THE BIRTH AND DEVELOPMENT
OF FINANCIAL FUTURES
at the China Futures Seminar
Zhen, Guangdong Province, China
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.
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
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 correctand for me, his unwavering
belief in free market forces represented a god-like logic which
could not be questionedthen the time was right to extend futures
markets and take them from their narrow agricultural base to the
unlimited horizon of finance.
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 endorsewhen
Bretton Woods collapsedthe 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.
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
the entire history of financial futures in the United States during
the last 24 yearsas they moved from their embryonic stages
of the early 1970s to their present dominant position in risk managementshould
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.
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.
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.
the IMM began life with foreign currency contractsitself a
revolutionary departure from the theretofore agricultural base for
futuresit 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.
16, 1972, the International Monetary Market opened for business,
listing seven foreign currency futures contractsBritish 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
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:
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.
private ownership of gold by U.S. citizens was legalized on
December 31, 1974, the IMM quickly responded with a new financial
futures contractgoldthat 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.
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.
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 securitiesTreasury 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.
leg of the journey was not easy. The U.S. government's two
major financial institutionsthe Treasury Department and the
Federal Reserve Boardwere 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.
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
Cash Settlement - Eurodollars
- Stock Index Futures
major milestonecash settlementcame 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.
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.
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 differencein cashbetween the value of
the instrument at the time it was bought and the time it was sold,
or vice versa.
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.
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
contemplatedfirst by way of Eurodollar futures, a contract
on LIBOR time deposit rates, and then later with the introduction
of our stock index futures.
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.
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
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.
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.
GLOBEXthe automated global transaction system developed by
the CME and Reuters Holdings PLCrepresented 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.
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.
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.
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 economiescoupled with
advancements in computer technologytransformed 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
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.
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.
of such contracts can be placed into one of four categories: foreign
exchange, interest rate, commodity, and equityreflecting 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.
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
waysfrom 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
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.
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.
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.
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.
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 environmentan environment
driven by instantaneous information flows and sophisticated technologyfinancial
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.
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 strategya 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
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