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Evolution of Markets: Forwards & Futures (Part 1/2)

7/4/2015

 
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July 6th, 2015 marked the day the CME grain pit closures took effect and after 167 years of trading and there is much to look back on. Not only the colorful jackets, mysterious hand signals and bold personalities, but a time honored tradition of how price is determined. Now is not the time to have pity and mourn the ending of an era, aptly named by Reuters. Instead, this is the opportune moment to review where price discovery has been and learn a bit about the innovations involved.
Ancient Rome – 1700’s
The Ancient Romans, arguably the most powerful civilization of the past, called their main exchange fora vendalia (sales market). Still standing today at the center of Rome, citizens bartered at a set time, with common currency and standard contracts. Central market places of this sort became harder to come by due to destruction of trade routes in war, leading to the end of steady trade in Europe.

But the market evolved, and decided to go on the road in the Dark Ages. Men of dusty feet traveled ahead of large fairs, alerting people of nearby towns and cities that the market was coming. England and France are regarded in history for their robust fairs around 1100 A.D. where the majority of transactions were completed on the spot, a term still used today in contracts. As civilization grew in Europe, rules were made on trading conduct and breaking of said rules would potentially bar a marketeer for good. Although, with the fairs constantly traveling, such rules were hard to enforce and never quite reached a formalized level. By the 14th century, cities were thriving as trade routes were re-established, along with transportation and communications. This brought exchanges back to city centers.

1700’s to 1850’s
It wasn’t until 1730 at the Dojima Rice Market in Japan that forward contracts were ever formally recognized, specifying a cash transaction at an agreed upon price, quality, quantity and date. These first forward contracts were for rice, but cotton, oil and metal joined the mix as transportation continued to develop. At the time, this concept was revolutionary because it gave way to reasonable expectations for what could be bought and sold at specific times of the year. Instead of wondering what the market for a certain product would be in the future, buyers and sellers who arranged these contracts knew, at least to some extent, what they could anticipate.

100 years later, Chicago was just coming into its own with a bit over 4,000 residents. Because of its proximity of nearby fertile land and access to the Great Lakes, Chicago became the epicenter of trade in the Midwest. If you can imagine the chaos of all the wagons from surrounding rural areas of Chicago, full of grain, flowing into the city from all directions at the same time during harvest season. That’s what it would have been like if it were not for the modernization of the city.

There had been a lack of everything concerning a modern trading hub, including storage, roads, transportation, waterways, harbors and financing. Out of necessity, Chicago attained all of the above, especially roads, updated from wooden planks at the time. After these developments, the Chicago Board of Trade created the futures contract in 1865 and goods poured into the city. Futures allowed for the arrangement of price in the future with the added bonus of having a standard quantity, quality, time and place of delivery. They also helped reduce the imbalance of supply and demand, eliminating a large chunk of price risk for the producers and making inventory management for processors more efficient.

That's it for part one of the series. The next addition will focus on technology and tenacity, two characteristics still alive and well today. For a direct link to part two, click here.

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