(This article first appeared on Oct. 23 in the Heartland Institute’s Heartlander Magazine: http://www.heartland.org?)
Financial professionals are well aware that the ongoing implementation of the Dodd-Frank Act will likely cause changes to market structure, including in the futures markets. Should market participants be concerned? The short answer is not necessarily, given that the history of U.S. futures trading has been one of responding to constant adversity, man-made or otherwise, through innovation.
Beginnings of U.S. Futures Trading
Arguably, the story of U.S. futures markets has largely been one of innovation in Chicago with several notable exceptions.
Once Chicago became a transportation hub and grain terminal in the mid-19th Century, grain merchants had to figure out how to manage the price risk for their accumulating volume of grain inventories. That solution was the development of a formalized exchange: the Chicago Board of Trade (CBOT).
At the time, Chicago was already a well-established center of financial risk-taking because of the land speculation that had occurred in Illinois in the 1830s during the building of a crucial canal that ultimately linked productive Illinois farmland to major population centers.
‘No Intent or Design’
In a pattern that would repeat itself, the Chicago Board of Trade’s existence was the “result of evolution, not intent or design,” wrote John Stassen, a derivatives legal expert, in a 1982 law journal article. “The Chicago Board of Trade was created by businessmen as a commercial exchange for businessmen – grain merchants – who needed some order in a world of chaos, and some relief from a hostile judicial system which only reluctantly enforced businessmen’s bargains. … [T]he courts in Illinois, as in most states, adhered to old English precedent which places damages for expected profits on a par with usury,” explained Stassen.
Granted, merchants in Chicago were not the originators of the concept of futures contracts. In his 1971 textbook on commodity markets, Professor Thomas Hieronymous of the University of Illinois noted: “The concept of futurity in contractual arrangements is as old as commerce. The rules of futures trading certainly date back to the medieval fairs of France and England which were large and complex by the 12th Century.”
“[B]ut as a practical matter,” Hieronymous continued, “we need look no further back than the frontier of the U.S. in the mid-19th century for the origin of modern futures trading.” He wrote the “circumstances of the frontier, particularly in the grain trade, were the catalyzing agent out of which futures trading grew.”
Hieronymous quoted an 1896 academic journal describing the business conditions of the mid-19th century: “Untrammeled by business traditions of past centuries … the trade of this country has unconsciously adopted new and direct means for attaining its ends. There has been little ‘history’ or ‘evolution’ about the process, for the practical mind of the business man has simply seized the most direct method of ‘facilitating’ business, a course forced on him by the constantly increasing size of transactions.”
‘With Crisis Comes Opportunity’
With hindsight, we know that Chicago’s century-plus heritage of financial risk-taking has served the city well. For example, it was Chicago futures traders who responded successfully to the dislocations that were caused by the collapse of the Bretton Woods system of fixed foreign-exchange rates, which President Richard Nixon unilaterally ended in a surprise announcement on August 15, 1971. The Bretton Woods system had been established near the end of the Second World War and was based on the U.S. dollar being redeemable for gold in foreign exchange. In his surprise announcement, Nixon said America would end the convertibility of dollars to gold.
The Chicago exchanges developed financial hedging instruments in both currencies and interest rates in the 1970s and 1980s. This development can be seen as a classic case of “with crisis comes opportunity.”
Given that the launch of financial futures trading in Chicago did become hugely successful, it may be surprising to read about the early skepticism that greeted these efforts, as discussed in 1994 by Leo Melamed, chairman emeritus of the Chicago Mercantile Exchange (CME) Group, Inc.
According to Melamed, “Some … thought it ludicrous that [in the early 1970s] a ‘bunch of pork belly crapshooters’ would dare” launch futures contracts on foreign exchange.
In fact, former CME Chairman Jack Sandner would later proudly explain, “Financial futures were spawned out of the belly of the hog.”
The maxim “with crisis comes opportunity” has been a constant for the Chicago futures exchanges and predates the collapse of the Bretton Woods system.
For example, in the 1960s the CME had to develop new futures contracts because its mainstay futures contracts in eggs and butter had become obsolete. “Technological changes had transformed the production and distribution of butter and storage eggs from seasonally produced commodities with classical production and price cycles to basically new and different products in their production, price, and distribution patterns. The economic necessity of hedging markets provided by a futures market had greatly diminished,” recalled Everette Harris, the former president of the CME, in 1970.
What was the response of the futures industry to this crisis? Innovation. Starting in the early 1960s, the CME began introducing livestock futures contracts. As of 1980, the live cattle futures contract had become the largest contract on the exchange, according to a speech at the time by Leo Melamed.
NYMEX Another Innovator
Admittedly, Chicago has not been the only center of innovation in U.S. futures market development. In the 1970s, for example, the New York Mercantile Exchange (NYMEX) had arguably faced possible extinction when its mainstay contract, the Maine potato, lost credibility during scandals in 1976 and 1979. Fortuitously, the NYMEX responded to an emerging opportunity. The structure of the oil industry had changed after numerous nationalizations in oil-producing countries. This forced some oil companies to shift from long-term contracts to the spot oil market, according to Pulitzer Prize winner Daniel Yergin in his book, The Prize.
With the structure of the oil industry changing, an economic need for hedging volatile spot oil price risk emerged, to which the NYMEX responded with a suite of energy futures contracts, starting with the heating oil contract in 1981.
According to Yergin, “The initial reaction to the futures market on the part of the established oil companies was one of skepticism and outright hostility. … A senior executive of one of the … [major oil companies] dismissed oil futures ‘as a way for dentists to lose money.’” But, he noted, the practice of futures trading “moved quickly in terms of acceptability and respectability.” Price risk meant many businesses had to participate in the futures markets.
Electronic Trading Competition Response
Later, new threats confronted the established U.S. exchanges. The CBOT, CME, and NYMEX had to face up to competitive threats resulting from electronic trading. The starkest example came from Europe in 1998. At that time, the electronic exchange, the EUREX (DTB), successfully wrested control of the 10-year German government bond futures contract, the Bund contract, from the (then) open-outcry LIFFE exchange in London with a “price war on fees.”
This unprecedented victory of an all-electronic venue accelerated change in Chicago. Soon thereafter both the CBOT and CME embraced concurrent open-outcry and electronic trading. Under pressure from ICE Futures Europe, an innovative electronic futures exchange, the NYMEX listed its energy futures contracts on the CME’s Globex electronic trading system in 2006.
In the late 1990s, worries about Chicago’s continued competitiveness continued unabated. According to Melamed in his 2009 autobiography, “the only way to prepare … [the CME] for the twenty-first century” was to demutualize; a member-driven organization would be too slow in its decision-making. Therefore, the CME went public in 2002, becoming the first U.S. financial exchange to do so.
By 2006, the Chicago Mercantile Exchange’s trading volume “exceeded 2.2 billion contracts – worth more than $1,000 trillion – with three-quarters of … trades executed electronically,” according to the CME.
In 2007 the CBOT merged into cross-town rival CME; and in 2008, the NYMEX merged into the combined Chicago exchange.
Confirming Melamed’s concern on how important the global environment could become, Futures Industry Magazine reported last year that two-thirds of all futures volume was traded outside the United States.
Adversity an Essential Element
Given the narrative above, perhaps one does not need to emphasize how much adversity is an essential part of the story on the evolution of the futures industry. After all, adversity is the story of trading itself. Author Ralph Vince stated in 1992 that trading “requires discipline to tolerate and endure emotional pain to a level that 19 out of 20 people cannot bear. … Anyone who claims to be intrigued by the ‘intellectual challenge of the markets’ is not a trader. The markets are as intellectually challenging as a fistfight. … Ultimately, trading is an exercise in self-mastery and endurance.”
Perhaps the same can be said about product development in the futures markets, whose history is largely one of overcoming failure and skepticism.
The CME’s Everette Harris noted in 1970, in words that still ring true today, that an enduring philosophy of the CME has been an acceptance of the possibility of failure in its new product ventures: “Necessity is the mother of invention. Beginning in the early fifties … [CME] members have vigorously researched, tested, and promoted many new contracts for futures trading. . . . Some have succeeded and some have failed, but fear of failure has not impeded progress.”
Always Resilient, Innovating
In this brief review of the history of U.S. futures markets, one does get a sense of the resiliency of these institutions, in constantly responding to adversity, from their earliest days and well into the present. Based on this history, one would expect that resiliency to continue, but not through some “designing intelligence,” but rather through a willingness to continue to innovate through trial-and-error efforts.
Arguably, this insight may be the most important lesson for emerging new financial centers, as well.
Hilary Till provides advice on risk-management and derivatives trading issues through Premia Risk Consultancy, Inc. In addition, she is a co-founder and principal of Premia Capital Management, LLC. She is also the co-editor of Intelligent Commodity Investing, a bestseller for Risk Books.
Previously, Ms. Till held positions in expert-system development, derivatives risk-management system development, foreign-exchange derivatives research, over-the-counter (OTC) equity derivatives research and trading, OTC interest-rate derivatives trading, commodity futures trading, commodity-index portfolio management, and fixed-income risk-management policy development.
Her prior positions include her appointment as Chief of Derivatives Strategies at Putnam Investments; Ms. Till was a quantitative analyst at Harvard Management Company. While at Putnam Investments, Ms. Till represented the firm on derivatives matters to U.S. regulatory agencies, the company’s mutual fund trustees, and to Putnam’s institutional clients.
Ms. Till has a B.A. with General Honors in Statistics from the University of Chicago and an M.Sc. degree in Statistics from the London School of Economics (LSE). She studied at the LSE under a private fellowship administered by the Fulbright Commission.