From the November 2009 issue of Research Magazine • Subscribe!

November 1, 2009

Historical Research: Inventing Financial Futures

How new financial markets emerged from turmoil in the early 1970s.

In November 1967, University of Chicago economist Milton Friedman was turned down for a loan, a rejection that ended up changing the course of financial history.

The problem was that he wanted to borrow in British pounds. He expected the pound to be devalued as a consequence of Britain's big-spending government policies, and then he could repay the loan at a low cost in dollars.

Chicago bankers, to Friedman's surprise, declined to perform the transaction, stating that the economics professor did not have a proper commercial interest in exchanging currency. Foreign-exchange speculation, it turned out, was discouraged by the Federal Reserve and the Bank of England.

However, Friedman, though not yet the Nobel Prize winner he'd become less than a decade later, was an economist already known for his free-market views and one with the prominent public platform of a regular column in Newsweek. He subsequently used that column to complain that currency trading was hampered by unjustified restrictions.

Those writings got the attention of Leo Melamed, a Chicago Mercantile Exchange board member who became its chairman in 1969. Drawing on Friedman's ideas and support, Melamed in the coming years would pioneer the expansion of futures trading from its traditional bailiwick of agricultural products into the realm of exchange rates, interest rates and other financial variables. The 1970s would see the birth of financial futures, a vast new frontier for the financial services industry.

Ending Bretton Woods

Currency futures, the first type of financial futures to be introduced, emerged against the backdrop of the unraveling of the Bretton Woods system of fixed exchange rates, named for the New Hampshire town where it was set up at an international conference in July 1945. The system was under growing strain by the late 1960s, with major currencies pushing against the narrow bands in which they were supposed to fluctuate.

The dollar, the system's linchpin, was increasingly overvalued, as U.S. inflation edged up as a result of heightened federal spending on the Vietnam War and Great Society. Policymakers first tried to tinker with Bretton Woods to make the fixed rates more flexible. Then, on Aug. 15, 1971, the Nixon administration closed the "gold window" at which foreign central banks had been allowed to exchange greenbacks for gold at $35 an ounce. This step opened the way for floating exchange rates.

Floating exchange rates were a policy regime that Friedman had long favored, as they could adjust to changing trade and capital flows without requiring government intervention. However, other free-market economists took a different view, believing fixed rates, especially with a link to gold, were preferable because they limited government printing and spending of money. That debate echoes on today.

But in the early 1970s, the world was moving, however uncertainly, to floating exchange rates. And that meant that companies and investors had a greater interest than ever in guarding against -- or profiting from -- currency fluctuations, which would now be constant as opposed to the occasional adjustments that had characterized Bretton Woods. Currency exchange, once a quiet service provided by banks through over-the-counter forward contracts, was about to become something much more open and noisy.

Trading in the Pits

Back in Chicago, Melamed was contemplating whether the commodity exchange he headed could play a role in the prospective currency market. This would be a radical departure. The Chicago Merc had gotten its start trading contracts on butter and eggs, before branching out into live cattle, frozen pork bellies and other agricultural futures. The idea of trading purely financial items in the pits was unfamiliar, to say the least.

Melamed had been inspired by Friedman's calls for free-market reforms -- even sneaking into a University of Chicago classroom to hear the economist lecture at one point. The two had breakfast at New York's Waldorf Astoria on Nov. 13, 1971. "Is there any reason foreign currency might not work in futures markets?" Melamed asked.

"None I can think of," Friedman replied.

To the contrary, the professor said it was a "wonderful idea" and encouraged Melamed to implement it. But the Merc executive, worried about the skepticism likely to greet such an unusual innovation, asked Friedman to put something in writing on the subject.

"You know I am a capitalist?" Friedman inquired. The two agreed on $7,500 for a feasibility study, which was titled "The Need for Futures Markets in Currencies."

Melamed was right to think he could use some help in overcoming doubts about the initiative. Futures trading had been used for agricultural goods since the 19th century, and some in the business were wary of trying to transplant it elsewhere. Meanwhile, there were some financial types who regarded the Chicago trading pits as d?class?.

"It's ludicrous to think that foreign exchange can be entrusted to a bunch of pork belly crapshooters," said one New York banker just before the opening of the Merc's International Monetary Market in May 1972. Business Week ran an article titled "The New Currency Market: Strictly for Crapshooters," saying the market would have great appeal "if you fancy yourself an international money speculator but lack the resources."

With Friedman's paper in hand, Melamed was able to convince bankers, brokers and government officials that currency futures had merit. Shortly after the IMM began trading, Melamed visited Treasury Secretary George P. Shultz, to whom he had sent the economist's study. Shultz, after listening to Melamed's pitch for the new market, said: "Listen, Mr. Melamed. If it's good enough for Milton, it is good enough for me."

The IMM's first currency futures included British pounds, Canadian dollars, Deutsche marks, French francs, Japanese yen, Mexican pesos and Swiss francs. Trading was cautious at first, but volume gradually built up, rising from 417,310 contracts in 1973, the market's first full year, to 643,000 in 1975. The market's credibility was enhanced in September 1975, when trading continued in Chicago during a Mexican peso crisis even as interbank forward activity in that currency ground to an unseemly halt.

Futures Ferment

As currency futures grew in acceptance, interest grew in having instruments to manage exposure to interest rates, which had become more volatile amid heightened inflation. The Chicago Board of Trade was the first to jump in, launching a contract for Ginnie Mae securities in October 1975. The IMM soon rolled out Treasury bill futures, with Friedman ringing the opening bell as trading commenced on January 6, 1976.

Initially, officials at the Treasury and the Fed were worried that futures contracts could have a disruptive impact on markets for government debt. The T-bill contract required regulatory approval (the Commodity Futures Trading Commission had been set up in 1974) and this was forthcoming only after Friedman placed a phone call to Treasury Secretary William Simon to allay concerns about the contract's effects.

Soon enough, it became clear that futures trading enhanced the liquidity of government debt markets, making them function more rather than less smoothly, besides giving banks and companies needed tools to hedge against rate swings. The Board of Trade came out with futures for Treasury bonds in 1977 and for Treasury notes in 1981.

By the early 1980s, financial futures were spreading into new fields. The IMM launched contracts for bank CDs and Eurodollars in 1981. The next year, stock index futures were added to the toolkit of investors and financial managers, as the Chicago Mercantile Exchange launched a contract for the S&P 500, the New York Futures Exchange launched one for the NYSE Composite index and the Kansas City Board of Trade unveiled its Value Line futures contract. More index futures would follow.

Over the subsequent decades, the financial futures industry boomed, with new contracts proliferating and exchanges being set up around the world. In the same period, though, over-the-counter derivatives expanded at an even faster clip than exchange-traded derivatives.

The recent financial crisis has brought heightened scrutiny of collateralized debt obligations and other over-the-counter instruments.

In an ironic historical twist, the financial futures markets -- once derided as being "strictly for crapshooters" -- now are quite often seen as models of prudent regulation and transparency. Indeed, there is a growing push to bring much over-the-counter trading onto exchanges such as those pioneered by Melamed and Friedman those decades ago.

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A Trader's Education

Leo Melamed received some lessons in currency trading long before he pressed for his vision of financial futures as chairman of the Chicago Mercantile Exchange.

Born in Poland in 1932 with the family name Melamdovich, the 7-year-old Leo was fleeing with his family from the Nazis when they arrived in the Lithuanian city of Vilnius. His father, Isaac Melamdovich, a math teacher, showed him a Polish zloty and a Lithuanian lit, and asked if he knew what these were. "Money," the child answered.

His father then explained the value of these two currencies -- that despite the official one-to-one exchange rate, buying a loaf of bread took two zlotys but only one lit.

The family received a life-saving visa to Japan from Chiune Sugihara, the Japanese consul general to Lithuania, who at risk to himself and his own family issued such papers to thousands of Jewish refugees.


In Tokyo in 1941, Leo received another lesson in currency trading. When Jewish families in Japan received an exit visa, they would deposit yen in a bank and receive dollars (or the currencies of countries where they were traveling) back at the official rate. They would then hand that money to the community's refugee committee, which sold it on the black market for a higher quantity of yen.

The profits from such transactions enabled the community to support the existing families as well as new refugees.

The family arrived in Chicago in the spring of 1941 and took the name Melamed. Leo went to law school and, seeking work as a law clerk, answered a help-wanted ad that changed his career. The employer was Merrill, Lynch, Pierce, Fenner & Bean, which Melamed assumed was a law firm seeking a "runner" to bring papers to court. The future lawyer and trader got the job of working as a runner in commodity futures markets.

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