From the February 2014 issue of Futures Magazine • Subscribe!

Futures industry: A story of crisis and opportunity

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.”

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