THE BIRTH AND DEVELOPMENT OF FINANCIAL FUTURES

Presented at the China Futures Seminar
Shen Zhen, Guangdong Province, China
April 25, 1996

Background

It 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 futures revolution.

Actually 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.

In 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.

It 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. 

"Bretton 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.

The Birth of Financial Futures

Indeed, 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.

To 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 to match.

The 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 and inspiration.

Although 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.

On 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.

If it Works with Currency Futures, the Sky's the Limit

In 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 I envisioned:

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.

When 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. 

But, 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.

The 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 markets.

This 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. 

As 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.

Cash Settlement - Eurodollars - Stock Index Futures

The 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.

Cash 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.

The 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.

Eurodollars, 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.

After 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.

For 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.

Not 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.

Mutual Offset and GLOBEX

In 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.

However 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.

The 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.

Derivatives

The 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.

Financial 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.

The 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.

Clearly, 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.

The 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 alphabet.

We 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.

In 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.

These 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 risk enlightenment.

In 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.

In 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.

When 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.

It 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.

Thank you.

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