The growth of financial futures has been one of the more remarkable success stories of the latter part of the 20th century. So much so, that it is hard to imagine a world without them — even though their age is a relatively green 40-years-old. It all began with the Chicago Mercantile Exchange’s International Monetary Market (IMM) and currency futures. Coincidently enough, financial futures are the same age as Futures. With September being our currency focus, we thought it was a great time to sit down with the architect of the IMM, Leo Melamed. Melamed details the difficult steps of getting this new concept for futures off the ground, its early hurdles and how the influence of future Nobel Laureate Economist Milton Friedman legitimized the idea in the eyes of the world’s economic leaders.
Futures Magazine: Leo, you have stated in the past that the idea for the International Monetary Market (IMM) was a broad one, encompassing many different kinds of financial futures in multiple sectors. Why were currencies the first?
Leo Melamed: There were a variety of reasons. First of all, currencies were in the news all around the late 1960s and early 1970s. The issue of whether flexible exchange rates would replace the fixed exchange rate system of Bretton Woods was uppermost in the news. You couldn’t open a newspaper in 1970 without seeing somewhere in the business pages the discussion about the fixed exchange rate system and the strong voice of Milton Friedman saying that he didn’t believe in fixed exchange rates and that they would not be able to be maintained going forward. So I was very cognizant of the currency issue. My main objective at the Merc was to diversify. I was very much conscious of the fact that when I was [just starting out] as a runner at the Merc, [the Exchange] had lost the butter and egg market, [its] dairy products went under and [it was] a one-product exchange.
[We] tried turkeys, potatoes, shrimp, but it was always agriculture because that was the definition of futures. So here is all around me this discussion about currencies and whether the fixed exchange rate would survive, and bingo — the light went on. Why not try currencies?
FM: Did you have much internal opposition?
LM: At the time I was under 30 and all the board of directors were just under 130, I thought (laughes). They all thought this young kid was going to bring the exchange down, like they had such a big deal. But I needed the votes. I needed a credible voice to say it was a good idea and the only credible voice I could think of was Milton Friedman.
FM: How did you convince them?
LM: I couldn’t get the board of directors’ approval. I couldn’t get the seven votes [I needed] without showing some credibility on this idea. I met with [Friedman] in July [1971] and said ‘I want to launch a futures market in currencies; do you think that’s an ok idea?’ He said, ‘That’s a terrific idea. I don’t know how soon it will be viable because [exchange] rates are fixed, but it won’t be too long before they are no longer fixed. You have to get a head start. It is a great idea, do it.’ I said, ‘Nobody is going to believe me,’ so he said, ‘Tell them I said so.’ I said, ‘I need it in writing,’ and he said, ‘You want a feasibility study on why currencies would make a good futures market?’ I said, ‘Exactly,’ and he said ‘I am a capitalist.’ I said, ‘How much?’ So the study cost us $7,500 and that $7,500 is worth some $18 billion to the Merc today; it was a good trade. That was July. In August, Nixon closed the gold window and then of course all hell broke loose, and I knew fixed exchange rates were not going to last. The idea was now much more valid than before and I was racing. We incorporated the IMM in December of 1971. ...The charter of the IMM said financial instruments. I knew from the beginning that if it was successful in currencies, finance was wide open.
FM: Talk about the impact of Milton Friedman in helping legitimize this effort.
LM: When Milton Friedman agreed with us, the world took notice. His 1971 paper explaining futures on currencies was the most important factor to give us credibility. His name made the difference. Because of his paper, people who otherwise would not listen gave us an audience. Private-sector officials, who otherwise would not have approved, gave us approval. Presidents, financial ministers, central bankers who otherwise would not have allowed us near their doors, opened the door for us. It was magical! I met with Secretary of the Treasury George Shultz and sent Friedman’s paper [ahead]. All he said was, ‘If it is good enough for Milton, it is good enough for me.’ His name was magic. After the launch, I met with every central banker in Europe and it was the same message: The great economist Milton Friedman thinks this is a great idea. And it worked.
FM: Were there any significant mid-course corrections you needed to make in the early days of these markets?
LM: Yes. When I first did all the research on how big the contracts should be and which currencies to trade, we ended up with seven currencies and went to commercial firms and banks. Well, most banks said this is not going to work, but if it works you [must] get the banks to use it, and if you want the banks to use it you [must] have big instruments. [They] trade in $1 million contracts so you have to have $500,000 contracts. So the original contracts were about $400,000. The locals who barely had enough money to buy a $10,000 membership were resistant. So I cut them in half. It got a little better, and in six months I cut them again to $100,000. Then it clicked.
FM: When did you know this experiment with currency futures was a success?
LM: There was a critical moment that made a huge difference [around] September 1975 when the Mexican peso was devalued. It devalued by more than 50%. Because normally futures margin was about 3%, we held very little money. We raised the margin when the standard deviation increased. If I had not prepared for the devaluation of the Mexican peso, we might have seen the end of the IMM in ’75. I came to the conclusion that there was no way that Mexico could get out of its troubles without devaluing the peso, and big. Because I was worried that the clearing members would fail and we would fail, we instituted, [roughly] three months before it happened, raising the margin by 30% on peso longs to the clearing firms.
The day it happened, Bill Butcher, chairman of Chase Manhattan, called right after the devaluation and said ‘Leo, I love the market you have, I know you are in trouble today. Chase Manhattan is prepared to give you $100 million to cover the losses in the clearinghouse for the Mexican peso.’ I said, ‘I can’t thank you enough, but we don’t need your money; we raised the margin months ago. We have more than 30% covered; we are fine.’ It was the moment of justification for the IMM. The strength of the clearinghouse was proven at that moment and our volumes took off after that.
FM: Many folks, even within the industry, simply view futures as instruments to trade. Talk about what global economic benefits financial futures in general, and currency futures in particular, have wrought.
LM: It is beyond my ability to explain because it was soon recognized as an economic tool of such great proportion that any nation that aspired to be a financial center had to have such a market. They grew up like mushrooms all over the place, starting in the ’80s. By 1981 London recognized that it needed such a market. Once that happened, everyone ran to the drawing board. It was a fantastic economic tool, the cheapest way to [manage] a risk that anybody ever invented. It was efficient, it was cheap and it freed up so much capital that the private sector could use for all kinds of other investments. Even if it wasn’t used, the commercial knew [he] had somewhere to go. When the dealers bought American government debt every Monday morning, they could afford to bid better for the American taxpayer because they knew there was a layoff market that they never had before.
FM: Did you see futures as competing with or complementing the inter-bank market? How has that relationship evolved over the years?
LM: It was a little bit of love/hate. They didn’t think much of the futures market at the beginning. They didn’t consider it a competitor at all. Later they learned to use it and it became a profit center, so then we became good friends. To this day, we have a little competitive attitude because now we are an important success. They have taken a lot of what we instituted and applied it themselves, so they do compete in many ways. But currencies grew over the course of 40 years far beyond anybody’s imagination; trillions of dollars are traded a day. The market got so much bigger that there is no complaint on their side that the IMM took away their business, because their business continued to grow. So we are harmonious in many ways and complement each other.
FM: What is the future of forex markets, both futures and over-the-counter?
LM: It is huge. It is the one market that never stopped growing. Many markets have waxed and waned; not this one. This one keeps going because of the globalization of the world. Look at what is happening to the euro. Isn’t that the number one issue facing the world? The value of the euro, will it exist? I do know that when China’s renminbi becomes [flexible], which will be soon, three years at the most, that will create enormous activity in the currency markets. All I can see is continued growth.
FM: The futures industry may be facing one of its more challenging periods. The MF Global debacle shook the industry and PFG showed that the customer protection problems MF Global revealed could not be dismissed as a one-off event. How serious is the crisis of confidence?
LM: Not as serious as the press is making it out to be. There is a bit of a shake-up, and remember the reason the event was as stark as it was, is because we went for more than 150 years without a problem; we went through the meltdown of 2008 [without a problem]. The fact that our industry in the downfall of Bear Stearns, Lehman Brothers and AIG and everything else held strong, that says a lot and that hasn’t changed. Now, I grant you that we have MF Global, but that is a consequence unfortunately of current times and so is the PFGBest thing, and it did shake up [the industry]. It is serious enough for the CME to do something about it. We cannot ignore it. We already have instituted some immediate changes that deal with how fast we will have to learn if the clearing member moves some money around, and we have put on the table a number of ideas that include a custodial concept. There will be other things on the table. We are going to study this so that we don’t make a mistake. When we come out of it, we will come out of it with a much stronger, secure system of segregated funds for the customer. We have to. It happened, and we can’t ignore it.
FM: Of the various solutions offered, which do you support? Which ones do you think are a mistake?
LM: The insurance is not viable, and the federal government involvement? That isn’t anywhere I would go. The idea of a custodial is a good idea; it has to be vetted. The big banks don’t need it and don’t want it. In their view, they are at an advantage. If you run this theory to its conclusion, it would say you only trade with a big bank because your money is safer there. But JPMorgan showed they could lose $9 billion with a [London] Whale, so I am not convinced of that. The fact that you could have money laundering at HSBC, and you have the Libor thing and you can’t draw that line too well. The smaller firms wouldn’t mind the custodial approach. If a custodial operation were in effect, it would help the smaller [futures commissions merchants] (FCMs). You [must] have the smaller FCMs because the large FCMs don’t want the small customer, he is a pain in the rear. For us, those are important customers, they create a hell of a lot more liquidity than a block trade does. We’ve got to protect that. It is what we are wrestling with right now.
FM: Do you think the days of self-regulation are over?
LM: I would like to think that self-regulation is still the best way. However, like all things, you become a little too complacent sometimes and that is the time you have to review and reconstruct, and that has to happen. But I wouldn’t give up the self-regulation role. What we have to do is never be complacent. You go for a long stretch of time and you think you [have] everything in place, and then you are shocked into reality where suddenly something happens like MF Global and Peregrine. That shakes you up and causes you to review and restructure. That will happen, and we will be all the better for it.
