Taking Stock: Chicago's Trading History
By Suzanne McGee
From fur traders to real estate speculators, Chicago’s settlers gave the city a reputation as a great place for risk takers. But Chicago’s most lasting business legacy may be the enterprise created to help those folks manage all the risks they were running: the futures exchanges created in the 19th century that today ensure Chicago a place on the map as one of the world’s most powerful financial centers.
It has been 165 years since a group of merchants assembled not far from where Fort Dearborn still stood to set up the first futures trading exchange. Its successor, the CME Group (now parent company to Chicago’s two original exchanges, the Chicago Board of Trade and the Chicago Mercantile Exchange) is not only alive but thriving, having become the hub of a global industry stretching from Beijing to Mexico City and beyond. It’s unlikely that the CBOT’s founders had any clue what they were doing when they created a place where farmers and grain traders could haggle over the price and delivery terms for upcoming corn or wheat crops. But ultimately Chicago’s traders realized that their forebears hadn’t just set up a commodities market but had perfected the ideal risk management tool, one that could be redesigned to manage pretty much any kind of market risk. Investment managers in Singapore could turn to Chicago’s futures markets to bet on the direction of US interest rates, while European hedge fund managers could place orders to establish positions in Standard & Poor’s 500 stock index via computers connecting them to the Chicago exchange. That epiphany transformed Chicago’s markets from a Wall Street sideshow to a main event.
The realization came in the nick of time. Over at the Chicago Mercantile Exchange (which was founded in 1898), trading in butter, eggs, and onions had long stopped by the mid-20th century; attempts to introduce shrimp and turkey futures contracts had never taken off, leaving the Merc with only its pork belly, live cattle, and hog futures. At times, trading was so slow that Merc members could be found gambling on gin rummy instead of commodity prices. “There wasn’t another animal out there we could trade,” recalls Leo Melamed, a lawyer turned trader who became chairman of the Merc in 1969.
Melamed learned early just how currency values could fluctuate. Born to a Jewish family in Poland, his father introduced him to the concept in the process of fleeing the Nazi invasion, pointing out how Polish zlotys weren’t worth as much as they had been at a bakery in Lithuania. Melamed’s father was stubborn and lucky and able to get his family to the United States via the Soviet Union Siberia and Japan, arriving in early 1941. A refusal to admit defeat ran in the family; Melamed found himself pondering currency price movements as he and his peers sought new strategies for the Merc. Why, they wondered, couldn’t Chicago’s markets trade futures contracts on any kind of asset? These products could help someone manage any kind of price risk. Over lunch at the Waldorf-Astoria Hotel in New York in ’71, Melamed convinced economist Milton Friedman to do a feasibility study for a new business model. “We settled on a $7,500 fee for the study, and the Merc is worth $20 billion today,” Melamed brags.
At the time, the new business was little more than a curious sideline, as the Merc unveiled currency trading and the CBOT moved toward bond futures. “We had simply no idea,” says Thomas Cashman, a soybean trader who arrived on the CBOT floor as a teenager in the 1950s, working as a “runner” carrying orders to and from the trading pit, before becoming a full-fledged member in 1962. It was the open-outcry trading in agricultural commodities like soybeans that gave Chicago’s markets their freewheeling reputation. But they have also borne the brunt of the changes. A decade ago, “the soybean pit would be full of 100 people or more, yelling and hollering and trying to trade all at once,” Cashman recalls. One memorable bull market enabled him to pay cash for a new house. In contrast, the soybean pit today is sleepy, with the hubbub having moved over to the financial products and to desks in offices upstairs—and everywhere around the world—where traders stare at computer screens and click to place orders far larger than any that Cashman ever handled.
But the slow atmosphere is deceptive. True, Ceres, the CBOT hangout where traders were once able to start their days with a stiff drink and that was said to sell more booze than any other bar in the city, now feels like a backwater, and even the local convenience stores are grumbling that their lottery ticket sales have fallen. But trading volumes at the CME are thriving: an astonishing daily average of 9.6 million contracts this past December. That isn’t because futures trading has vanished, however. “Before [electronic trading] came along, we struggled to get trading up to $1 million trades a year,” says Melamed. “Today we average $11 billion every day.” The advent of financial futures was just the start, as the globalization of finance and new technologies combined to radically reshape Chicago’s futures trading world.
Once, traders had to fight—literally—for a prime position in crowded trading pits (on average, each occupied a space only 13 inches wide in which to stand and trade). Some took classes from opera singers to learn how to project their voices and donned flashy magenta or silver lamé jackets simply to stand out in the crowd and be able to execute their trades. One legendary trader compared the hubbub to a rugby scrum, with injuries ranging from hernias to fatal heart attacks. (Then there were the self-inflicted wounds, like the jubilant hog futures trader who, to celebrate a good day of trading, poured liquor onto his chest and set it on fire.)
Then came the computers. Trading became faster; volumes rose. So did liquidity, crucial if Chicago’s futures exchanges were to fend off challenges from rivals as far afield as London, Frankfurt, and Tokyo. No longer was trading volume limited to the number of trades that a few hundred men crammed into a trading pit could execute in several hours a day. Instead, from around the world, anyone could turn to his or her computer and establish a position on S&P 500 stock index futures via a linkup to the Chicago futures markets.
To traders like Terrence Duffy, who today serves as executive chairman and president of CME Group, formed by the 2007 merger of the CBOT and the Merc, the transformation was logical. “The more volume, the more money the exchange could make, the more the seats would be worth, and the more business would come to the exchange,” he says. It was a virtuous circle, based on scale and efficiency. The merger made even more sense. “We both figured that if we didn’t come together, one of us might end up somewhere else other than Chicago, [acquired by a foreign rival], or just gone,” Duffy says. “The merger put a whole new life into the exchanges.”
The new products—futures and options on the S&P 500 stock index, Treasury bond futures, short-term interest rate futures, currency futures—offered hedge fund and mutual fund managers a way to hedge their risk or express an opinion about the health of the Japanese economy by betting on what the yen would do. The way that market participants viewed those markets was altering, and Chicago had anticipated this change. The city’s futures and options traders didn’t approach markets as if the only choice were to buy in expectation of a price increase, or stay away, says Emily Lambert, author of a chronicle of Chicago’s markets titled The Futures. “They realized that markets can go up and down, and that it’s possible to use these products to express both views, a view that the whole investment industry has adopted over time,” she explains.
The liquidity in these products grew so rapidly that they became still more attractive: It was a lot faster for a trader to buy or sell an S&P 500 futures contract than to accumulate positions in even a handful of the underlying stocks. And because of the structure of the futures contract itself, it was cheaper, too. Technology meant that instead of phoning in an order and waiting for it to be “filled” in the pit, all a trader had to do was push a button. The proliferation of quantitative investment and trading models made the Chicago exchange’s products more appealing still. Of course, it came at a cost. Faster trading on computers may be speedy and cost-efficient, but the demise of the open outcry systems means traders can no longer read body language in the pit. “On days when trading was violent, that helped give people confidence in what they were doing,” says Cashman, who noticed that he had less insight into what the “commercials”—those grain traders with a vested interest in the underlying commodity—were doing as the bulk of trading volume went off the floor. That, he explains, means he has less insight into market trends.
“It’s a lot calmer these days,” says Lambert, a former Forbes reporter who moved to Chicago in 2004. Today’s futures industry conferences are dominated by geeks—quantitative traders and the computer programmers and video gamers they have hired to develop high-frequency trading programs. “There’s still a lot of bravado, but it’s of a different kind. It’s less clubby, and while the old trading floor could be ruthless or bloody, if you blew yourself up, someone would take up a collection for you, or pay off your debts if you died.”
Today, futures trading is as firmly centered in Chicago as it has ever been, even if most Chicagoans have less understanding of what actually takes place behind the walls of the old Board of Trade building. While once futures trading was a sideline to the stock market, these days it has become the tail that wags the dog. The trades that move markets take place in index futures and ripple through into the prices of individual stocks. The “flash crash” of 2010 that wiped more than 600 points off the Dow Jones Industrial Average in just five minutes had its roots in the S&P futures products, and the high-frequency trading firms that have sprung up as a result of the shift from “cash” stocks to futures exacerbated the move. “In difficult market environments, you really like to have someone to work your order,” says Thomas S. Caldwell, founder of Toronto-based Caldwell Securities Ltd. and a veteran trader who has studied and invested in a wide array of financial exchanges worldwide. “The open outcry system can enhance confidence and rein in the raging idiocy that most young traders demonstrate.” While markets are global, more liquid, and faster than ever before thanks to Chicago’s innovations, those changes have brought fresh challenges for both market participants and regulators.
Still, if there is one group of financial experts that is best positioned to manage those new risks and address those challenges, it is likely to be the folks in Chicago. CME Group might have to devise a way to replace what has been lost along with floor trading, such as the culture that taught young members how to take risk without being reckless. But if you’re looking for the future leaders of finance or those with the right skills and tools to construct the future of the futures industry, the logical place to start is still LaSalle Street.
photography by Scott Olson/Getty Images (exchange, donohue); Scott Olson/Liaison (oliff); Visions of America/UIG via Getty Images (trading)
William H. Macy gets dapper in this behind-the-scenes exclusive.