Yesterday’s Tomorrows: Past Visions of Future Financial Markets By Robert I. Webb Prof. Robert I. Webb is the Paul Tudor Jones II Research Professor at the McIntire School of Commerce at the University of Virginia in Charlottesville, Virginia, USA. Introduction It is easy to imagine that the present - yesterday’s to observe some of the changes in financial markets; first as tomorrow - was always the future expected in the past. Yet, a student of finance, and later with service: at a regulator; what we now accept as the normal state of affairs - the at an exchange; as a trader; in academia. I will draw upon present - was not the only possible outcome that could some of my recollections and personal experiences in the have come to pass nor was it often the most commonly discussion that follows. expected one. What is now considered “inevitable” – Most readers have always lived in a world where when viewed from the vantage point of 20/20 hindsight - exchange traded derivatives on financial assets existed. was often not immediately embraced or accepted. Many readers have always lived in a world where interest In order to understand where we are going it is important rate swaps and other over-the-counter (OTC) derivatives to understand where we have been and how we got there. were important. Many readers have always lived in a world I want to discuss some past visions of the future of financial where exchange traded derivatives on energy, in general, markets, in general, and derivative markets, in particular, and crude oil, in particular, existed and were important. as seen by academics, practitioners and policymakers at Some readers have always lived in a world where large various points in time. There are few advantages of age Asian financial and commodity futures markets existed and but one of them is the opportunity to witness changes were important in the global price discovery process. Yet, and remember the contemporary context in which they this was not always the case. occurred. I have been fortunate to have had a catbird seat Yesterday’s Tomorrow: 1972 2012 marked the 40th anniversary of the development of ICE) in New York. Leo Melamed argued that the reason the first successful financial futures contracts. On May 16, why the IMM-traded FX futures were successful was timing 1972—trading on foreign exchange or FX futures began on - the Bretton Woods Agreement and its system of fixed the International Monetary Market (IMM) in Chicago. The exchange rates had collapsed.2 IMM was established as an independent exchange and later became a division of the Chicago Mercantile Exchange Yesterday’s Tomorrow: 1973 (CME). FX futures arose in part because small speculators It has been 41 years since the introduction of exchange had a difficult time trying to put short speculative FX positions traded equity options. On April 26, 1973, options trading on with the large banks that dominated the market.1 in 16 listed stocks began on the Chicago Board Options To be sure, FX futures had been introduced earlier but Exchange (CBOE). According to the CBOE, 911 option failed. The first FX futures contracts were introduced on April contracts traded on opening day. Only call options were 23, 1970 on the International Commercial Exchange (not to allowed to trade. Today, exchange traded equity options be confused with the present Intercontinental Exchange or are an integral part of financial markets. 02 Yesterday’s Tomorrows: Past Visions of Future Financial Markets What did the future look like in the past? Specifically, what Interestingly, in the mid 1980’s Merton Miller (1986) argued did it look like for exchange traded equity options? There that the development of financial futures rather than were a number of worries. One worry was that speculators exchange traded equity options was the most important would eschew trading in the cash stock market in favor financial innovation of the previous 20 years. The essence of trading equity options. That is, a successful options of Merton Miller’s argument is that the development of market would cause trading volume on the stock market financial futures preceded the development of exchange to dwindle as people traded options instead of stocks. The traded equity options and that the success of FX futures fundamental premise behind this fear - that option prices contracts stimulated the development of futures contracts would be volatile while equity prices were stagnant reveals on numerous other financial instruments. a fundamental misunderstanding of the nature of options. It is tempting to believe that all currently successful Another fear at the time was that if trading in put options financial futures were an immediate success. However, were permitted it would push down stock prices. This fear they were not always immediately embraced. For instance, was powerful enough to cause the Securities and Exchange the Chicago Board of Trade introduced Treasury bond Commission (SEC) to prohibit trading in put options for futures on August 22, 1977. The 30-year U.S. Treasury bond almost an additional 4 years. Thanks to this decision, put- futures market traded around 4,000 contracts a day until call parity in U.S. exchange traded equity options remained early October 1979 when the Federal Reserve switched to a theoretical concept during those four years. targeting the quantity of money rather than interest rates. It is easy to imagine that exchange traded options began The ensuing volatility in interest rates that resulted from with the trading of equity options on the CBOE. However, this central bank policy shift created a need for investors it is important to note that exchange traded options did to manage interest rate risk exposure or face the risk of not begin with exchange traded equity options. Indeed, large avoidable losses. Essentially, volatile financial markets options on futures (“privileges”) were once common on U.S. penalized those who failed to avoid risk by not hedging. commodity futures markets as Miller (1986) notes. However In this sense, government and central bank policy played trading in “privileges” (futures options) was prohibited and an important role in making financial futures successful by then re-allowed in the U.S. in the 1980s. It is also important to exacerbating financial market volatility. recall that the Chicago Board of Trade (CBOT) created the CBOE.3 Put differently, the idea of exchange traded equity Yesterday’s Tomorrow: 1981 options originated at a futures exchange in Chicago. It has been 33 years since the first interest rate swap was Given that the first successful financial futures contracts transacted in 1981 between the World Bank and IBM. This also originated in Chicago, there is also an important lesson financial market took off quickly. In contrast, Eurodollar about the nature of financial innovations—namely, they futures took longer to become successful even though they don’t always originate in financial capitals. allow one to replicate interest rate swap positions. However, 2013 also marked the 40th anniversary of the publication the need by swap dealers to hedge their net interest rate of the seminal article on option pricing by Fisher Black and swap exposure helped make the Eurodollar futures market Myron Scholes. This article is often rightly credited with both incredibly successful. It also stimulated active trading in stimulating academic research and igniting the subsequent deferred contract months--so much so that Eurodollar explosion in derivatives trading. futures trading extended 10 years out into the future. The Black-Scholes article is also every Editor’s nightmare. It was rejected by many journals before it was finally Yesterday’s Tomorrow: 1980s accepted at the Journal of Political Economy. The The New York Stock Exchange (NYSE) created the seminal article by Fisher Black and Myron Scholes played New York Futures Exchange (NYFE or “Knife”) in 1980 in a crucial role in stimulating the use, and study, of options. In an attempt to bring the financial futures business to New a testament to the power of the wisdom of (trading) York. The introduction of stock index futures in 1982 pitted crowds, later studies showed that competitive markets the Chicago Mercantile Exchange, which traded futures reached similar prices even before the Black Scholes contracts based on the S&P 500 stock index against the model was developed. For example, Moore and Juh NYFE, which traded futures contracts based on a New (2006) report evidence that Johannesburg Stock Exchange York Stock Exchange index. Both started to trade at the traded “warrant prices were surprisingly accurate” during same time in April 1982. It was not immediately clear which 1909-1922. exchange would dominate stock index futures trading. APPLIED FINANCE LETTERS | Volume 03 - ISSUE 01 | 2014 03 To be sure, the NYFE failed to attract much trading volume At the time, futures exchanges viewed energy as the to its Treasury bond futures contract where it competed last great-untapped commodity market. Both the Chicago against the Chicago Board of Trade but that was an Board of Trade and the Chicago Mercantile Exchange established market.4 Both markets traded futures in pits sought to wrest control of the energy futures markets from using open outcry. Ultimately, Chicago won the battle and the NYMEX. They failed. Just as the NYSE’s NYFE fought dominated financial futures trading in the U.S. Incidentally, a losing battle to wrest control of financial futures from Chicago would likely also have dominated U.S. equity the Chicago markets, the Chicago futures exchanges options trading were it not for a SEC desire to regulate fought a losing battle to wrest control of the energy futures multiple option exchanges. The SEC ensured the existence markets from New York. Why did the NYMEX –an exchange of multiple options exchanges by dividing potential stocks whose most important futures contract less than a decade for listed options among multiple exchanges rather than earlier was Maine potatoes--succeed and the far larger letting the Chicago Board Options Exchange dominate the CBOT and CME fail? Was it a lack of resources? No, both nascent market.