The International Monetary Market: Chicago's 1972 Currency Futures

On 16 May 1972 a roped-off corner of the Chicago Mercantile Exchange floor opened for business in seven foreign currencies. The space had been carved out of a room whose main trade was frozen pork bellies and live cattle, and the men standing in it were commodity locals who had never seen a bank dealing room. By the close they had traded 333 contracts.

Nothing in that scene announced what it was. Currency risk in 1972 belonged to banks, who quoted forward contracts to corporate customers they had credit lines for, in amounts and on dates negotiated case by case, with no exchange, no clearing house, and no price a stranger could look up. A pork-belly exchange proposing to standardise that business and sell it to anyone who could post margin was, to most of the people who ran international finance, not a serious proposition.

Fifty years later every major currency, interest rate and equity index in the world trades in listed futures, and the contract design Chicago used in 1972 is the one they all use.

A Butter-and-Egg Board Running Out of Eggs

Chartered in 1898 as the Chicago Butter and Egg Board and renamed in 1919, the Merc spent its first seventy years in perishables. That was a shrinking franchise. Shell eggs, once the exchange's staple, lost their futures market as poultry production industrialised and the cash trade moved to long-term supply contracts. Onions had been the other pillar until Congress, responding to a corner run by the grower Vincent Kosuga in 1955, passed the Onion Futures Act of 1958 and banned trading in them outright — a prohibition still on the books.

What remained came from new listings. Frozen pork bellies began trading in 1961 and became the exchange's signature contract. Live cattle followed in 1964, the first futures contract written on a live animal, which required the exchange to solve delivery problems nobody in grain had faced.

Leo Melamed, a lawyer who had taken a job as a runner on the floor while at law school and stayed, was elected chairman in 1969 at thirty-seven. His reading of the institution he had inherited was that it could not survive on agricultural listings alone and had no obvious agricultural products left to add. What it did have was a floor, a clearing house, and a membership willing to take the other side of almost anything.

Then Washington handed him a product. When Richard Nixon suspended the dollar's convertibility into gold on 15 August 1971, the fixed-rate system that had made currency risk a minor administrative matter began to come apart. The Smithsonian Agreement of 18 December 1971 devalued the dollar against gold to $38 an ounce and widened permitted bands to 2.25 per cent either side of par, which was less a repair than an admission. Anyone who thought the bands would hold had not been watching. The Sunday night speech that ended the gold standard had created a market in something that had not needed a market since 1944.

Friedman's Paper

Melamed's problem was credibility rather than design. He needed an argument for currency futures that bankers and regulators could not dismiss as promotion by a commodity exchange, and he went to get one from the most quotable free-market economist alive.

Milton Friedman had his own grievance. In 1971, convinced that sterling was overvalued and would be devalued, he had tried to sell it short through a Chicago bank and been refused: the forward market existed to hedge commercial exposure, not to accommodate a professor's opinion about parity. The refusal left him with a concrete example of a market closed to everyone but its incumbents.

Melamed put the proposition to him late in 1971 and commissioned a feasibility paper for a fee of $7,500. Friedman delivered "The Need for Futures Markets in Currencies" in December, and the exchange published it. Its central passage read as a forecast and functioned as a licence: changes in the international financial structure, Friedman wrote, would create a great expansion in the demand for foreign cover, and it was highly desirable that the demand be met by as broad, as deep, and as resilient a futures market in foreign currencies as possible (Friedman, 1971).

The paper also answered the objection that mattered most to officials — that a speculative market would destabilise exchange rates. Friedman's position, which he had held since his 1953 essay on flexible exchange rates, was that speculators who destabilise prices buy high and sell low and are therefore removed from the market by their own losses. A liquid futures market would carry risk from those who did not want it to those who did, at a price everyone could see.

Washington

Melamed took the paper to Washington. George Shultz, then director of the Office of Management and Budget and Friedman's colleague from the University of Chicago, gave the answer that has been quoted in every account since: if it was good enough for Milton, it was good enough for him. Arthur Burns at the Federal Reserve raised no objection he pressed. Nobody in the government had a regulatory hook to hang a refusal on, because no federal agency then had jurisdiction over futures in anything other than the enumerated agricultural commodities.

That gap was deliberate on the exchange's part. Rather than list currencies alongside pork bellies, the Merc chartered a separate entity, the International Monetary Market, with its own memberships and its own board, which kept the new business legally distinct from a regulated agricultural exchange and gave sceptical outsiders a name that did not smell of livestock (Melamed, 1996).

Seven contracts opened on 16 May 1972: the British pound, Canadian dollar, Deutsche mark, French franc, Japanese yen, Mexican peso and Swiss franc. Everette B. Harris, the exchange's president since 1953, ran the launch alongside Melamed, who chaired the new division himself.

What the Contract Actually Changed

A forward contract and a futures contract promise the same thing — currency on a future date at a price fixed today — and differ in everything that determines who can use them.

Bank forwards were bilateral credit. The customer's exposure was to the bank, the bank's to the customer, and access depended on a credit officer's view of the counterparty, which excluded small firms, foreign firms and individuals entirely. Terms were bespoke, so a position could rarely be closed except by dealing with the same bank again.

Futures replaced the counterparty with the clearing house. Every contract standardised the amount, the delivery month and the tick, which made one seller's position interchangeable with another's and allowed a trader to get out by selling to anyone on the floor. Positions were marked to market daily and losses collected in cash the next morning, so credit risk was measured in hours rather than months, and nobody needed to know who was on the other side.

Lester Telser's account of why organised futures markets exist turns on exactly this substitution: the exchange supplies standardisation and a clearing guarantee, and in doing so converts a credit relationship into a traded instrument (Telser, 1981). Dennis Carlton's survey of contract launches and failures found that the ones that survived shared a liquid, volatile underlying cash market with no dominant incumbent controlling access — a description of foreign exchange after 1971 and of almost nothing before it (Carlton, 1984).

The Peso

Early volume was thin enough that the exchange kept the new division alive partly on its own members' trading. Vindication arrived from Mexico.

The peso had been fixed at 12.50 to the dollar since 1954, twenty-two years of a rate so stable that Mexican and American businesses had stopped treating it as a variable. The IMM listed a contract on it anyway. On 31 August 1976 the López Portillo transition and a drained reserve position forced President Luis Echeverría's government to abandon the peg, and the currency fell to roughly 20 to the dollar by the end of the year.

That was the first occasion on which the exchange's machinery was tested by a move nobody had priced. Every position was settled, every margin call was met, and the clearing house did not require a cent from anyone it had not already collected from. Traders who had sold the peso forward at a rate the Mexican government still officially defended were paid in full. Banks noticed. The same devaluation cycle would recur, on a far larger scale and with far more counterparties exposed, in the peso collapse of 1994 and 1995.

Jurisdiction

Regulation arrived after the product. The Commodity Futures Trading Commission Act of 1974 created a federal regulator with exclusive jurisdiction over futures on any commodity, a definition written broadly enough to cover instruments that did not exist yet. Chicago had spent three years in a jurisdictional gap and emerged with a supervisor whose statutory mandate made the new contracts unambiguously legal.

Cash settlement was the next legal frontier. A futures contract on a Eurodollar deposit cannot be delivered — there is no certificate to hand over — so the contract launched in December 1981 settles in money against a reference rate. Approving it meant deciding that a contract with no possible physical delivery was not a wager, which is precisely what the nineteenth-century bucket-shop statutes had been written to prohibit. Once that door opened, the underlying could be anything measurable, and stock indices followed within five months.

Equity indices brought the Securities and Exchange Commission into the argument, since a future on the S&P 500 is economically a claim on stocks. The Shad-Johnson Accord of 1982, negotiated between SEC chairman John Shad and CFTC chairman Philip Johnson and written into statute, gave the CFTC broad-based index futures and barred futures on single stocks — a line that held until 2000 and that shaped where American risk transfer took place for a generation.

Merton Miller, reviewing two decades of financial engineering, judged financial futures "the most significant financial innovation of the last twenty years," and grounded the claim in the observation that the contracts reduced transaction costs for hedging by an order of magnitude rather than merely offering a new way to speculate (Miller, 1986). William Silber's work on the innovation process reached a similar conclusion from the supply side: exchanges introduce contracts to compete for order flow, and the successful ones are those that solve a real hedging problem cheaply (Silber, 1981).

The Screen

Melamed's second structural bet took longer to pay. In 1987 the exchange announced a partnership with Reuters to build an electronic system for trading outside floor hours; Globex went live in 1992, initially as an after-hours venue that floor traders tolerated because it did not compete with them during the day. It ended up replacing them. Open outcry at the Merc dwindled through the 2000s and the currency pits closed for good in the following decade, with the contracts they had invented migrating entirely to a matching engine.

The exchange itself completed the same journey from club to corporation. The CME demutualised in 2000, listed its shares in 2002, and acquired the Chicago Board of Trade in 2007 and the New York Mercantile Exchange in 2008, consolidating the American futures industry into one company whose largest single business line remains interest rate contracts.

The 1972 design also produced risks nobody had listed. Index futures made it possible to buy or sell the whole American equity market in one trade, which is what portfolio insurance strategies relied on when they sold into a falling market on 19 October 1987, and the Brady Commission's inquiry spent much of its length on the mechanical relationship between the Chicago futures pit and the New York floor. Cheap risk transfer and fast risk transmission turned out to be the same property viewed from opposite ends.

What the 333 contracts of 16 May 1972 settled was a question about who is permitted to hold an opinion about a price. Friedman could not sell sterling short in 1971 because a credit officer decided he had no business in the market; after the IMM, the only requirement was margin. Chicago did not invent floating exchange rates, and it did not ask for them — it built the room they would be priced in, and had it open within nine months of the announcement that they were coming.