Financial futures have also increased the liquidity for portfolio managers by enabling them to take advantage of market opportunities cash positions may not always permit.  How often have you heard, "if only I didn't have to take a loss on this position, I could take advantage of such and such an opportunity."  With hedge protection, it is often possible for a portfolio manager to get out of an "underwater" position.

High interest rates over the past three years have forced money managers to become more aggressive in capturing high rates of return.  A money manager who knows he will be receiving cash from dividends or from a maturing investment can lock in current yields by an anticipatory hedge using futures.

Government securities dealers and other money managers are now using futures as a hedge to increase current and compounded yields on a cash position.  Even the U.S. Treasury department has openly testified that interest rate futures have materially aided its securities dealer community to fund government debt especially during this period of increased federal financing requirements and shrinking capital availability.

The recent introduction of stock index contracts and their instantaneous success is another clear example of the present demand for and acceptance of financial futures.  In less than six months of life, these contracts have challenged all other highly successful contracts for transaction volume leadership.  They have already produced a dramatic positive impact in the methodology of equity market utilization.

Index fund managers are effectively arbitraging cash portfolios with futures index contracts and money managers are learning to use these markets and their broadening liquidity base as a means of temporarily buying and selling the stock market before actually doing so in the cash equity markets. Stock index futures have been particularly helpful for a non-diversified portfolio which is seeking overall market protection.  Even equity underwriters have utilized them to reduce the risk in an unsold stock position.  This new methodology of risk protection for underwriters may enable many new companies, having no access to equity funding, to raise capital. Moreover, market makers, specialists, block traders and options traders have incorporated stock index trading in the normal course of their business as a means of reducing their risk exposure.

While the foregoing represents broad general uses available through the futures market, they do not spell out the many sophisticated and intricate maneuvers and applications that experienced participants have devised or are devising. Nor should one be fooled by the phenomenal growth or growing acceptance of this marketplace.  Financial futures are still very much in their infancy, and their utilization will expand with each new passing month and every new participant.

Nor do the markets presently in existence represent the end to the innovative process that produced them.  Inventive necessity, as it pertains to financial futures, is still on the upswing.  Competitive pressures among the exchanges are forcing new concepts and contracts to be explored and instituted.

New stock indexes and sub-index contracts are poised to be launched as are a full array of options.  Option contracts in themselves may represent a field of market applicability as vast and potentially explosive as its futures market counterpart. On the drawing boards of the exchanges, both in the futures and securities sector as well as in the minds of research staffers and economists, the possibility of financial markets are being discussed which today sound esoteric if not down right ridiculous. Contracts on the prime rate, the fed-fund rate, the repo rate, as well as index markets on consumer prices or freight rates and a full array of energy futures are all being considered.  While some of these may never be launched and some will be unsuccessful, the inventive process will go on.

It is therefore prudent to conclude these remarks on a note of caution. We are in the midst of a financial revolution requiring continuous review of the situation and swift inventive response to the demands of the times.  Financial futures are today the fastest growing sector of the financial world. But, it is also true that most axioms have their own counter-axiom.  In the case at hand, it is that our positive reaction to inventive necessity has an inherent danger.  Sometimes our zeal directs us toward the wrong invention.  Sometimes, the applied invention is either too early or too late. And in financial markets, timing is as important as being right. The exchanges should be particularly mindful of these hazards.  If they ignore them and guess wrong, or are too early or too late too many times, they may indeed find it difficult to recover.

For example, the Chicago Mercantile Exchange failed in its attempt to institute four-year and one-year Treasury bill contracts—the wrong invention or one that was too early; the Amex failed in its bid to become a financial futures exchange—it was too late; the New York Futures Exchange almost mortally wounded itself in attempting to reinvent that which was already invented; similarly, the New York COMEX has expended funds in an all but a futile attempt to duplicate successful market arenas elsewhere. This would also have been the case of their avowed interest to create a Pacific Coast Exchange.  Of equal futility, was the idea of an electronic link between the Chicago Board of Trade and the New York Futures Exchange. One must also wonder about the need for new futures contracts basically duplicating the purpose provided by the ones already successfully trading.

Exchanges, potential exchanges, and the business community they serve or intend to serve have the same failing as does the human race.  They are all too easily deluded by mass psychosis.  Everyone wants to get in on a good thing, even when it is too late or unnecessary. The financial cemetery is crowded with brazen entrepreneurs who bet their all on an imagined necessity whose time had already passed or represented but a passing social madness.

As I have often stated to the regulators of the Commodities Futures Trading Commission, economic justification is ultimately determined by the marketplace.  If the time for the idea is at hand, it will become irresistible.

Reprinted by permission. Excerpted from Melamed on the Markets, by Leo Melamed. John Wiley & Sons, 1993

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