1700BC – Jacob & Laban
Some people consider the story of Jacob and Laban from the Bible ( Genesis 29) to be among the earliest example of a derivatives “trade”. Laban offers Jacob an option to marry his youngest daughter Rachel in exchange for seven years of labour. After seven years Laban reneged and only offered his eldest daughter Leah. As polygamy was allowed in those days he was able to marry Rachel as well later on in return for another seven years of labour.
580BC – Thales of Milesia
Derivatives go back to ancient times. Thales of Milesia, a pre-Socratic Greek philosopher and considered one of the seven sages of Greece was thought to have bought options on olive presses. His prediction was for good weather and a bumper crop, which ended up making him a fortune.
1600’s – Rice Trading in Osaka
Commodity futures can be traced back to rice trading in Osaka in the 1600s. Feudal lords collected their taxes in the form of rice, which they sold in Osaka for cash. Successful bidders were issued with vouchers that were freely transferable. Eventually it became possible to trade standardized contracts on rice, similar to modern futures, by putting down a deposit that was a relatively small fraction of the value of the underlying rice.
1637 – Tulip Bubble
The Tulip Bubble was facilitated by forward contracts on Tulip bulbs. As the price of tulip bulbs increased Dutch dealers also started tulip bulb options trading so that producers could sell the rights to owning tulip bulbs in Call Options on tulip bulbs. This means of hedging risk turned into speculative frenzy as the price of tulip bulbs skyrocketed between the end of 1636 to February of 1637. The contracts were OTC and in the absence of legal enforcement personal reputation was what the trading was based on.
1697 – Dojima Rice Exchange
First to to trade standardized futures contracts had two types of rice markets – the shomai and choaimai (spot and futures respectively). Different grades of rice were contracted with standardized agreements. No cash or vouchers were exchanged; all relevant information was recorded at a clearinghouse. The contract period was limited to four months at a time and had to be settled prior to contract expiry. Settlement of the differences in value between the current spot price and the contract had to be done with cash or an opposing contract position. With a few interruptions and updates, the rice exchange operated until 1937. Participants in the exchange were required to establish lines of credit with a clearinghouse. The clearing house assumed the risk of the various counterparties – very similar to today.
1720 – South Sea Bubble
South Sea Bubble – The South Sea Company was a trading concern with interests in South America. They had a monopoly on trading in this region after the War of Spanish Succession. In return for this concession the company assumed some of the national debt of England. Enthusiasm for the share led to the price moving from £100 to £1000 in under a year. It also fell back equally quickly when expectations about the company became more realistic. Options and Futures were used widely during this era in London.
1848 – CBOT Created
Chicago Board of Trade created. Chicago was a hub for the storage and transport of grain from the Midwest. Grain prices rose and fell sharply seasonally. Storage was also often at a premium following the harvest. To cope with all these vagaries the “to-arrive” contract was created. The idea was that the farmer could lock in the price and the deliver the grain at a future date. This allowed farmers to hedge against price moves and protect themselves. The earliest forward contract (on corn) was traded in 1851 and the practice rapidly gained in popularity. In 1865, following a number of defaults on forward deals, the CBOT formalized grain trading by developing standardized agreements called ‘futures contracts’. The exchange required buyers and sellers operating in its grain markets to deposit collateral called ‘margin’ against their contractual obligations. Futures trading later attracted speculators as well as food producers and food-processing companies. Trading volumes expanded in the late nine- teenth and early twentieth centuries as new exchanges were formed, including the New York Cotton Exchange in 1870.
1872 – Synthetic Options Created
Russell Sage created the first OTC options in New York. His business model relied on using the principles of Put-Call Parity. He would buy the stock and a put from the customer and then sell them a call back – while fixing the put, call and strike prices. In effect he was creating a synthetic loan, which allowed him to charge much higher rates of interest that the prevailing usury laws allowed. What is interesting is that he had in 1867 been convicted and fined for usury, so he had just found a very clever way around it.
1972 – Bretton Woods Collapses
The collapse of the Bretton-Woods System and the advent of free floating currencies meant that currency futures became very quickly a necessity. This is when the CME (Chicago Mercantile Exchange) created the IMM (International Monetary Market) in 1972. These were the very first time futures were traded on non-physical commodities. By 1975 there were Interest Rate Futures, initial attempts (based on the Ginnie Mae) did not succeed until one was created based on a Treasury Bill underlying. It was not till 1982 that an Index Equity future was introduced (on the S&P).
1973 – CBOE
The Chicago Board of Trade created the Chicago Board Options Exchange. This was the first time standardised options were traded through a central clearing house and the prices were listed in the press. On the first day of trading there were 911 contracts across 16 underlying stocks.
1973 – Black Scholes Formula
Fisher Black and Myron Scholes introduced a mathematical framework to price options. This is what we know today as the Black-Scholes equation and this formed the basis for much of the financial engineering that would happen in the next few decades. In 1973 the first equity index options was introduced following hot on the heels of the equity index future.
1980’s – OTC Market evolves & grows
This decade saw a move to OTC products again as the financial industry started to innovate. Swaps were the big innovation of this era with huge growth in interest rate swaps as corporations started using these contracts to hedge themselves and sometimes also speculate on interest rates. It was in 1985 that the NYSE also introduced equity options. By now derivatives were pretty much an integral part of the financial system. Innovation was the name of the game and banks hired mathematicians and physicists to develop ever more complex models and structures – “exotic options”.
Derivatives Losses make news
This was the decade when derivatives started entering the popular consciousness and not in a positive way. There was one scandal after another. This was either due to losses at corporate who bough contracts that they did not understand e.g. Proctor and Gamble, Metallgesellschaft, and even municipalities like Orange County, California. In 1995 the really big story was of a trader in Singapore by the name of Nick Leeson who brought down the venerable Barings Bank (the Queen’s Bank no less). This brought changes to the regulatory environment and tougher risk management rules.
Electronic Trading & CDS Trading
This decade also saw the rise of the electronic trading platforms. In 1992 the CME launched an electronic trading platform and soon this method become more and more popular. This meant that anyone could trade anything from the privacy of their own home thanks to the internet and electronic execution. This decade also saw more innovation in the form of Credit Default Swaps (CDS’s and CDP’s). These would not really take off till the next decade but this is when the groundwork was laid.
2000 – CDS Market Takes off
CDS trading begins to really take off. More computing power (distributed computing) and the growth of hedge funds and the hunt for higher yields (in a low interest rate environment) allows for more structured products to be created.
2002 – CDX Index Introduced
In 2002, the CDX Index, a credit based reference index was created to serve as a reference point and they also became tradable.
2003 – CDO market Grows
Collatralised Debt Obligations (CDO’s) begin to take off in a bid to get higher yields. Models become more and more complicated. This would lay much of the groundwork for the catastrophic market meltdown that occurred in 2008 blamed largely on the CDO market.
2008 – Credit Crisis
The Credit Crunch with much of the blame being laid on derivatives. As banks begin to fail (Bear Stearns, Lehmans etc) worries about systemic risk cause markets to seize up. Massive intervention by governments averts a compete disaster. CDS’s and CDO’s are blamed for being mispriced and too complicated. CDO pricing based on very faulty theoretical assumptions, which led to massive losses and big write downs for banks balance sheets.
2009 – Regulators Framework Reform Proposals
Measures were discussed to regulate the derivatives markets further and to make them more transparent. There were increasingly more calls for CDS’s to be exchange traded.
2011 – UBS Trading Losses
UBS loses $2bn due to a bet by a rogue trader on the Delta One desk. Poor internal controls and a lack of understanding of the derivatives traded were blamed yet again for the huge loss.