The Second City: First in Derivatives
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“… the Eastern seaboard did not represent the interests of America whose rich, red heart beat within the walls of the Chicago Board of Trade.” – General Robert F. Wood, chairman of the Board of Directors Sears, Roebuck & Company
In 1833, Chicago was a wilderness outpost of just 350 residents, clumped around a small military fort on soggy land, where the Chicago River met Lake Michigan.1 The city was built in the middle of a mud flat, which required raising portions of downtown to be on stilts above the sloshy earth, giving Chicago the first of many nicknames: Mud City.2
Shortly thereafter, Chicago's commodity markets were on the upswing as a result of the city's strategic position within the nation's transportation network and proximity to some of the most productive farmland in the world. By the end of the 1830s decade, Chicago emerged as a center of financial risk-taking due to land speculation during the building of a crucial canal that ultimately linked the bounty of Illinois farmland to population centers in the U.S.
Fifteen years later – in 1848 – was a transformative year on Lake Michigan’s shores. The Illinois & Michigan Canal was completed in 1847 and opened that spring. The first telegraph arrived in Chicago. The Galena and Chicago Union Railway began construction on its first 32 miles of track. The first stockyard was built (at Madison & Ashland) and the first grain elevator opened.3
Far from the Eastern seaboard and New York, a group of Chicago merchants and farmers formed the world’s first modern futures exchange. On April 3, 1848, 83 merchants gathered at 101 South Water Street. The Board of Trade of the City of Chicago (CBOT – now part of the CME Group) was essentially a farmers’ market. The CBOT was created by businessmen as a commercial exchange for grain merchants who needed order in a world of chaos and relief from a hostile judicial system.4
Those pioneers developed a set of codes and rules for buying, grading and trading the prairie gold that flowed to Chicago from America’s Midwest farmland. This “standardization” of grading and trading grain did for the first modern futures exchange what standardization of railway track gauges did for railroads as they displaced barges and boats in the mid and late 1800s. Standardization of rail track gauge – the width between inside faces of a pair of tracks – allowed passengers and cargo to travel longer distances without having to change trains. Prior to the adoption of the uniform “Stephenson gauge” (4’ 8.5” or 1,435mm), loads and passengers had to be unloaded from one set of rail cars to another, a time-consuming and expensive process.5
A series of mechanical inventions were first combined in Chicago after the Civil War. Purple waves of grain flourished in prairie states; emerging rail lines connected the City of Chicago to the hinterlands. A steam-powered grading system of grain-elevator storage replaced selling by physical sample. The telegraph provided near-instantaneous communications between farms and markets.
These inventions, when linked to financial innovations, strengthened Chicago’s role as a leading trade capital. In 1888, American farmers harvested 415 million bushels of wheat. However, an estimated 25,000 trillion bushels of wheat were sold in futures contracts in the United States that were “set-off” – never actually delivered – with the Chicago pits leading the way.6 The Chicago futures markets constituted a new relational geography. Through word of mouth and newspapers, and later Morse’s telegraphy, the “City Of Broad Shoulders” became the central node of the transport and exchange of grain and undoubtedly, the transmission center of grain prices.
By the end of the nineteenth century, Chicago’s grain market (the wheat pit) had become the world’s preeminent commodity trading market. Futures traders trafficked in the gut of the U.S. economy – agricultural production for the world markets and food at supper tables. The prairie’s amber waves of grain – products of Western toil and fertility – were first deposited in storehouses and elevators. Then the prairie gold was transported by railcars to vessel holds in Atlantic seaport harbors and shipped overseas to American and European ports.
The CBOT was the epicenter of rivers and railcars of trade. Chicago’s futures exchange and trading pits turned pigs and cows and wheat into money. The futures exchange stitched together collectivities separated in time and space. This alchemy was accomplished by combining thousands of acres of grazing land, the invention of feedlots, telegraph wires and railroads with the magic of the trading pits.
Yet moving physical goods was not the greatest achievement of the futures exchanges. No, Chicago’s greatest innovation was in pricing American provisions – for itself, the Midwest, these United States and the globe. Futures prices set in Chicago unified the nations and the world’s commodity markets. Chicago emerged as the very heart of the global financial circulatory system.
The derivative markets emerged from the American grain belt in the middle of the 19th century. In the 1970s, Chicago’s derivative exchanges applied the speculative logic of agricultural derivative markets to financial instruments, such as financial futures. The people who designed the GNMA futures contract for the CBOT relied heavily on their knowledge of agricultural contracts to figure out how to rate, grade, categorize and standardize mortgages. The U.S. and global derivatives markets were not derived from New York and its finance sector but from Chicago and its agricultural sector.7
Bucket shops and SCOTUS rules on Chicago futures
The Chicago Board of Trade’s role in standardizing futures contracts received the imprimatur of the Supreme Court of the United States. In Board of Trade v. Christie Grain & Stock Co., 198 U.S. 236 (1905), Justice Oliver Wendell Holmes penned the brief for the majority that affirmed the right of the CBOT to withhold its price quotations from “bucket shops.”8
Bucket shops were places where customers wagered small sums on the price movements of stocks and commodities. The term “bucket shop” has several etymologies. One origin is that poor urban children drained beer kegs thrown out by pubs and sold them out of abandoned shops.9 The other is derived from limitations imposed by the CBOT. The CBOT prohibited its members from trading in amounts less than 5,000 bushels. Individuals who wanted a smaller quantity would order a small bucket or "bucketful" from unauthorized speculators.10 In late 1870s and early 1880s, many bucket shops leased “tickers” from telegraph companies using real-time price quotations from exchanges like the CBOT as the basis for customer wagers.
Bucket shops were unofficial and usually illegal betting operations in which the prices of stocks and commodities were posted. Bucket shops posed a dual threat to the CBOT. They lured away speculative dollars that might otherwise trade on the exchange. Potentially more damaging, bucket shop “trades” were pure wagers with no connection to actual commerce or production of grain prices. The CBOT sought to demonize and outlaw bucket shop gambling while framing its members and pit traders as virtuous and rational capitalists.11 The Illinois Legislature passed a law in 1887 banning bucket shops.
In the 1905 landmark court decision on futures contracts, the U.S. Supreme Court legalized speculation and “hedging” as economic activities. The Supreme Court stated, “…the plaintiff’s chamber of commerce (the CBOT) is in the first place, a great market, where, through its eighteen hundred members, is transacted a large part of the grain and provision business of the world” … which gives its character to the great market for future sales. Speculation of this kind by competent men is the self-adjustment of society to the probable.”12
Justice Holmes and the court declared futures trading not only legal but desirable. The future of Chicago – the “Metropolis of the Prairies” – and its futures exchanges and trading pits were inextricably linked. The future of futures trading in the Windy City was bright indeed.13
Chicago – The derivatives capital of the world
The global futures trading market is a story of Chicago innovations with a handful of notable exceptions. Futures are one of the oldest contracts in civilization. A futures contract is an agreement between a buyer and a seller to exchange an amount and grade of an item at a specific price and future date. The item or underlying asset may be an agricultural commodity, a metal, mineral or energy commodity, a financial instrument or a foreign currency.
Chicago merchants did not originate futures trading. Medieval fairs in France and England featured futures trading in the 12th century. Antwerp and Amsterdam had active derivatives trading exchanges in the early 17th century.14 But the origin of modern futures trading was established in Chicago’s trading pits.15 Financial historian, Thomas A. Hieronymous, stated, “… we need look no further than the frontier of the U.S in the mid-19th century…particularly in the grain trade …were the catalyzing agent out of which futures trading grew.”
Derivatives are a special financial product whose value is linked to another financial commodity, be it a bond, stock, foreign exchange, crop or metal. Futures contracts and options are the two most common forms of derivatives and the staples of Chicago’s exchanges.
Derivatives have dual lives. They are tools of hedging or risk management and of pure speculation. The Chicago exchanges bring together thousands of traders, market makers and speculators to seek out profits. These traders are the mechanics who keep the engines of capitalism moving forward.
In the 1970s, while the commodities traded in this new market were financial, the market rules, regulators and structures were inherited from distinctively speculative agricultural markets. The financial innovations weren’t discovered or created on New York City’s Wall Street, Broad or Broadway. They were fertilized, hybridized, conceived and brought to life on Jackson Boulevard, LaSalle St. and Wacker Drive (on Chicago’s loop).
Chicagoans, unlike New Yorkers, learned how to build a wide array of commodities and assets. Chicago’s futures traders and investors were not necessarily interested in what was being traded per se. Their interest and desire was to trade prices – on anything.
Chicago’s future tied to financial futures
“Financial futures were spawned out of the belly of the hog.” – Former CME Chairman Jack Sandler (2012)
Financial markets are mesmerizing, immense, globally connected and built for lightning-fast transactions. They’re both a symptom of and cause for the changing face of finance where trading links nation states, global exchanges, organizations, traders and investors. Financial exchanges bring together some of the most powerful elements of twenty-first century economies.
Futures make possible the circulation of agricultural, energy and metal commodities and financial instruments without the physical commodity ever changing hands. In 1971, the notional dollar value of futures contracts traded exceeded the value of all the securities traded on the New York Stock Exchange (NYSE).16
In 1972, the Chicago Mercantile Exchange (CME) crawled out of its “agricultural market cradle.”17 The CME relied heavily on its institutional experience in designing agricultural futures to start a futures contract on foreign currencies – the first financial futures contract. A year later, the CBOT began trading similar contracts on corporate stocks. Over the next few years, the two Chicago exchanges developed financial hedging instruments – financial futures – in interest rates, U.S. Treasury bonds, mortgages, stocks and stock indexes.18
Financial futures emerged from the farm belt to the forefront of a global financial system. From 1975 to 1987, the Chicago commodity/futures business was transformed from one almost exclusively focused on foodstuffs and raw materials to one mostly focused on financial products and financial markets.
A principal contribution to functioning economies is that financial futures reduce transaction cost and enhance market liquidity. Although price discovery and hedging can be accomplished in cash markets, it is demonstrably cheaper and more efficient to use financial futures. By centralizing order flow to a unique location – a trading pit or exchange – a single price emerges. This reduces the cost of capital to companies that use financial futures.
Chicago’s futures trading places are a mechanism to redress the time differential and trade in objects and concepts that lack material properties.
Futures trading is beneficial to the United States and global economies. Even as Chicago’s legendary trading pits have been relegated to the past, its exchanges remain at the center of the derivatives universe.
Futures trading provides price discovery in an increasingly uncertain world. The future of futures trading is bright! Chicago’s future in the futures industry is assured by its willingness to innovate through trial-and-error experimentation because the second city is truly first in derivatives.
The author, Rick Roche, is a managing director at Little Harbor Advisors, LLC and 40-year industry veteran. Little Harbor Advisors is the majority-owner of a Chicagoland-based investment and derivatives trading firm, Thompson Capital Management. Rick is a frequent industry speaker and has been published in numerous financial trade publications.
Rick was born in the Garden State and now resides in the Bay State. But Rick and his family lived for 22-years in Minneapolis, MN, so he readily relates to Midwestern culture family values. Rick is a Chartered Alternative Investment Analyst (CAIA) and holds Series 3, 7. 63 and 65 securities (Investment Adviser Representative) licenses.
Rick Roche, Little Harbor Advisors and Thompson Capital Management are not affiliated with any of the other firms mentioned herein. The author has not received any compensation for writing this piece and has no conflicts of interests. The information contained in this article was obtained from sources believed to be reliable but its accuracy cannot be guaranteed. Any errors are the sole responsibility of Rick Roche.
Appendix – Exhibit A
Chicago futures past and present
1848 – The Board of Trade of the City of Chicago receives corporate charter from the State of Illinois to establish a grain and provisions exchange. The Chicago Board of Trade (CBOT – now part of the CME Group) creates the world’s first modern futures exchange.
1865 – CBOT formalizes grain trading with the first-ever standardized 'exchange traded' forward contracts, called “futures” contracts, the world’s first such agreements.
1973 – Chicago Board Options Exchange (now Cboe®) is founded. World’s first organized Options Exchange and first exchange to establish an entire industry-- listed stock and stock index options.
1982 – CME launches first successful stock index futures contract – S&P 500 Index futures.
1983 – Cboe – First marketplace to trade options contracts on the S&P 500 Index®.
1993 – Cboe® introduces the original version of the VIX® Index to measure the market’s expectation of 30-day volatility of the S&P 100 Index.
2004 – Cboe introduces VIX® Index futures contracts
2006 – Cboe begins trading VIX® Index options trading
1“How Chicago Transformed From a Midwestern Outpost Town to a Towering City”, Joshua Salzmann, SMITHSONIAN Magazine, Oct 12, 2018.
2Paddy whacked: The Untold Story of the Irish American Gangster, T. J. English, HarperCollins, 2005.
3“Chicago’s Financial Firsts: The Firsts and Innovations of Chicago’s Financial Sector”, by David Baeckellandt, presented at FinTech, Chicago Merc, Oct 20, 2014.
4Stassen, J., “The Commodity Exchange Act in Perspective: A Short and Not-So-Reverent History of Futures Trading legislation in the United States”, Washington & lee Law review, Summer 6-1-1982.
5Puffert, D., “The Standardization of Track Gauge on the North American Railways, 1830-1890”, The Journal of Economic History, Dec 2000.
6Levy, J., L., “Contemplating Delivery: Futures Trading and the Problem of Commodity Exchange in the United States, 1875-1905, American Historical Review, Apr-2006.
7Muellerleile, C. 2015. “Speculative Boundaries: Chicago and the Regulatory History of US Financial Derivatives”, page 1805.
8Board of Trade v. Christie Grain & Stock Co., 198 U.S. 236 (1905), Opinion of the Court
9Hochfelder, D., “Where the Common People Could Speculate”: The Origins of Popular Participation in Financial markets, 1880-1920”, The Journal of American History, Sep 2006.
10Tate, J., C., “Gambling, Commodity Speculation, and the ‘Victorian Compromise’", Yale Journal of Law & the Humanities, 2007.
11Muellerleile, C. 2015. “Speculative Boundaries: Chicago and the Regulatory History of US Financial Derivatives”, published in Environment and Planning, vol 47, 2015, pages 1805-1823.
12Board of Trade v. Christie Grain & Stock Co., 198 U.S. 236 (1905), Opinion of the Court
13Hayes, A., A., “The Metropolis of the Prairies”, Harper’s New Monthly Magazine, Oct-1880.
14Poitras, G., 2009. “From Antwerp to Chicago: The History of Exchange Traded Derivative Securities Contracts”, published in Editions Sciences Humaines, 2009.
15Till, Hillary. 2015. “The Trial-and-Error Development of the Chicago Futures Market”, May 8, 2015.
16Ibid., Muellerleile, C. 2015. “Speculative Boundaries”, page 1813.
17Ibid., Muellerleile, C. 2015. page 1813.
18Muellerleile, C. 2013. “Commoditizing Finance: Chicago’s Financial Futures Markets, 1972-1988”