Financial Cold War. James A. Fok
the price of the underlying asset, duration and interest rates can be known, future volatility is a prediction based on historic experience. Traders who forget that the past is not always a good guide to what will happen in the future often suffer catastrophic losses. Ironically, Robert Merton and Myron Scholes, the academics who shared the 1997 Nobel Prize in economics for inventing the famous Black-Scholes model for pricing options, learned this lesson the hard way. Just a year after their Nobel award, the hedge fund Long-Term Capital Management (LTCM), in which they were partners, had to be bailed out by Wall Street banks under Fed supervision after suffering spectacular losses.66
Notwithstanding its inventors' later misadventures, the advent of the Black-Scholes model in 1973, coupled with developments in computer technology, brought about a revolution in the financial services industry. Before that, trading required few academic qualifications and there were many examples of mailroom clerks who had risen to untold riches in the rough and tumble of the markets. Nowadays, trading rooms have been taken over by mathematicians and scientists holding advanced degrees.
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President Nixon's abandonment of the dollar's fix to gold sparked demand for hedging currency volatility that had previously been subdued by the Bretton Woods system. This was a void that CME's energetic chairman Leo Melamed moved rapidly to fill.
Melamed was born into a Jewish family in Bialystok, Poland in 1932. His father was a mathematics teacher. At the outbreak of WW2, the family fled to Lithuania and were one of the fortunate Jewish families to receive a life-saving transit visa issued by Japanese vice-consul Sugihara Chiune in 1940. After a long passage via Siberia to Japan, the family eventually crossed the Pacific to the US and settled in Chicago. Melamed trained as a lawyer but, while attending John Marshall Law School, he answered a job advertisement for a position at Merrill Lynch, Pierce, Fenner & Beane. Thinking that a firm with such a lengthy name could only be an established law partnership, he inadvertently found himself working as a trading floor order-runner on the CME. He became hooked on the markets and it was not long before he bought his own membership seat on the exchange. By 1969, he had risen to become chairman.
Melamed had long subscribed to the free market theories espoused by University of Chicago economics professor Milton Friedman. He saw that the end of Bretton Woods created the conditions for a market in foreign exchange rates, and immediately began to think about launching currency futures on the CME. However, many of the exchange's members at that time did not believe that financial futures could succeed and thought that the CME should stick to its traditional agricultural futures products. Indeed, the New York Produce Exchange had renamed itself the International Commerce Exchange in April 1970 and launched currency contracts targeted at small-time speculators, but these had not found success. Nevertheless, that had been before Nixon's August 1971 bombshell and Melamed was convinced that that crucial development would enable global currency futures to take off.
To build credibility for his cause, he enlisted Friedman's help. Over breakfast at the Waldorf Astoria in November 1971, Melamed explained his idea to the famed economist. Friedman agreed that, with the suspension of the Bretton Woods Agreement, conditions were ripe for developing a market in currency futures. Melamed asked Friedman if he would be willing to put his opinion in writing, to which the economist answered: ‘Yes, but I am a capitalist’. For a fee of $7,500, Friedman agreed to write a feasibility study on ‘The Need for a Futures Market in Currency’ and submitted it to the CME in December 1971. With this endorsement, Melamed launched the International Monetary Market (IMM) in May 1972 and began offering futures contracts on seven currencies against the US dollar.67 The currency futures achieved rapid success and, with the backing of Friedman's academic prestige, the IMM received regulatory support for the launch of interest rate futures on US Treasury bills in 1975.
Volatility ushered in by the end of Bretton Woods was not just restricted to currency markets. As global oil demand increased in the years after WW2, the US had found itself becoming increasingly dependent on oil imports, particularly from the Middle East. Prior to the 1970s, the international oil companies had been vertically integrated operations, carrying out all the functions from oil exploration to distribution to end customers. However, the end of colonialism and rising nationalism had seen a wave of nationalisations of these natural resources by oil-exporting countries. Consequently, the oil companies no longer owned the oil in the ground and the commodity became increasingly traded through world markets. The devaluation of the dollar angered the exporters, who effectively received less in return for their oil. Meanwhile, price controls in the US discouraged new exploration and boosted consumption, leading to tighter supply. When the Arabs initiated an oil embargo in October 1973 in response to US military assistance to Israel during the Yom Kippur War, prices rocketed. Panic buying saw the posted price for Iranian oil shoot up from $2.90 a barrel in mid-1973 to as high as $22.60.68
Such a steep increase in energy prices set off global inflation and led to deep economic hardship in much of the developed world. Although the embargo was ended in March 1974, oil prices remained elevated versus their previous level and volatility persisted. The overthrow of the Shah of Iran by Ayatollah Khomeini in 1979 set off a second oil price shock, with oil prices doubling over 12 months to $39.50 a barrel.69 Faced with this price volatility, businesses from airlines to utilities scrambled to hedge the cost of their oil. NYMEX started offering trading in futures contracts on home heating oil and gasoline to meet this demand.
In March 1983, NYMEX launched a futures contract on light sweet crude oil delivered to tanks located in Cushing, Oklahoma. This grade of oil, known as West Texas Intermediate (WTI), became a global standard for oil prices. The benefit of a standardised benchmark is that it serves as a reference against which other grades of oil can be priced and concentrates trading liquidity, so as to enable traders to transact large quantities of oil without causing major price swings. In 1988, the International Petroleum Exchange (IPE) in London launched futures contracts on Brent Crude, a heavier grade of oil extracted from the North Sea. The IPE was acquired by the Atlanta-based Intercontinental Exchange (ICE) in 2001 and Brent has now overtaken WTI to become the benchmark used to price over three-quarters of the world's traded oil.
Growth in derivatives trading from the 1980s has been explosive. This was fuelled by a set of factors that each reinforced the others: growth in financial markets; consequent greater demand for hedging tools; product innovations by the financial industry; a larger supply of graduates with the necessary quantitative skills; and technology-enabled electronification of financial trading. The pros and cons of this growth are explored in Chapter 7; however, the development of these derivatives has been critical in consolidating the dollar's global position.
As of the end of 2020, the total notional value outstanding of all derivatives contracts was estimated to be $667 trillion.70 This compares to the $110 trillion combined market capitalisation of all stock markets in the world71 and $139 trillion in total debt outstanding in global bond markets.72 It is also roughly 7.9 times the size of global GDP. These contracts are vital to the smooth functioning of international trade and financial markets, as they allow businesses and individuals to manage their risks across foreign exchange, interest rates, credit, stocks and commodity prices. To be effective risk management tools, derivatives must be liquid and, preferably, supported by infrastructure such as clearing houses to help minimise counterparty risks.73 Given the sheer size of this ecosystem of products and infrastructure, it would be extremely difficult for this system to be replaced. And since the vast majority of these derivatives are priced in US dollars, the growth and standardisation