History of Derivative Markets
Learn How Derivatives Evolved and Where They Are Today
Studying the history of derivative markets helps us understand derivatives better, as well it offers unique insights into how derivative markets are structured today.
Rudimentary derivatives can be found throughout the history of mankind. In the Middle Ages, engaging in contracts at predetermined prices for future delivery of farming products, for example, was quite frequent. Hundreds of years ago, Japan had a semblance of an actual futures exchange. But it was not until 1848 that the first modern, organized futures market in North America was created—the Chicago Board of Trade.
Agricultural Futures Dominate the First 100 Years of Derivatives Trading
After the Chicago Board of Trade first opened its doors, the grain market in Chicago almost exploded. Farmers needed to secure prices for their grain, needed to know those prices in advance of the crops, needed a place to store the grain, and needed someone to facilitate delivery and settlement of futures contracts.
Around that time, the first customized option contracts were offered, too. To illustrate, a well known financier of the era, Russell Sage, offered customized options that effectively imitated loans at interest rates that were much higher than rates allowed under the then-existing usury laws.
After the Chicago Board of Trade, other organized derivatives markets were established in the U.S., including the Chicago Mercantile Exchange, and later The New York Mercantile Exchange and the Chicago Board Options Exchange. The latter two subsequently became the main driving forces of the derivatives industry worldwide.
During the 1970s, Financial Derivatives Enter the Scene
The new era for the derivative markets was ushered with the introduction of financial derivatives, and it continues to last to this day. Although commodity derivatives are still quite active, particularly oil and precious metals, financial derivatives dominate trading in the current derivative markets. In addition, although customized options existed since the 19th century at least, the introduction of standardized options in 1973 completely overshadowed their customized counterparts.
Another important factor impacted the derivatives markets in the 1970s—deregulation of foreign exchange rates. When foreign exchange rates became freely floating, not only have new currency markets developed, but also the markets for trading customized forward contracts in foreign currencies. This market was later referred to as the interbank market because most of the participants were, and still are, domestic and international banks. Aside from facilitating trading in currency derivatives, the currency interbank market also set the stage for the banking industry to become more involved in trading of other types of financial derivatives.
The Age of Deregulation in the 1980s
More deregulation of the 1980s further blurred the regulatory lines among financial services providers, such as banks, insurance industries, securities dealers, etc. Banks in particular discovered they could create various types of derivatives that were to be sold to corporations, as well as to other financial institutions. The idea was to create tailored products that were designed to alleviate risk exposure specific to certain situations and certain players.
Of course, banks were not the only ones profiting from financial derivatives designed to transfer or lay off risks elsewhere. Investment banking firms, also called derivatives dealers, soon joined in the burgeoning derivative markets.
The Age of Maturity in the 1990s
Although the derivatives markets slowed down considerably by the end of the 20th century, that did not mean that there were not a steady offering of existing, as well as new derivative products. Derivatives exchanges also went through a period of change; some consolidated, some merged, some became for-profit institutions. Regardless, they all had something in common—the need for less regulation.
Aside from structural changes, some derivative exchanges also changed the way they conducted trading. Old systems of face-to-face trading on trading floors have been replaced with electronic trading, and telephone and computer networks. With the advent of Internet, electronic trading evolved into e-trading. And although trading floors still dominate derivative markets in the U.S., it is obvious that to stay competitive, the U.S. will have to eventually embrace electronic trading.
Derivatives Markets in the 21st century
There is a general consensus that London and New York are the world’s primary markets for over-the-counter derivatives. Notably, significant derivatives trading is also happening in Tokyo, Paris, Frankfurt, Chicago, Amsterdam, etc.
In terms of size, today the U.S. accounts for almost 35% of futures and options trading worldwide. However, the Korea Stock Exchange is the largest derivative exchange in the world. The second largest by volume is the Eurex (German-Swiss), followed by the Chicago Board of Trade, the London International Financial Futures and Options Exchange, the Paris bourse, the New York Mercantile Exchange, the Bolsa de Mercadorias & Futuros of Brazil, and the Chicago Board Options Exchange. Note that in 2001, these exchanges traded in aggregate 70 million derivative contracts (Source: Futures Industry, January/February 2002).
