A BRIEF HISTORY OF FINANCIAL FUTURES

Presented at the Seminar on Financial Futures
Shanghai, China
May 3, 1994

It is my very great pleasure to address you this morning on a subject that is very close to my heart.  Indeed, the Chicago Mercantile Exchange and I have become somewhat synonymous over the years as together we engineered the financial futures revolution.

Financial futures occasioned several milestones in their short history. The first two milestones, both of a revolutionary nature, occurred on the floor of the Chicago Mercantile Exchange. The first milestone was their very creation. The departure by traditional futures from their century old agricultural base and entrance into the world of finance dramatically changed their direction and history. By definition, no financial futures history could have ensued without its conceptual inception. It is clear today that the revolutionary concept sponsored by the CME in 1972 was destined to change the world of finance and become an indispensable risk management tool the world over.

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.

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.  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 then 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.

While there is no single action that stands out as the founding moment of the IMM, certain events clearly played crucial roles 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. It was the breakdown of these established relationships twenty-six years later, combined with other economic developments, that brought the need for a way to hedge currency fluctuation risk directly before the world financial community.  The problem was clear.  So was the solution.

At the behest of the CME, Dr. Milton Friedman 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 that he needed in just eleven pages.  His paper, entitled "The Need for Futures Markets in Currencies," provided the CME administration with academic authenticity of the highest magnitude to prove that their theory was a viable necessity.  As I often stated, "Professor Friedman gave our idea the credibility without which the concept might never have become a reality."  For with Dr. Friedman's paper in hand, we were 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. "The President's action (President Nixon) on August 15 in closing the gold window was simply a public announcement of the change that had really occurred when the two-tier system was established in early 1968," he observed.  "No one can be sure just what kind of a system will develop in coming years— whether the world will continue on a dollar standard or whether a substitute international standard will emerge."

As a result of Professor Friedman's strong support, the determination of the Exchange leaders, its Board of Governors and its rank and file members, the IMM was chartered by the State of Illinois in December of 1971.  It opened its currency contracts for trading on May 16, 1972.

Alas, hardly anyone recognized that event as significant back in 1972. Indeed, hardly anyone believed it to be of any consequence at all, and few gave it any chance of success. Pundits and critics mocked the idea, regarding it as no more than a joke or, at best, a quixotic impossible dream. Some simply thought it ludicrous that a "bunch of pork belly crapshooters" would dare contemplate treading on the hallowed ground of foreign exchange. But succeed we did. The reason? Quite simple! Victor Hugo explained it when he told us that no general was smart enough and no army strong enough to suppress an idea whose time had come. In fact, a New York foreign exchange expert was widely quoted a few months after Dr. Friedman delivered his paper: "I'm amazed that a bunch of crapshooters in pork bellies have the temerity to think that they can beat some of the world's most sophisticated traders at their own game."

But this missed the point.  The IMM was not out to beat anybody.  Instead, as traders around the world would learn, the new market was to become an important adjunct and alternative to the world's interbank market.  It offered money managers and foreign exchange traders an avenue to transfer their inherent risks unto the speculative world which, in turn, welcomed the opportunity.  It represented a new mechanism that grew out of necessity and became mandatory in response to the new financial era which had dawned.

But, as noted before, 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.  Its eventual approbation came as a result of the stubborn determination of its early protagonists.  Only a visionary few could have known at the time just how important, and how popular, these new contracts would become.  The phenomenal growth of the IMM and financial futures through a decade of international tension, high inflation, oil embargos and stagnant economies, stands as a tribute to the abilities, energy and patience of its founders.

The concept of a centralized market for transferring foreign currency risk gained momentum in 1971 when the dollar was devalued and member countries of the International Monetary Fund agreed to widen the original one percent parity to a 2-l/4 percent par value level.  This move was one of a series of steps leading up to the eventual collapse of the Bretton Woods Agreement which, in turn, ushered in an era of considerable risk in currency price fluctuation— risks which could be limited if there were a viable market for currency futures trading.

As noted, on May 16, 1972, the International Monetary Market opened for business, listing eight foreign currency futures contracts—British Pounds, Canadian Dollars, Deutsche Marks, Dutch Guilders, French Francs, Japanese Yen, Mexican Pesos and Swiss Francs.  For the first time, the economic benefits of risk transfer and price discovery that were indigenous to futures became available to those outside the agricultural sector. Trading on the new exchange began cautiously.  But, within two years, volume started to build momentum almost tripling, from 144,928 contracts traded in 1972 to 417,310 in 1973.

Early on, IMM officials saw an opportunity to encourage the growth of the fledgling foreign currency futures market by allowing firms to become Class "B" clearing members.  Designed to facilitate foreign exchange arbitrage between the interbank market and the futures market, these new members not only succeeded in forging a close link between the two markets, but also helped gain widespread acceptance of foreign currency futures as alternative trading instruments for cash market participants.

Gold Opportunities

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.  The Exchange introduced trading in gold futures that same day.  It represented the first expansion of IMM contracts into a second type of financial instrument and emphasized the exclusive specialty of the IMM Division.

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.  In just seven years, volume had grown to exceed 2.5 million contracts annually.

At the same time, enthusiasm for foreign currency futures trading continued to build.  More than 959,000 contracts changed hands during 1974 and 1975 firmly establishing the IMM as an important part of the global exchange network.

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.

A Growing Rate of Interest

The second 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 began in January 1976 and represented the most important stage in the revolution of futures markets which began with the currency contracts.  It also epitomized the broad scope of the IMM as the specialized financial futures division envisioned by its founders.

I should note that this leg of the journey was one that 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.  Their skepticism has not only vanished, but today, most Treasury Department officials will 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 few years without the existence of futures contracts.  Equally, the Federal Reserve has recognized the good that interest rate futures can do for banks and has not only permitted banks to use futures to manage risk but has approved petitions by several banks to become directly involved in the futures business. 

U.S. Treasury bill futures in their first five years grew to become the largest contract of any on the CME or IMM with more than 5.6 million transactions in 1981. Moreover, they were an indispensable hedge vehicle for money managers and government dealers whose overwhelming acceptance of this contract prompted Exchange officials to pursue additional interest rate futures. 

As transactions in foreign currency, gold and interest 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

The third 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. 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.

The third major stage in the development of these futures markets was as revolutionary as their very introduction in the first place.  It again 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 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 against risk in the stock market.  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, however, overcame these obstacles and thus in 1982 the Merc got into the stock index business with a contract on the Standard and Poor's 500 index of stock prices.  The S&P 500 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 premier stock index contract, one that today has captured over 75 percent of the business in this market sector. 

Options

The next important development in our markets was brought about by the lifting of a 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 offer market users an unending array of applications and therefore give us every reason to feel that these instruments represent a new successful dimension of futures markets.

Mutual Offset

Finally, financial futures took another giant leap in 1984 when a mutual offset system 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 position (long or short) in a given futures contract at the Merc can be offset by an equal and opposite transaction (buy or sell) at the SIMEX or vice versa.  Obviously, such a system of mutual offset represents an extremely cost-efficient methodology for global trading of futures and will no doubt be a very positive influence on the continued growth and use of these markets.

GLOBEX

Another milestone for financial futures, inspired by the telecommunications revolution, was also led by the CME. For all the landmarks have a single common denominator; each represent a dramatic departure from status quo. GLOBEX—the automated global transaction system developed by the CME and Reuters Holdings PLC—represents a move toward automation in the transaction process. It touches 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.

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.

This brief history of financial futures, hopefully, has given you a general idea of their development and will enable us now to take a closer look at these markets themselves.  Clearly, the mechanics of futures trading as well as the nature of contract specifications is every bit as interesting as what is traded. 

The most striking thing about futures noticed immediately is that the units of trade of a given contract are all the same.  In other words, rather than being personalized as in the commercial world, futures contracts are standardized.  Indeed, while in the spot market you can buy or sell U.S. Treasury bills with maturities ranging from a few days to a year, in futures you can only trade in units of $1 million of U.S. Treasury bills with exactly 13 weeks to maturity.

Moreover, futures contracts can be settled only at a limited number of set times during the year.  In the case of the Treasury bill contract, delivery can take place only in March, June, September or December.  In the spot market, of course, delivery can be made at any time that is acceptable to both sides of the transaction.

At first glance, one may consider such a high degree of standardization to be very restrictive.  Actually, this is the very element of futures that gives them their wide appeal.  Even though a futures contract may seldom offer the precise specifications needed in a prospective commercial transaction or hedge, it serves as a model for a wide range of commercial needs and uses.  Their standardization thus allows a wide range of people who face risk in a wide range of specific commodities to focus their attention on a single market—the market for the futures contract.  The result of that focus is a concentration of liquidity.  And, it is the liquidity that you can find in a futures market together with the resulting low costs of buying and selling that endow them with their primary virtue.

The way we trade is another important reason for the success of futures markets.  First, all trading is done by open outcry in a competitive arena.  If you wish to buy or sell, you must shout the price for everyone surrounding you to hear.  Second, our markets are open to anyone.  We do not keep people out of the market because we do not know them—nor do we ask their commercial reason for trading.  As a result, complete strangers, from commercial and investment worlds, who might otherwise never have done business together, are given access to a trading arena allowing them to transfer or assume risk.  This is an important virtue of futures markets which should be obvious and a point to which I would like to return shortly.

The Success of Financial Futures

Financial futures have been so extraordinarily successful since their creation because they are especially useful for managing risk, and they do not allow embarrassing losses to be swept under the carpet.  Consider these in turn.

First, consider the efficiencies.  Everyone who does business in financial markets finds his business to be a complex combination of performing services and taking risks.  Take, for example, the government securities market in the United States.  In our country, the job of buying and distributing the government securities sold weekly by the U.S.  Treasury has fallen quite naturally to a relatively small group of government securities dealers.  Their chief function, of course, is to distribute these securities to their ultimate investors. 

In doing this job, however, each dealer finds it worthwhile to make a market in these securities, and this function—together with the task of buying and distributing the securities—requires a dealer to hold large quantities of bills, notes and bonds.  And, of course, having to hold a position exposes the dealer to risk. How does the dealer cope with the inherent risk of his profession?  Well, before the advent of interest rate futures, he had two options—he could limit the size of his position, or he could take an offsetting position in the forward markets.

The first approach to managing risk interferes with his function as an underwriter.  If he is concerned with interest rate risk, he bids less aggressively in Treasury auctions and requires higher bid/ask spreads to compensate him for making a market—the higher resulting costs are then necessarily passed on to the consumer.

The second approach to managing risk, trading in the forward market, is costly, cumbersome and has the undesirable effect of blowing up the size of his balance sheet.  Since forward trades are made between specific individuals, the dealer who sells into the forward market and later buys in the forward market most often will have two positions on the books—a short position resulting from the first trade, and a long position resulting from the second.  As you can imagine, enough of these trades can produce bloated balance sheets fraught with credit risk.

In contrast, opposite trades done in the futures market are completely offsetting.  Since they are all fungible, it does not matter which obligation is offset with which trade.  That is, a short sale followed by a purchase, or vice versa, will leave the dealer with no position at all. He will be out of the market altogether rather than having to carry the burden of a complex network of short and long positions in the forward market.

Thus, with financial futures, the government securities dealer is armed with a superb risk management tool that allows him to hold as large a position as he thinks is necessary for him to compete effectively in doing his job.

The same is true for banks.  The main function of a bank is to provide transactions services and to be an intermediary between lenders and borrowers.  In the past, however, these jobs also required a bank to undertake the risk exposure to changes in interest rates.  Depositors seldom want to lend at the same maturities at which borrowers would like to borrow.  Faced with such risk, a bank would demand compensation in the form of a lower rate paid to lenders and a higher rate charged to borrowers.

Now, however, banks can balance their risk exposure efficiently by taking positions in futures markets.  There is no longer any need to impose on their clients the costs of bearing interest rate risk.  As a result, banks are able to perform their primary function.

A natural question, of course, is how much all of this matters.  On this score, I can assure you that futures markets matter a great deal.  Our interest rate futures markets close at 2:00 PM Chicago time, 3:00 PM New York time.  This, however, does not mean trading in government securities ends at that time -- it does not.  But, the trading that continues after our market closes is done at bid/ask spreads that can be twice as wide as those available while our markets are open.  By the same token, the trades done without our markets are considerably smaller in size.  The reason, of course, is that a commercial trader is far less willing to take on a position he cannot immediately hedge in the futures market.

The difference this makes to the public good is quite obvious.  The bid/ask spreads available when the futures markets are closed are those you would see all the time if there were no futures markets.  And, the cost of these larger bid/ask spreads would be borne either by the taxpayer (who would have to pay the higher borrowing cost associated with the lower bid) or by the investor (who would get the lower return associated with the higher offer).  All in all, it is quite clear that financial futures have been of significant benefit to the U.S. debt markets and thereby to the American public.

I should note that the corporate sector also reaps substantial savings from our markets.  The investment banking firms who underwrite corporate bond issues hedge their risk in futures markets.  Because they can do so, they are willing to bid more aggressively for the right to underwrite corporate bonds.  The result of more aggressive bidding is a lower cost of for the corporate borrower.

Another aspect of the efficiencies permitted by futures contracts stems from their use as a temporary substitute for doing a trade in the cash market where transactions costs can be quite substantial.  Consider, for example, the problem faced by someone who manages a portfolio of stocks but who is worried about a decline in the general stock market.

Before the advent of stock index futures contracts, the only way to deal with the risk of a decline in the stock market was to sell stocks out of the portfolio.  Anyone who runs a portfolio hates to do this for two reasons.  First, to sell a stock and later buy it back is expensive in terms of market impact and brokerage commissions.  Second, and possibly worse, is that the portfolio manager selected those stocks for a reason -- he believed those stocks would yield higher rates of return than other stocks available in the marketplace.

The portfolio manager's dilemma is that he wants to sell the market but keep his stocks.  This dilemma is resolved by the stock index futures contract.  Using the S&P 500 futures contract, the portfolio manager—if concerned about a decline in the stock market—can retain his stocks while selling the stock index futures.  The transaction costs of this approach are demonstrably lower than the costs of actually selling the stocks and buying them back again.  And, of course, the productivity of the fund manager's research department is enhanced if the stocks in the portfolio outperform the market, enabling the fund manager to reap those rewards even if the stock market does decline.

The last point I would like to make concerns a property of futures markets appreciated by all too few.  Recall that we require everyone to settle their losses at the end of every day.  This practice is called mark-to-market, and if a trader fails to make good his losses (no one ever turns down gains), his position is closed out and he is not allowed to trade.

Requiring all gains and losses to be settled each day has the striking salutary effect of requiring those who sustain losses to recognize them the instant they occur.  It is impossible to let losses ride or to sweep them under the carpet.  The importance of this feature for banks and other financial institutions should be clear.  The failures of Herstatt Bank in Germany and Franklin National Bank in this country were in large part the result of trading losses hidden either from management or from the public eye, or both.

Major banks in Japan have not been immune from such problems.  Fuji Bank, for example, recently sustained major losses due to unauthorized trades -- and the losses were compounded because they were kept hidden from management's view.  Such a thing almost certainly could not happen with futures. 

A trader might make an unauthorized trade but, if he were to sustain a loss, we would require the loss to be made good the next morning. As a result, the comptroller of the bank who must cover the loss, knows immediately about the trades.  As a result, the position cannot be tucked away in a drawer or under a blotter and the losses cannot be allowed to run.  In this way, futures contracts provide an exceptionally effective management tool for those whose job it is to monitor the financial integrity of their companies.

Derivatives

Historical and anecdotal references notwithstanding, it fair to say that the modern concept of financial derivatives as tools in business dates back only about twenty years. The process was initiated by the financial futures revolution in the early 1970s when the International Monetary Market was launched at the Chicago Mercantile Exchange with the express intent of developing futures trade in financial products. This innovation created the first broad-based risk management instruments and ushered in the Era of Financial Futures. 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.

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.(1) 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. The bulk of derivatives trading presently 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.

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.

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.

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.

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     (1) Robert Lenzer and William Heuslein, "The Age of Digital Capitalism", Forbes, 29 March 1993, 62-66, 71-72

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