A Brief History of Derivatives
Warren Buffett memorably described derivatives as “financial weapons of mass destruction”.
The much vaunted – and maligned – financial products have become a dirty word in the popular press. But without them, financial markets and the world as we know it simply wouldn’t work. Banks, corporates, governments and supranationals rely on these sometimes simple, sometimes incredibly complex instruments to hedge risk and exploit opportunities. Consumers rely on derivatives too, often without knowing it.
But what are the origins of these tools? How did they achieve ubiquity? Join us as we take a whistle-stop tour of financial history via prehistoric Sumer, ancient Greece, medieval Europe, feudal Japan and Nineteenth Century North America.
Present day interest rate swaps, currency derivatives and structured products are actually the offspring of ancient business practices. Trading was an established practice for prehistoric people over a hundred thousand years ago, who exchanged goods and services before the invention of money. People used non-perishable items such as wine, grain, or other objects as an intermediary store of value – a nascent physical currency.
Between 4500 and 4000 BCE, the people of Sumer – in the Tigris and Euphrates river region – started to use writing and mathematics to develop a revolutionary new accounting method for financial transactions. The Sumerians used clay tokens stored in a clay vessel, and later clay writing tablets, to represent commodities, recording delivery dates for goods being traded. These resembled futures contracts and are thought to be the first example of financial derivatives.
The first recorded example of a derivative transaction dates back to around 600 BCE in ancient Greece, when philosopher Thales of Miletus become the world’s first oil derivatives trader – olive oil, that is.
After a series of mediocre olive harvests, Thales exploited his knowledge of astronomy to predict a bumper season – and positioned himself to profit from the rising price of oil by negotiating what were effectively call options on olive oil presses for delivery in the spring. The stars aligned and he cornered the market, making a fortune in the process. Similarly, the Athenians used shipping contracts that stipulated pricing, commodity type and volume, and time considerations, and hence resembled forward contracts.
Financial derivatives enjoyed more widespread usage in Medieval Europe, with the use of “fair letters” to buy and sell agricultural commodities. Sellers stocked merchandise at regional fairs and buyers bought from them with letters of credit, which could then be settled by moneychangers. Merchants afterwards deposited their money with local goldsmiths, who evolved into banks. The Champagne fairs in particular evolved into international clearinghouses for credit and as such, they are the not-too-distant ancestors of modern day commodities markets.
Later, the fairs fell from prominence and trade moved to the coastal regions, which were closer to major trade routes. In 1515 Antwerp opened its Bourse, a building where traders could congregate to do business. By this time, traders were no longer purchasing commodities directly. They were buying and selling forward contracts. For the next two hundred years forward contracts were the main way commodities were traded, more akin to OTC derivatives than exchange-traded options.
In Eighteenth Century Japan, there was a major breakthrough. The first secondary market for commodity derivatives was born, with transferable rice vouchers actively traded that could be settled for cash. Like today, transactions in feudal Japan were executed through a clearinghouse, which acting as an intermediary and guaranteed payments. For this reason, the Dojima Rice Exchange is considered by many to be the first truly modern futures market.
This new approach to trading soon crossed over the Pacific to North America. In 1848, the Chicago Board of Trade (CBOT) was founded. This new exchange wrought order out of chaos. In 1865, standardised agreements and regulations were introduced, making the market more efficient and reducing transaction costs. Soon speculators moved in, seeking to profit from fluctuating asset prices. The result was a huge increase in liquidity. In the Twentieth Century, the Chicago exchanges become home to trading in a range of product types from agricultural commodities to metals.
The next chapter in the story of derivatives came with the invention of the computer. This has revolution the way derivatives are originated and traded. In next week’s blog post we’ll be exploring the development of the modern derivatives market, from the 1970s to present day.
Finance isn’t considered to be a creative industry, but the history of derivatives seems to suggest otherwise. No matter the obstacles, humans have always found ways to build relationships and trade with each other. Clay vessels, writing tablets, fair letters, rice vouchers and microprocessors were once new technologies that revolutionised life and business for our ancestors.
Today, fintech is introducing a new generation of technologies that seek to improve the way that counterparties do business. Origin is proud to be at the forefront of this movement.