Anthony J. Pennings, PhD

WRITINGS ON DIGITAL ECONOMICS, ENERGY STRATEGIES, AND GLOBAL COMMUNICATIONS

Origins of Currency Futures and other Digital Derivatives

Posted on | January 13, 2016 | No Comments

Thus, it was fitting that Chicago emerged as the Risk Management Capital of the World—particularly since the 1972 introduction of financial futures at the International Monetary Market, the IMM, of the CME.
– Leo Melamed to the Council of Foreign Relations, June 2004

International currency exchange rates began to float in the post-Bretton Woods environment of the early 1970s. The volatility was created by US President Richard Nixon’s decision to end the dollar’s convertibility to gold and a new uncertainty produced in the international sphere, particularly by the two oil crises and the spread of “euro-dollars.”

Multinational corporations and other operations grew increasingly uneasy as prices for needed foreign monies fluctuated significantly. Those requiring another country’s money at a future date were unnerved by the news of geopolitical and economic events. Tensions in the Middle East, rising inflation, the U.S. military failure in Southeast Asia, were some of the major factors creating volatility and price variations in currency trading. This post introduces these new challenges to the global economy and how financial innovation tried to adapt to the changing conditions by creating a new system for trading currency derivatives.

Currency trading had long been a slow, glamour-less job in major banks around the world. Traders watched the telegraph, occasionally checked prices with another bank or two, and conducted relatively few trades each day. But with the end of the Bretton Woods controls on currency prices, a new class of foreign exchange techno-traders emerged in banks around the world. Armed with price and news information from their Reuters computer screens and with trading capabilities enhanced by data networks and satellite-assisted telephone services, they began placing arbitrage bets on the price movements of currencies around the world. Currency trading was transformed into an exciting profit center and career track. But the resulting price volatility raised concerns about additional risks associated with the future costs and availability of foreign currencies.

It was a condition that did not go unnoticed in Chicago, the historical center of US commodity trading. Members of the Chicago Mercantile Exchange (CME) in particular were curious if they could develop and trade contracts in currency futures. Enlisting the help of economist Milton Friedman, the traders at the CME lobbied Washington DC to allow them to break away from their usual trading fare and transform the financial markets. It helped that fellow and former University of Chicago professor George Schultz was the current Secretary of the Treasury.

In early 1972, the International Monetary Market (IMM) was created by the CME to provide futures contracts for six foreign currencies and start a new explosion of new financial products “derived” from base instruments like Eurodollars and Treasury bills.

The end of Bretton Woods also created the opportunity for a new “open outcry” exchange for trading in financial futures. The IMM was an offshoot of the famous exchange that preferred, initially, to distance themselves from “pork belly” trading and offer seats at a cheaper rate to ensure that many brokers would be trading in the pit. Growing slowly, at first, the IMM would be soon taken under the wing of the CME again and become the start of an explosion of derivative financial instruments that would soon grow into a multi-trillion dollar business.

The computer revolution would soon mean the end of “open outcry” trading strategies in the “pits” of the CME and the floors of other financial institutions like the NYSE. Open outcry is a system of trading whereby sellers and buyers of financial products aggressively make bids and offers in a face-to-face situation using hand signals. The system was preferably in trading pits because of deafening noise and the speed at which trading could occur. It also overcame crowd situations as traders could interact across a trading floor. But it lacked some of the flexibility and efficiencies that came with the computer.

In 1987, the members of the Chicago Mercantile Exchange voted for developing an all-electronic trading environment called GLOBEX, developed by the CME in partnership with Reuters. GLOBEX was designed as an automated global transaction system that was meant to replace eventually open outcry with a system of trading futures contracts that would not be limited to the regular business hours of the American time zones. They wanted an after-hours trading system that could be accessed in other cities around the world, and that meant trading 24/7.

Today’s $5.3 trillion dollars a day currency trading business is going through another transformation. Automation and electronic dealing are decimating foreign-exchange trading desks. Currency traders are now being replaced by computer algorithms.

Notes

[1] Leo Melamed, “CHICAGO AS A FINANCIAL CENTER IN THE TWENTY FIRST CENTURY,” A speech to the Council on Foreign Relations, Chicago, Illinois. June 2004.From http://www.leomelamed.com/Speeches/04-council.htm, accessed on November 14, 2004.

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AnthonybwAnthony J. Pennings, PhD is Professor and Associate Chair of the Department of Technology and Society, State University of New York, Korea. Before joining SUNY, he taught at Hannam University in South Korea and from 2002-2012 was on the faculty of New York University. Previously, he taught at St. Edwards University in Austin, Texas, Marist College, and Victoria University in New Zealand. During the 1990s he was also a Fellow at the East-West Center in Honolulu, Hawaii.

Category: digital monetarism, electric money, financial news, financial technology, geopolitical risk
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    Professor at State University of New York (SUNY) Korea since 2016. Moved to Austin, Texas in August 2012 to join the Digital Media Management program at St. Edwards University. Spent the previous decade on the faculty at New York University teaching and researching information systems, digital economics, and strategic communications.

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