A historical flash back with Leo Melamed

August 23, 2014 07:00 PM

In 1990, Nobel Laureate in Economics Merton Miller in assessing the financial landscape of that day called financial futures “the most significant innovation of the past two decades.” He was right. Not only did this event initiate the transformation of futures from their traditional usage in agriculture, it vaulted futures markets to their present position in finance as one of the most efficient risk-management tools. They are indispensable to the mechanics of efficient capital markets.

Few would argue that the modern era of futures markets began with the birth of financial futures at the International Monetary Market (IMM) of the Chicago Mercantile Exchange (CME) and its launch of currency futures on May 16, 1972 (a few months after the first issue of Futures hit newsstands).  Those were seminal moments.  Until then, we were trapped in our agricultural cradle and constricted by the limitations of physical delivery. Once those constraints were removed, futures markets soared. This first-mover advantage coupled with “cash settlement” and our subsequent introduction of Globex provided the momentum which ultimately brought the CME Group to today’s pinnacle of futures markets.  

According to the Bank of International Settlements (BIS), 81.3% of all futures traded in 2013 were financial futures and options. The notional value of those traded equaled an astounding $1,886,283.4 billion. The success of these instruments of finance resulted from a combination of factors. First was the ending of U.S. dollar convertibility to gold on Aug. 15, 1971 by President Nixon.

By closing the gold window, President Nixon’s action led to an irreversible breakdown of the system of fixed exchange rates, initiated the era of globalization and provided the rationale for the CME, and later other futures exchanges, to prove that the traditional idea about use of futures markets in physical commodities was also applicable to instruments of finance and beyond. Tangentially, it is important to note that while it took a great deal of time for world recognition of our market’s capabilities, the Chicago community and its banks were immediately supportive.

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Of particular importance were the local floor-traders themselves who had the trust and courage to believe in these new markets. Of course, we needed avenues for publicizing the values we represented.  In this respect, my hat is off to the publishers and reporters at the first influential magazine originally called Commodities and later renamed Futures, which recognized the metamorphoses that was occurring. 

With the advent of computer technology in the early 1980’s, business risks that exist in the marketplace could be unbundled and transferred to those most willing to assume and manage each risk component. 

Consequently, financial derivatives soon evolved into a growing array of exchange-traded and over-the-counter (OTC) financial instruments with more sophisticated applications. The economic function of these instruments was to provide a safety-net based on benchmark groupings of inherent business exposures or to unbundle the risks involved into their basic components and transfer them to those most able and willing to assume and manage each component.  



Consequently, financial derivatives—both on centralized futures and options exchanges or customized in the OTC market—can be likened to a gigantic insurance company that allows financial market risks to be adjusted quickly, more precisely and at lower cost than is possible with any other financial procedure: a process that has improved national productively growth and standards of living. 

However, with the financial meltdown of 2008 behind us, we know that without proper safeguards OTC derivatives can be misapplied and create risks that result in unintended consequences. The primary purpose of Dodd Frank legislation is to correct this problem to protect end-users. It is imperative to note, however, that futures markets operated flawlessly during the crisis. Our industry experienced no failures and did not apply for nor need government assistance. Point in fact, the new regulatory structure embraces the futures markets “mark-to-market” discipline. 

Today our markets provide risk management capabilities on a nearly round-the-clock basis on a vast array of products that cover the gamut from finance to energy, from securities to the environment, from banking to agriculture.  Today the trading “pit” has been electronically transported to every corner of the globe.  Whereas as little as 10 years ago American futures exchanges were still predominately limited to floor-based execution. Now the trading screen enables everyone everywhere to execute trades without the need for physical representation on the floor of an exchange.  

Thus, the future of futures markets is limited only by our own imagination. Congratulations to Futures on its 500th issue. 

Leo Melamed is chairman emeritus at CME Group and chairman and CEO of consulting firm Melamed & Associates, Inc. He is a former chairman of CME who established the International Monetary Market (IMM) and was the primary driver in the creation of Globex.

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