Chicago’s rich endowment includes both its geography and its many financial and intellectual risk-takers, dating from the 19th century through today. The city’s endowment led to the development of the futures industry, sustained the industry during adverse times and continues to play out in new and unique ways.
A significant part of the history of U.S. futures markets includes the story of Chicago innovation. Once Chicago became a transportation hub and grain terminal in the mid-1800s, grain merchants had to figure out how to manage the price risk for their accumulating volume of grain inventories, which one creative author referred to as “prairie gold.” Eventually in 1848, the solution was the formation of an exchange: The Chicago Board of Trade (CBOT), whose function gradually evolved from arbitrating commercial disputes and spot trading to bilateral forward trading, and finally to becoming a member-owned exchange with standardized futures contracts.
By the mid-1800s, Chicago already was 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. This canal was completed in 1848, by which time it already was on “its way to becoming obsolete” because of the opening of the railways, according to a former DePaul University history professor. With both the canal-building and the railway-building projects, a large measure of public corruption was involved, making you realize how truly deep-rooted this particular tradition of Chicago and the state of Illinois actually is. But happily for Chicago, there was a sufficient number of productive merchants to tip the balance of the “production-to-corruption ratio” toward prosperity, quoting a concept originated by Janet Tavakoli, a Chicago derivatives expert. In the mid-19th century, the productive merchants in Chicago included the founders of the CBOT, who started the city’s tradition of finding opportunity in crises. At the time, this included the Crimean War and later the U.S. Civil War.
“By the time of the Crimean War in the 1850s, Chicago, with its rich outlying agriculture area, was in an excellent position to supply the disrupted world grain trade. During the [U.S.] Civil War, Chicago served as the chief grain concentration point of the Union armies,” wrote the late Thomas Hieronymous, a professor at the University of Illinois, in a 1971 textbook. And with the concentration of grain in Chicago came the need for managing the price risk of these immense inventories during the unpredictable times brought on by the two successive wars.
The CBOT’s first directory of 25 members included “a druggist, a bookseller, a tanner, a grocer, a coal dealer, a hardware merchant and a banker,” according to a CBOT historian. From this directory, we can see the start of commodity speculation as being separate from the business of the commodity itself. Derivatives legal expert John Stassen explained in a 1982 law journal that the formation of the CBOT resulted from businessmen seeking “some order in a world of chaos, and some relief from a hostile judicial system, which only reluctantly enforced businessmen’s bargains.”
This would not be the last time that financial innovation resulted from an unwelcoming legal environment. The late Merton Miller, a Nobel-prize-winning University of Chicago economist, discussed the financial innovation that followed the Glass-Steagall Act: “By a curious irony, the vast structure of financial regulation erected throughout the world during the 1930s and 1940s, though intended to, and usually successful in throttling some kinds of financial innovation, actually served to stimulate the process along other dimensions.” (This quote was drawn from David Baeckelandt’s presentation to the CFA Society of Chicago on “Chicago’s Financial Firsts.”)
In hindsight, we now know that Chicago’s century-plus heritage of financial risk-taking served the city well. It was Chicago futures traders who successfully responded to the financial dislocations that were caused by the collapse of the Bretton Woods system of fixed exchange rates. Commercial market participants needed to hedge new risks and could do so with financial futures, which the Chicago exchanges developed in the 1970s and 1980s. Given that the launch of financial futures trading in Chicago became hugely successful, it may be surprising to read about the early skepticism that greeted these efforts. Leo Melamed, chairman emeritus of CME Group, loves to repeat the story of how one prominent New York banker stated, “What, we are going to trust finance to pork belly traders!”
This skepticism continued. In 1982, Institutional Investor pronounced the then-new Eurodollar futures product as just about dead: “Eurodollar contracts do not appear to have much of a future … Five months after their noisy launch on the Chicago Mercantile Exchange, Eurodollar contracts still haven’t caught on,” according to a citation in a CME brochure.
One should note that there were fledgling efforts at other exchanges that predate the Chicago exchanges’ entry into financial futures. “Nevertheless, ultimately [financial futures] contracts thrived … [only] in Chicago, which contained by far the biggest pool of experienced futures traders,” wrote Hal Weitzman, director of intellectual capital at the University of Chicago’s Booth School of Business.
Weitzman’s observation is still relevant. In a 2013 Opalesque Round Table on Chicago, Paul MacGregor of FFastFill noted: “Chicago is … the only town in the world I have ever found where you can walk into a large proprietary firm [and] what you see is literally three guys: The trader, the technology guy and the manager, and that’s it. And then you look at the kind of volumes they are trading and you are just staggered. You don’t see that … anywhere else in the world.”
Another reccurring historical theme in Chicago is the need for constantly developing new products. For example, “In response to slumping trade in its traditional contracts, the [Chicago] Board of Trade … [initiated] soybean futures [contracts] in 1936, soybean oil contracts in 1950 and soymeal futures contracts the following year,” wrote Weitzman.
Later, in the 1960s, the CME had to develop new futures contracts because its mainstay contracts had become obsolete. What was the response of the CME to this crisis? Innovation. Starting in the early 1960s, the CME began introducing livestock futures. By 1980, the live cattle futures contract had become the largest contract on the Exchange.
But admittedly, Chicago has not been the only center of innovation in the development of commodity futures markets. In the 1970s, the New York Mercantile Exchange (Nymex) had arguably faced possible extinction. Fortuitously, Nymex responded to an emerging opportunity. The structure of the oil industry had changed after numerous nationalizations in oil-producing countries. This forced oil companies to shift from long-term contracts to the spot oil market, according to Pulitzer Prize winner Daniel Yergin. An economic need for hedging volatile oil price risk thereby emerged, which Nymex responded to with a suite of energy futures contracts, starting with heating oil in 1981. The contracts succeeded despite the “established oil companies” initially viewing the contracts “as a way for dentists to lose money.”
Later, new and different threats confronted the established exchanges, which brought about wrenching change (see “In a flash,” above). The CBOT, CME, and Nymex had to (and did) face up to competitive threats resulting from electronic trading. In the case of Nymex, the Exchange had to face up to pressure from the upstart IntercontinentalExchange (ICE). William Kokontis, a veteran of both the Chicago Mercantile Exchange and the Commodity Futures Trading Commission, summarized the tectonic shifts: “Just as board trading inevitably gave way to open outcry and pit trading, the latter inevitably gave way to electronic trading.”
Melamed discussed the constant worries concerning Chicago’s continued competitiveness with Futures. He said: “Without electrification we were destined to remain either very small, or someone really big would take it away from us.”
However, the battle to build an electronic trading engine was tough and Melamed realized competitive challenges would come too quickly for a member organization to respond efficiently. He wrote, “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. The CME went public in 2002, followed a few years later by the CBOT and then Nymex.
With lightning-fast execution in the new electronic markets, a “whole new world of very short-term algorithmic trading [opened up] to speculators in the [futures] market[s],” wrote Chicago trading expert George Dowd. Product innovation is arguably now moving “from [the] exchanges to electronic trading firms, which develop their own algorithms rather than [relying] … on the exchanges to create new instruments,” explained Weitzman in an article.
And the innovation by Chicago’s proprietary trading firms continues, of necessity. Alex Brockmann of TradeLink Capital explained current trends to Mark Melin in the 2013 Opalesque Round Table: “What I have noticed is that the profitability of the prop trading businesses has actually been declining since about 2009, and what you see as a consequence is that some proprietary trading firms are edging toward asset management as a way to earn something from the infrastructure and the intellectual capital they have developed.”
Transformations by exchanges are continuing as well, of necessity. For example, in 2012 CME Group announced plans to establish a European derivatives exchange in London. Explained an Exchange official: “The more we have invested in our global infrastructure, the more we have realized that there are customer acquisition opportunities by creating regional access to our services,” as reported by a Dow Jones writer.
Chicago’s legacy now
Historically, the Chicago futures industry developed from participants solving problems in a trial-and-error fashion. Hieronymous’ 1971 textbook quoted an 1896 author in describing the business conditions of the mid-19th century, which led to the development of grain futures trading: “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 ….”
You could argue that this trial-and-error approach was best personified recently by two Chicago futures industry participants, James Koutoulas and John Roe. In the immediate aftermath of the 2011 bankruptcy of MF Global, nobody appeared in court to represent the interests of customers. Koutoulas and Roe proactively stepped into this legal vacuum and quickly created a grassroots organization, the Commodity Customer Coalition (CCC), deftly using social media, to successfully advocate for thousands of futures customers in ongoing legal proceedings.
This article has already noted that Chicago’s endowment includes its assembly of willing financial risk-takers. The city has another rich endowment: A tradition of intellectual risk-taking by individuals associated with the University of Chicago.
It was the University of Chicago’s Milton Friedman, a Nobel-Prize-winning economist, who provided “the intellectual foundation for the birth of currency futures” in 1971, according to Melamed (see “University of Chicago fed industry growth,” next). The relentless use of logic, as was historically the hallmark of a University of Chicago education, is now best personified by the University of Chicago-trained economist Professor Craig Pirrong (now of the University of Houston) and the University of Chicago-trained lawyer, Eugene Scalia, who each have been at the forefront of the debate over the proper way to regulate commodity futures trading.
Further, the University of Illinois at Urbana-Champaign has produced economists who have deepened our understanding of the economics of futures trading, even when this has been unpopular politically. This tradition began with Professor Thomas Hieronymous, and is now best exemplified by Professor Scott Irwin of the University of Illinois through his careful empirical research (see “It’s not the long onlies,” above).
How did Chicago become the global center for exchange-traded derivatives markets? Essentially through its deep pool of both financial and intellectual risk-takers, which happily endures to this day.
As noted in “Exchanges and regulators let traders down in 2013” (page 18), the industry is once again facing challenges and will need to lean on this tradition of innovative risk-takers to continue its impressive growth.
Hilary Till is a co-founder and principal of Premia Capital Management, LLC., a proprietary trading and research firm. In addition, Till provides advice on risk-management and derivatives trading issues through Premia Risk Consultancy, Inc. She is also the co-editor of Intelligent Commodity Investing. She has produced numerous white papers and recently has written articles on the resiliency of Chicago’s futures industry.
University of Chicago fed industry growth
One historic example of the University of Chicago’s originality is as follows: “[B]y 1950, [Friedrich] Hayek’s market economics were so completely out of fashion that when he sought a full-time academic job in the United States, …only one university was willing to hire him,” and that was the University of Chicago, according to the PBS documentary, The Commanding Heights. Hayek later became a Nobel Laureate.
Another Nobel Laureate associated with the University of Chicago was Myron Scholes, who earned his doctorate at the university. “Scholes and his co-author, the late Fischer Black, derived the [eponymous option pricing] formula in 1970. They submitted the article to the Journal of Political Economy, and it was rejected without even being reviewed. Merton Miller and Eugene Fama, two financial economists at the University of Chicago persuaded the [journal’s] editors to take another look, and the journal published the article in 1973, recounted an encyclopedia entry on Scholes. Fama joined Scholes this year in receiving a Nobel Prize.
The timing of the journal article on pricing options was fortuitous. The bear market of 1973-1974 was so financially destructive that market participants became open to the idea that perhaps there was a “scientific and rational way to tame the markets, to use the power of mathematics to conquer risk,” explained the BBC documentary, The Midas Formula.
At this time, the University of Chicago already had a tradition of training graduates with the skills that would become useful in the new field of mathematical finance. Many of these graduates would later staff up Chicago’s proprietary trading firms from the 1970s onward and deepen Chicago’s already diverse group of financial risk-takers.
The Chicago Board Options Exchange (CBOE) “opened for business just one month before the Black-Scholes paper appeared in print,” noted Baeckelandt’s CFA presentation. Mathematically trained graduates were able to turn crisis into opportunity. Stan Jonas, a derivatives expert, recounted to The Midas Formula documentarians: “Word of the [Black-Scholes] model began to circulate, particularly amongst people in the University of Chicago and more particularly amongst the option traders, and literally before the official publication of the model, traders had effectively started to program the model and begin to use it to trade [at the CBOE].” The CBOE thereby became the first options exchange in the world, and the first exchange to establish an industry, noted Baeckelandt’s presentation to the CFA Society of Chicago.