The history of futures contracts reveals their important economic role and impressive social benefits. The Crimean War of the 1850s and the U.S. Civil War gave rise to price uncertainties for growing inventories of grain made possible and necessary by population growth, new forms of transportation, and improvements in agricultural productivity. The Chicago Board of Trade was established to enable suppliers and consumers to manage such risks. The collapse of the Bretton Woods system of fixed currency prices similarly created the need for businesses to be able to hedge against sudden changes in currency exchange rates. Economic disruptions affecting oil and natural gas created similar demands for futures contracts.
History also shows how futures markets are largely self-regulating. Futures contracts fail when risks are not sufficiently material, when existing contracts or exchanges already serve to adequately manage risk, and when technology and government policies change in ways that reduce risk or make past ways of hedging no longer effective. Competition among exchanges is also intense, as illustrated by the loss of Bund futures contracts by the London International Financial Futures and Options Exchange to Eurex in 1998 and the mergers of the Chicago Mercantile Exchange, Chicago Board of Trade, and NYMEX in 2007 and 2008.
Speculators have played an essential role in the success of futures contracts, taking on the other side of commercial hedgers’ positions. Professional speculators can achieve this by spreading the position taken on from the commercial hedger against a futures contract in another maturity of the futures curve or against a related commodity. Or speculators may take on an outright position from a commercial hedger and include this position in a portfolio of unrelated trades, relying on portfolio theory to manage risk. Chicago has thrived as a center for futures contracts due in large part to its large and sophisticated pool of speculators.
Lawmakers have tried repeatedly to “limit, obstruct, or prohibit futures trading” (Jacks, 2007) based on the public’s misunderstanding of how futures contracts are self-regulating and their essential role in helping businesses manage risks. Pressure for increased regulation often follows economic disruptions, such as the rapid inflation that followed the collapse of the Bretton Woods system in 1971 and the oil embargo of 1973-74, when speculators were blamed for price spikes.
Markets discipline government regulators as well as speculators and commercial hedgers. Exchanges compete furiously with one another, requiring national regulators to establish regulatory parity with other countries or risk losing the economic benefits of being the home of successful exchanges. The existence of competing exchanges and futures contracts means even draconian regulation, such as banning trading in a particular commodity, cannot prevent markets from finding alternative ways to manage risk, a fact illustrated by the market response to the Carter administration’s suspension of U.S. grain futures trading for two days in 1980.
In conclusion, futures contracts and exchanges succeed only if they respond to genuine commercial hedging needs and if speculators are capable of managing the risks associated with taking on the hedgers’ positions. Unnecessary or inefficient futures contracts and exchanges don’t last long, the result of competition and continuous innovation by a sophisticated global futures industry. The industry must educate the public and policymakers about the important role it plays in a global economy and the benefits it produces for the public, or else needless and counterproductive regulation will continue to be proposed and imposed.
