Constructing a Market, Performing Theory: the Historical Sociology of a Financial Derivatives Exchange1

Constructing a Market, Performing Theory: The Historical Sociology of a Financial Derivatives Exchange1 Donald MacKenzie University of Edinburgh Yuval Millo London School of Economics This analysis of the history of the Chicago Board Options Exchange explores the performativity of economics, a theme in economic sociology recently developed by Callon. Economics was crucial to the creation of financial derivatives exchanges: it helped remedy the drastic loss of legitimacy suffered by derivatives in the first half of the 20th century. Option pricing theory—a “crown jewel” of neoclassical economics—succeeded empirically not because it discov- ered preexisting price patterns but because markets changed in ways that made its assumptions more accurate and because the theory was used in arbitrage. The performativity of economics, however, has limits, and an emphasis on it needs to be combined with classic themes in economic sociology, such as Granovetterian embedding and the way in which exchanges can be cultures and moral communities in which collective action problems can be solved. INTRODUCTION The most challenging recent theoretical contribution to economic sociology is Callon’s (1998) assertion of the performativity of economics. The 1 We are extremely grateful to our interviewees, and to Emily Schmitz of the Chicago Board Options Exchange: without her help, this article could not have been written. Insightful comments on the first draft of the article were provided by Wayne Baker, Joe Doherty, Paul Draper, Richard DuFour, Irwin M. Eisen, John Hiatt, Esther-Mirjam Sent, Charles W. Smith, and the AJS reviewers. Financial support for our research came from Edinburgh University, the Interdisciplinary Research Collaboration on the Dependability of Computer-based Systems (U.K. Engineering and Physical Sciences Research Council grant GR/N13999), the Committee of Vice-Chancellors and Prin- cipals, and the Anglo-Jewish Association, and is being continued by a professorial ᭧ 2003 by The University of Chicago. All rights reserved. 0002-9602/2003/10901-0003$10.00 AJS Volume 109 Number 1 (July 2003): 107–145 107 This content downloaded from the British Library Management & Business Studies Portal. All use subject to Terms and conditions. American Journal of Sociology economy, Callon (1998, p. 30) writes, “is embedded not in society but in economics.” Economics does not describe an existing external “economy,” but brings that economy into being: economics performs the economy, creating the phenomena it describes.2 Sociology, Callon argues, is wrong to try to enrich economics’s calculative, self-interested agents. Such agents do exist, he suggests; sociology’s goal should be to understand how they are produced, and he claims that economics is key to their production. Not surprisingly, Callon’s argument has commanded considerable at- tention and has begun to attract sharp criticism. Thus, Daniel Miller defends classic economic sociology and anthropology in the tradition of Polanyi against Callon: “Contrary to his own claims, Callon’s work amounts to a defence of the economists’ model of a framed and abstracted market against empirical evidence that contemporary exchange rarely if ever works according to the laws of the market” (Miller 2002, p. 175). Empirical material for examination of these issues is less rich than might be wished. Most of the studies collected in Callon (1998) are not informed directly by performativity, and they and subsequent discussions such as Slater (2002) focus largely on accountancy and marketing. That these “economic” practices play a constitutive role in modern economies is easy to establish but not a novel assertion.3 The contributions of economists such as Faulhaber and Baumol (1988) to discussion of performativity have been missed in the sociological debate. The central case study of the performativity of economics in the narrower sense is the examination of the creation of a computerized strawberry market in the Loire by Garcia (1986), who demonstrates how a reasonable approximation to a “perfect market” was consciously constructed, in good part by the efforts of a functionary trained in neoclassical economics.4 Though a delightful study, it is limited in its scope and has not, for example, persuaded Miller (2002, p. 232) of the case for performativity. In this article, we explore performativity by examining one of high modernity’s central markets, the Chicago Board Options Exchange (CBOE). The CBOE opened in April 1973; it was one of the first two fellowship awarded to Donald MacKenzie by the UK Economic and Social Research Council. Permission to reprint figs. 1 and 2 was generously given by Blackwell Pub- lishers and by Jens Jackwerth and Mark Rubinstein. 2 The term “the performativity of economics” is based on the notion of a “performative utterance”: one that makes itself true by being uttered, as when an absolute monarch declares that someone is an “outlaw” (see Austin 1962; Barnes 1983). 3 As Callon (1998, p. 23) acknowledges, the claim that double-entry accounting is critical to the emergence of capitalism goes back to Weber, Sombart, and Schumpeter (see Carruthers and Espeland 1991). 4 Other broadly sociological case studies that raise the issue of the performativity of economics are Muniesa (2000a, 2000b) and Guala (2001). 108 This content downloaded from the British Library Management & Business Studies Portal. All use subject to Terms and conditions. Constructing a Market, Performing Theory modern financial derivatives exchanges (“derivatives” and other signifi- cant terms are defined in the glossary in table 1).5 The Chicago derivatives exchanges were the prototypes of a wave of successors—the London In- ternational Financial Futures Exchange (LIFFE), the Deutsche Termin- bo¨rse (DTB, now Eurex), and many others—and part of a process of liberalization that has transformed global markets. In 1970, financial derivatives were unimportant (no reliable figures for market size exist). By June 2000, the total notional amount of derivatives contracts outstanding worldwide was $108 trillion, the equivalent of $18,000 for every human being on earth.6 The CBOE is an appropriate site at which to look for performativity because it trades options, which have a special place in modern economics. The theory of option pricing developed by Black and Scholes (1973) and Merton (1973) was a crucial breakthrough that won the 1997 Nobel Prize for Scholes and Merton (Black died in 1995). This theory allowed refor- mulation of a host of issues such as business decisions and the valuation of corporate debt, and it became the central paradigm—in the full Kuhn- ian sense—of financial economics: “Most everything that has been developed in modern finance since 1973 is but a footnote on the BSM [Black- Scholes-Merton] equation” (Taleb 1998, p. 35). Above all, option pricing theory enjoyed empirical success: “When judged by its ability to explain the empirical data, option pricing theory is the most successful theory not only in finance, but in all of economics” (Ross 1987, p. 332). The study of the CBOE thus allows the question of performativity to be given a precise formulation. Why was option pricing theory so successful empirically? Was it because of the discovery of preexisting price regularities? Or did the theory succeed empirically because participants used it to set option prices? Did it make itself true? As will be seen, the answer is broadly compatible with Callon’s analysis. The CBOE, however, also demonstrates (even in a case favorable to the discovery of performativity) limits to the argument that homo œconomicus, though “not to be found in a natural state,” nevertheless “really does exist” (Callon 1998, p. 51). The very agents who performed option theory were not and did not become atomistic, amoral homines œconomici: if they had, they could not have constructed their market. So classic themes of economic sociology remain relevant, in particular Granovetter’s embeddedness and the views of markets as cultures, moral communities, and places of po- litical action (Granovetter 1985; White 2001; DiMaggio 1994; Abolafia 1996; Fligstein 2001). 5 The other, the Chicago Mercantile Exchange’s currency futures exchange, named the International Monetary Market (IMM), will also be discussed more briefly. 6 Data are from the Bank for International Settlements (http://www.bis.org). 109 TABLE 1 Terminology Term Meaning Arbitrageurs ............ Traders who seek to profit from price discrepancies. Black-Scholes ........... The canonical option pricing model, in which the underlying stock price follows a log-normal random walk. Call ...................... See option. Clearing ................. The process of registering and settling transactions. In Chicago, traders who are not members of an exchange’s clearinghouse (which sets margin require- ments and becomes the counterparty to all transactions) have to clear via those who are. Cox-Ross-Rubinstein ... An option pricing model similar to Black- Scholes but based on a discrete-time random walk. Derivative ............... An asset, such as a future or option,the value of which depends on the price of another, “underlying” asset. Future ................... A standardized exchange-traded contract in which one party undertakes to buy, and the other to sell, a set quantity of an asset at a set price on a given future date. Implied volatility ....... The level of volatility of an asset consis- tent with the price of an option on the asset. Log normal ............. A variable is log-normally distributed if its natural logarithm is normally distributed. Margin .................. The sum (typically adjusted daily as prices change) that sellers of options or parties to a futures contract must deposit with the clearinghouse. Market maker .......... In the options market, a market partici- pant who trades on his/her own ac- count, is obliged continuously to quote prices at which he/she will buy and sell options, and is not permitted to execute customer orders. Open outcry ............. Trading by voice and/or hand signals within a fixed arena. This content downloaded from the British Library Management & Business Studies Portal.

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