There is a lot that farmers have given the world, and in the world of high finance, farmers taught Wall Street how to trade the future. This is an esoteric process that farmers and financial traders use to provide the nation with food on time and to hedge the bets of both groups in the face of uncertainty.
Historians have actually found “futures” contracts for rice in Japan that date back to the 17th century, but the modern history began in Chicago in 1848. That was the year that the Chicago Board of Trade was established.
Chicago had become the Midwest hub of commerce. It was situated in the middle of the growing country with Lake Michigan and most of the day’s railroads running through it. Chicago was becoming a major center for storage, sale and distribution of grain. But there was a problem – grain is seasonal and Chicago didn’t have enough storage bins to handle all the grain produced at harvest time. If it tried to build enough storage bins, they would have sat idle each spring. Chicago prices for grain, therefore, rose and fell dramatically.
So, a group of grain traders began to write “to-arrive” contracts that permitted farmers to lock in a price for their grain early in the growing season and deliver it even much later than harvest. This shifted the problem of storing the grain from the buyer to the farmer or cooperative associations that grew up. These “to-arrive” contracts proved to be useful in allowing the farmers and buyers to hedge their risks and speculate on the future price of grain. Farmers and traders soon realized that the sale and delivery of the grain itself was not nearly as important as the ability to transfer the risk associated with the grain. The grain could always be sold and delivered anywhere else at any time.
As trading of forward pricing contracts increased, the Chicago Board of Trade standardized the contracts to streamline the trading and delivery process. The contracts were identical in terms of quantity, quality delivery month and terms, so the only thing left for traders to negotiate was the price and the number of contracts.
In 1874, the Chicago Board of Trade got a competitor in the futures trade when the Chicago Produce Exchange was formed. In 1919, the Produce Exchange was renamed the Chicago Mercantile Exchange (CME), and it went on to become a leader in futures markets.
By the 1920s, the futures trade was so lucrative that corrupt “bucket shops” were being set up. These cutthroat operations would lure in investors and then flee without making the promised investments. About the same time, there was a downturn in grain prices, and farmers began to blame the futures market.
So, the government regulated warehouses and stockyards, placed ceilings on freight rates, promoted farmer cooperatives, eased credit conditions and taxed or banned different types of futures trading. However, the futures trading ban did not survive a Constitutional challenge. It was not until much later that effective regulation of the futures industry was enacted.
By the middle of the century, many farmers were in the futures market. In effect, selling a futures contract allows the farmer to make a “side bet” – he or she wins the side bet if the prices for the commodity falls because the futures contract is bought back at the lower price. If prices rise, the farmer won’t make as much money as possible, but he or she will have covered the risk by selling a contract that covers the cost of production plus a profit. Yet, not every farmer used futures contracts because there is still some risk and they are complicated to manage effectively.
Financial Futures. Finally, in 1971, the financial markets caught up with the farmers.
Before that date, world currencies had been pegged to an international gold standard. In ’71, the gold standard was abolished and currency values were allowed to “float.” The Chicago Mercantile Exchange realized that a floating currency whose value was determined by market forces had become a commodity, just like pork bellies. The CME created the “International Monetary Market” and offered futures contracts as a way to hedge against price changes and to profit when the currency price changes go an investor’s way. Other “financial derivative products” followed –
- In 1975, the Chicago Board of Trade created the first interest rate futures contract based on the value of Ginnie Mae mortgage rates. This market never took off.
- In 1975, the CME offered a Treasury bill futures contract and it became the first successful interest rate futures market.
- In 1977, the Chicago Board of Trade was successful with the Treasury bond futures contract.
- In 1982, the CME created the Eurodollar contract.
- That same year, 1982, the Kansas City Board of Trade launched the first stock index futures contract pegged to the Value Line Index.
- The CME quickly followed with a highly successful contract on the future of the S&P 500 index.
In 1994, the derivatives markets were hit with a series of large losses by some huge firms that had been trading in futures. Most firm selling the contracts instituted tighter controls, but continued to use derivatives.
The farmers who had started the whole thing continue to use futures contracts to manage their risks.
Agronomist Alex Martin (left) believes that major agriculural producers today have to make use of futures. “It allows them to lock in a price that they deem profitable into the future,” he says.
But, not everyone is convinced that futures trading is a good thing. Tom Hoffman (right) says that futures have driven the small producers out of the cattle industry. “Futures trading killed them,” he says. “I think that probably had more influence, good or bad (take your pick), on the livestock market. And then packer concentration. They go hand in hand.”