Collapse of the Bretton Woods Agreement

Up to the First World War, the world’s currencies were described either as hard or soft currencies, depending on whether they were convertible into gold at a fixed or floating exchange rate.

In 1945, after the Second World War, the Bretton Woods Agreement was reached and was responsible for keeping a narrow band of fluctuation (2 per cent) between the US dollar, which was pegged and convertible into gold, and other currencies.

By the 1970s it had become impossible to keep so many currencies, each from countries with completely different economic growth rates, within the agreement, and so in 1972 it was abandoned.

With the collapse of the agreement, foreign currency exchange rates were no longer fixed and could float freely. Belchambers outlines what happened next:

This new freedom in the movement of exchange rates, coupled with substantial rises in property values, oil prices and the widespread printing of money to finance publicexpenditure, led to substantial instability in the money markets and to double digit inflation and interest rates. Countries which had seen rapid trade growth suddenly plunged into recession led by an explosion of volatility in the ‘price’ of money. The climate was ripe for the introduction of ‘financial’ futures contracts. In 1970, the first such contract was introduced in the US in order to provide a hedging vehicle againstfluctuating exchange rates. It failed. Nevertheless, the idea was taken up by the CME, which, in 1972, formed a subsidiary (IMM) for the trading of currency futures. On 20th October 1975, the CBOT introduced a futures contract on the Government
National Mortgage Association (GNMA). Within a matter of months, the CME
introduced a futures contract based on the ninety-day Treasury Bill. The CBOT
followed with the launch of the most successful contract of all time, namely its US
Treasury Bond futures contract. In the unstable environment of the 1970s, these new
contracts proved an instant success and the concept was soon extended to equity indices.
Anthony Belchambers

Nowadays, financial futures products dominate trading over the more traditional commodity contracts worldwide.

International Development of the Derivatives Industry

Since the Second World War, the futures and options industry has seen massive growth on an international scale, with other countries coming in to challenge the US markets in their position as leading providers of futures and options.

This was clearly demonstrable in 1991 when turnover figures for worldwide exchanges showed the US markets experiencing a drop of 4.5 per cent in the volume of futures and options business, against an increase in the rest of the world of 16 per cent over 1992. Looking over the longer term, it has been estimated that over the past five years the percentage of business done in the US has gone down from 90 per cent to 50 per cent.

Although admittedly not a turnover figure which is typical of its day to day volumes, the volatility in the European currency markets through September 1992 made Liffe in London briefly the biggest exchange in the world by volume.

In the middle of the 1970s, the commodity futures industry was clearly divided among the main centres: Chicago for wheat, corn, soya beans and livestock; New York for gold; London for sugar, base metals, coffee and cocoa; and, to a lesser extent, Paris for sugar and coffee. By the mid and late 1980s, this was no longer the case. New futures markets were being established around the world, and the development of new technology ensured the wider distribution of price information. Meanwhile, restrictions imposed by regulatory requirements on cross-border trading or currency limitations were—and still are—being rewritten to allow for truly global financial trading. Finally, the natural international spread of expertise in futures trading had pushed the futures industry out from under the domination of the US and the UK and into the rest of the world.

Of the top 10 futures exchanges in 1992, measured by volume, the UK’s Liffe and France’s Matif now hold the third and fourth positions, while the remaining exchanges come from every corner of the world (see Table 1.1).

The highest new entry in this table in 1991 was the BM & F, the Bolsa Mercadorias & de Futuros of Brazil, whose option on the Brazilian stock index, the Bovespa, came in at position 20 in the 1991 list of top contracts by volume. BM & F was the fastest-growing futures exchange in 1991, with a volume rise of over 90 per cent on the year before.

The newer exchanges, outside the US, tend to be computer-based rather than using the open-outcry system that is still a feature of the CBOT and the CME.

Development of Over-the-counter Products

The international futures exchanges have seen massive growth over the last few years, but the over-the-counter (OTC) markets have seen an equally significant increase in business.

OTC derivatives contracts are tailor-made products which offer greater flexibility in return for greater cost, little regulatory protection and potential liquidity problems. They are generally used by institutions which have specific needs, for which exchange based contracts cannot provide, such as a French franc/Swedish krone cross rate or, indeed, specific interest rate date requirements.

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• The Origins of the Futures Industry (part 1)
• The Evolution of Managed Futures Funds
• Using currency options to manage risk
• Inside of the foreign exchange market continue...
• Average rate options
• Applications of swaps to risk management
• Key Points and bottom lines in Currency Forward Rates
• Reasons for the swap markets' existence
• The Case Against Managed Futures