Free Markets, Foreign Exchange and the International Monetary Market
The Empire Club of Canada Addresses (Toronto, Canada), 10 Apr 1986, p. 364-375
Melamed, Leo, Speaker
Media Type
Item Type
The International Monetary Market (IMM) of Chicago and its economic backdrop. The IMM as the marketplace which ushered in the financial futures revolution that ultimately changed and reshaped modern concepts of risk management. Some statistics to show the worldwide acceptance of this tool of finance, and a detailed discussion of how the IMM is viewed. Some general misconceptions about our markets and an explanation of them. How the value of every product is determined by the fundamental factors of supply and demand. The fate of the value of the Canadian dollar in the hands of the Government of Canada. Canada's economic growth over the last three years and the vast growth in exports. Canada's problem of its federal budget deficit. The negative implications of Canada's deficit on the Canadian dollar. Looking at the total picture for Canada.
Date of Original
10 Apr 1986
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The speeches are free of charge but please note that the Empire Club of Canada retains copyright. Neither the speeches themselves nor any part of their content may be used for any purpose other than personal interest or research without the explicit permission of the Empire Club of Canada.
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Full Text
April 10, 1986
Leo Melamed, Chairman, Executive Committee, Chicago Mercantile Exchange
The President, Harry T. Seymour, Chairman

Mr. Seymour

Messrs. Consuls General, Reverend Sir, distinguished head table guests, members and friends of The Empire Club of Canada: It is my pleasure to welcome as our guest speaker today Leo Melamed, chairman of the executive committee and special counsel to the board of directors, Chicago Mercantile Exchange.

The legendary Thomas P. "Tip" O'Neill, Jr., Speaker of the U.S. House of Representatives, in a May, 1982, letter to John F. Sandner, chairman of the board of the Chicago Mercantile Exchange, wrote:

"As the Merc prepares for next month's celebration of the tenth anniversary of the International Monetary Market, let me offer my congratulations early.

"Under the leadership of Leo Melamed, the IMM has become a positive and creative force in the financial world. You have pioneered new markets and helped the futures industry experience a decade of tremendous growth."

While there is no single action that stands out as the founding moment of the IMM, originally established as an independent division of the Chicago Mercantile Exchange, certain events clearly played crucial roles in the new market's evolution from dream to reality. One of the most important was the breakdown of the Bretton Woods Agreement in 1971. For 26 years, the pact had established a narrow band of fluctuation between Western currencies and the U.S. dollar.

The absence of these defined currency relationships, combined with other economic developments, brought to the attention of the world financial community the need for a way to hedge currency fluctuation risk.

The problem was clear, so was the solution.

At the request of the Chicago Mercantile Exchange, Dr. Milton Friedman, subsequently the Nobel laureate in economics, wrote a study in December, 1971, entitled The Need for Futures Markets in Currencies, which became the intellectual foundation for the birth of currency futures.

As the result of Professor Friedman's strong support, the determination of the Exchange leaders, its board of governors, and its rank and file members, the International Monetary Market was chartered by the State of Illinois in December, 1971.

When the IMM opened for business in May, 1972, it listed seven foreign currency contracts-British pounds, Canadian dollars, Deutsche marks, Italian lira, Japanese yen, Mexican pesos and Swiss francs. Lira were delisted and Dutch guilders added in 1973, plus French francs in 1974.

For the first time, business and financial managers had the same access to price risk-transfer opportunities that their agribusiness counterparts had been using successfully for more than 100 years.

Trading on the new exchange began cautiously, but, within two years, volume started to build momentum, almost tripling between 1972 and 1973. Success prompted the exchange to add gold futures in December, 1974, U.S. Treasury Bill futures in January, 1976, and, subsequently, domestic certificates of deposit and Eurodollar deposit contracts.

As currency, gold and interest-rate futures transactions continued to grow worldwide, the new exchange saw the need to broaden its base and, in 1976, merged with its Chicago Mercantile exchange parent.

The success of this merger is evidenced by the fact that the Merc established its ninth consecutive annual volume record in 1985, with better than 56 million contracts traded, an increase of 26 per cent compared with its 1984 total.

Included in this impressive total were 468,996 Canadian dollar contracts, representing only 2.8% of the almost 17 million currency futures contracts traded in 1985.

How is it, then, that certain journalists have seen fit to write recent newspaper articles? These articles were headed: "How a Handful of Chicago Speculators Drove our Dollar Down" and "Rumours Persist Speculators Caused Canadian Dollar Dip"

A counter-argument put forth by the chief economist of one of Canada's leading investment dealers prompted the writer to entitle his article:

"Economist Cites Central Bank in Dollar's Fall" Meanwhile, the senior vice president of one of Canada's major chartered banks was quoted as saying: "Speculators play a necessary role, but they can affect the value of a currency. . .I'm not saying that they run the show. . .but once the movement of a currency gets under way, the speculators can take it past the point where it would otherwise stop." I am certain our guest will attempt to set the record straight today. Recognized as a foremost authority on financial futures, Mr. Melamed has lectured and written extensively in the field and acted in an advisory capacity to the Commodity Futures Trading Commission.

On a business level, he has remained an active futures market trader and is Chairman of Dellsher Investment Company Inc., a clearing member of the Merc and the Chicago Board of Trade.

By profession, he is an attorney, having received his Doctor of Laws degree from the John Marshall Law School, Chicago. Ladies and gentlemen, it gives me great pleasure to introduce Leo Melamed, Chairman of the Executive Committee and Special Counsel to the Board of Directors, Chicago Mercantile Exchange who will address us on the subject "Free Markets, Foreign Exchange and the International Monetary Market."

Leo Melamed

In recent days, it has become quite the vogue in certain Canadian circles to blame the falling value of the Canadian dollar on the speculators in Chicago, specifically on the traders of the International Monetary Market (IMM) of the Chicago Mercantile Exchange (CME).

Indeed, the Canadian press gave the IMM generous coverage, blaming the fall in value either on "unusually high short selling" on our market or perhaps even on a "small conspiracy of hotshot traders." Moreover, I am ashamed to say, this view found support in some Canadian economic and political quarters.

And why not? Speculators are a most-convenient scapegoat; they have been accused, at one time or another throughout history, of virtually every economic ill with which politicians have had to contend.

Indeed, to behead the messenger of bad tidings is not a Canadian invention. The patent for this idea goes back to the dawn of civilization itself, and, I dare say, will continue to be a viable substitute for the truth for many years to come.

To a degree, therefore, I feel somewhat like a sacrificial lamb, not knowing the precise attitudes, biases or level of compassion of the audience before me and, having come here directly from the very den of iniquity in Chicago, the IMM.

Indeed, before someone suggests I become the perfect sacrifice for the angry god of Canadian dollars, who in recent years has not been smiling on your fair currency, allow me this one attempt to dislodge fiction from fact, expunge myth from reality and perhaps even replace some politically inspired sophistry with economic truism.

The IMM of Chicago, born in May, 1972, is a perfect example of Victor Hugo's reminder that "necessity is the mother of invention." Allow me to briefly sketch the economic backdrop leading up to the events that spawned this market in Chicago.

The Bretton Woods fixed-exchange rate system, instituted directly after World War II, functioned famously well for the first two decades of its life. It worked because the world wanted it to work, and the U.S. was determined it should work.

Unfortunately, the basic and fundamental flaw of fixed exchange rates-its rigidity-eventually began to have a cumulative effect. The system that served so well during conditions of post-war internal reconstruction was highly inadequate, once that process was complete. Because every one of the system's members achieved a different level of economic competence, each at a different rate of growth with widely-divergent expectations and limitations-and because each operated under significantly different fiscal and monetary policies as well as within substantially different forms of government-their respective FX values could not forever be ordained by committee nor adjusted every year or so.

The daily flow of political and economic events, the constant competitive stresses between member nations, the emerging demands of the Third World and the non-ceasing tug of war between the East and West, all combined to continuously change the supply/demand statistics that governed relative FX values. Thus, beginning in the mid-1960s, even while the world was enjoying unprecedented prosperity, it began to witness a constant and consistent erosion of the effectiveness of the exchange rate system upon which it depended. Revaluations and devaluations began to occur at a faster and faster pace, each larger than the one before.

At the same time, the dollar circulation outside the U.S., which had been rising at an alarming rate, had reached a level causing the system's gold accountability to come into question. The widening gulf between dollars in circulation and gold reserves that backed it, made it obvious that the official price for the precious metal was unrealistic. Eventually, foreign demands on Fort Knox for dollar conversion into gold, coupled with a growing U.S. trade deficit, resulted in unbearable pressures on the system's integrity. Indeed, by the time the decade was drawing to a close, confidence in U.S. strength and viability had eroded to a point of near-crisis proportions.

Thus, in 1971, when the United States suspended its guaranteed support price for gold, it effectively ended the fixedexchange rate era and ushered in a brand new and untested financial age-one that we at the Merc correctly identifiedan era that would spell enormous new risks and would therefore create new demands and new opportunities. Because our business was assuming and insuring risk, we were wellplaced to respond to the challenges thus created.

Wrote Nobel laureate Dr. Milton Friedman on the eve of the birth of our market:

"What the world will need is a futures market in foreign exchange that has breadth, depth and resilience... such a market needs speculators who are willing to take open positions as well as hedgers. The larger the volume of speculative activity, the better the market and the easier it will be for persons involved in foreign trade and investment to hedge at lower costs and at market prices that move only gradually and are not significantly affected by even large commercial transactions."

Yes, the IMM became that marketplace and, as a result, ushered in the financial futures revolution that ultimately changed and reshaped modern concepts of risk management.

The phenomenal growth of this idea is unequivocal evidence of its worldwide acceptance as an indispensable tool of finance.

• 1972 futures industry volume was 18.3 million;
• 1977 volume was 42.8 million, an increase of 133.7 per cent in just five years;
• 1982 volume, a decade after the birth of financial futures, was 112.6 million, an increase of 514.1 per cent;
• And last year's U.S. volume was 178.7 million, a 876.5 per cent increase since 1972.

And, at the Merc, the institution that led this revolution and shaped the idea to encompass every aspect of finance, from FX to interest rates to stock index futures with option products on each item, at this Chicago marketplace, the success story is even more evident, growing as it did from 3.3 million transactions in 1970 to 56.5 million transactions last year, an increase of 1605 per cent.

For those who wonder how much of that transaction volume is representative of commercial as opposed to speculative activity, allow me to point out that our membership scrolls include the names of Citicorp, Morgan Guaranty, Chase Manhattan, Manufacturers Hanover, Bank of America, Salomon Brothers, Goldman Sachs, Morgan Stanley and scores of other respected commercial entities on whose books much of our business activity is carried. Moreover, the futures and options business conducted by our member firms is often on behalf of commercial entities throughout the business world and representative of virtually every country around the globe including Canada.

The point I am trying to underscore is simply this: futures and options activity is now a central tool of risk management and an integral adjunct of every major financial institution the world over.

Indeed the value of futures and options markets was recently endorsed by none other than the U.S. Federal Reserve Board when, after its two-year study of our markets, it concluded that:

1) Financial futures and options serve a useful economic purpose by providing a more efficient way to manage risk;

2) That, if anything, the liquidity of related cash markets has been improved by the presence of futures and options; and

3) That there appears to be no significant regulatory problem concerning either manipulation or customer protection.

The Fed said: "It would appear the futures and options make possible greater output per unit of productive resources, just as in the case of any cost-saving technological innovation."

Those are strong words especially from an agency that had no positive bias on behalf of our markets. Rather, if the truth be know, the Fed began its study with a good measure of skepticism.

In view of these endorsements, in view of these volume statistics, in view of the overwhelming acceptance by the commercial community, it is little wonder that our Chicago markets are a most coveted financial arena. Virtually every financial centre the world over, be it Singapore or Sydney, Montreal or Manhattan, Toronto or Tokyo, Great Britain or Geneva, Brussels or Brazil, is desirous of creating a similar facility in its own backyard.

Little wonder also, I suppose, that many are resentful of the Chicago success story, and would greatly relish finding the evil they are certain is there.

And, on the surface, can you blame them for thinking thus? The tumult of our floor, the colour, the noise-how can this represent a respectable business activity? How indeed can traders, who know so little about the economics that dictate currency values, be entrusted with so important a role in the process?

The answer is complex. It begins with the notion Adam Smith long ago pronounced: that the combined effect of individuals pursuing their life's greedy mission acts as an invisible hand that promotes and achieves a public good.

The traders on the Merc know much more than many would give them credit. They are attuned to the important financial information channels and have a highly refined expertise called "feel." Besides, their own money is on the line; a finer discipline is yet to be achieved. But, given all that, they are only performing the role Adam Smith envisioned for them and do not, I repeat, do not determine the value of currency or anything else.

When they are brokers, their mission is to carry out the orders of their principal: to buy or sell as they are told. When they are market-makers, their mission is buy and sell to make money for themselves. Sometimes, they do well, sometimes not. In either case, they have very little to do with the ultimate value of the product involved.

More to the point, without a large pool of experienced and well capitalised market-makers, there can be no centralised futures exchange that has depth and resilience as Professor Friedman suggested. Local speculators are the lifeblood of a successful market, providing its essential element: liquidity. Simply explained, liquidity is the constant supply of bids and offers flowing to a market, ensuring that the next transaction will be executed at a price not too-distant from the previous one recorded. Liquidity thus enables commercial hedgers to use a given market with confidence, allowing them to transfer the price risks they do not wish to assume. And, price insurance is precisely what futures markets are about. But, to make that system work successfully, the more speculators, the better.

There is yet another general misconception about our markets that needs explaining. Futures are a zero sum game. For every winner, there is an equal and opposite loser. For every seller there must, by definition, be a buyer.

Therefore, if one accuses our local traders of being shortin other words, sellers-the allegation, even if true, does not by itself prove that their selling pushed down the price of the Canadian dollar. Someone on the other side of that transaction was a buyer. It must always be so. In a falling market, the buyers are simply less aggressive than the sellers, and vice-versa in a rising market. But, it always takes two to tango, so to speak.

Actually, according to a CFTC report, on December 31, 1985, 52 per cent of large speculative traders were short and 66 per cent of commercial activity was long. What does this

statistic prove? Not much ! But, usually commercial positions have much greater staying power than do speculators. I make this point because otherwise one gets the impression that our traders can unilaterally force a market in one direction or another. Momentarily, yes, but because there is a counter-balance to each transaction, if the price is out of line with real-world expectations, it snaps back in quick order.

One more thought. Every day before the IMM opens, the cash markets in currency, which trade in Europe long before our North American dawn (and before that, the ones in the Far East), have already established a price for every currency. That price reflects the very latest data and economic prospects as viewed by financial participants and is usually the opening level for American markets.

In other words, the Canadian dollar price, higher or lower, is established even before the IMM is opened. And, thereafter, the transactions executed on the IMM are but one factor in world currency value determination. The total volume of transactions within the inter-bank structure dwarfs that at the IMM each day.

Ultimately, the value of every product not controlled by a monopoly, cartel or sovereignty, is determined by the fundamental factors of supply and demand. That economic fact of life is so, whether the product is gumballs or gold, sorghum or silver, corn or copper, oat or even oil, as the OPEC people recently discovered, much to their chagrin. And, yes, ladies and gentlemen, that fact of life is equally true for the currency value of the Canadian dollar.

Fortunately or unfortunately (I leave you to decide), the fate of the value of the Canadian dollar is in the hands of none other than the Government of Canada, as it always has been. In other words, the Canadian dollar price will ultimately reflect the economic fortunes of your country.

Of course, it must be remembered that there are benefits stemming from a relatively low price of currency if one has an exporting economy. Witness the problems in the United

States as a result of the opposite-the high-priced U.S. dollar. It has literally dealt a crippling blow to many within our manufacturing sector, as well as being a major contributing factor in our depressed farm economy. We simply cannot export competitively with the high-priced U.S. dollar. A cheaply priced currency has a reverse and positive effect.

Indeed, much of Canadian economic growth over the last three years can be attributed to a vast growth in exports. Unfortunately, while exports are still on the increase, some analysts do not expect the rapid growth to be sustained. This, coupled with the fact that some forecasters are now predicting an increase in imports, creates the possibility of a smaller currency-account surplus and possibly even a deficit. But, do not be alarmed. I come from a country that seems to thrive on such deficits.

In this respect, I hope I will not strain my welcome if I make the following observation. It seems to be that Canada's biggest problem-one that materially affects the value of its currency unit-is its federal budget deficit, currently three times as large as the one in the U.S. in terms of percentage of GNP. And, since the American deficit is of monumental proportions, yours is no small matter.

Indeed, my statisticians tell me that 35 per cent of all your tax revenues go for debt service. Clearly, this is not conducive to a healthy economy and does not project a strong internal currency. I know that this is not a problem of current vintage, and I am cognizant that the present administration is struggling with the issue. However, until it is rectified, the negative implications will weigh heavily on the Canadian dollar.

Still, as a trader of currency, I must look at the total picture. When doing so, I see enough on the positive side of Canada's economic ledger to lead me to conclude that, given the present price, there is ample rationale to build a bullish case for the currency. But, that is not the point. No matter what my opinion, the value of the Canadian unit will depend upon the economic factors as they unfold and the collective interpretation of them by financial participants everywhere. And, to those who suggest that perhaps floating rates have failed, that perhaps we should return to Bretton Woods, to them I say, it's been tried, the idea is obsolete. Indeed, I submit that the fundamental truths governing the value of money are no different than those for all commodities. I, for one, am convinced that it is far, far better to allow a value determination to be made by the forces of the free market than a handful of government officials, irrespective of their benevolent intent.

Indeed, in the history of mankind, there are few, if any, examples where policy-makers have been able to outsmart, for any extended period of time, the collective judgment of buyers and sellers in the marketplace. Those sovereigns who chose to ignore this truth have paid a heavy price. I am confident that Canada will not fall prey to such misguided philosophies.

The appreciation of the audience was expressed by Dennis Madden, a director of The Empire Club.

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Free Markets, Foreign Exchange and the International Monetary Market

The International Monetary Market (IMM) of Chicago and its economic backdrop. The IMM as the marketplace which ushered in the financial futures revolution that ultimately changed and reshaped modern concepts of risk management. Some statistics to show the worldwide acceptance of this tool of finance, and a detailed discussion of how the IMM is viewed. Some general misconceptions about our markets and an explanation of them. How the value of every product is determined by the fundamental factors of supply and demand. The fate of the value of the Canadian dollar in the hands of the Government of Canada. Canada's economic growth over the last three years and the vast growth in exports. Canada's problem of its federal budget deficit. The negative implications of Canada's deficit on the Canadian dollar. Looking at the total picture for Canada.