Futures

Prior to the invention of modern day futures exchanges, farmers and purchasers of agricultural products such as grains were subject to wild fluctuations in market prices. During the harvest season when farmers were bringing their grains to market, there was often a huge oversupply of grains, which would send prices crashing down to the point where excess grain was left in the street to rot. Conversely, in the off season there were major shortages of grains causing the price that purchasers of grain had to pay to skyrocket.

To help combat this issue, grain exchanges were established where farmers could sell their grain for either immediate delivery, or forward delivery at some future date. The forward contracts where private agreements between buyers of grain and sellers of grain where the buyer agreed to pay a price agreed upon on the date of the contract for future delivery of a specific quantity of the sellers crop. This gave the buyers and sellers of grains a certain level of price certainty, and helped to smooth out the wild fluctuations in the grain markets.

Initially these exchanges where spread out all over the country, until about the mid 19th century, when railroads significantly improved farmer’s ability to transport their crops large distances. Around this time Chicago emerged as a major hub for the grain trade, and the first futures exchange, the Chicago Board of Trade (CBOT) was established. At the time of the founding of the CBOT, futures contracts still had not been invented yet, so initially the CBOT did not facilitate trade in futures contracts like it does today, but rather the forward contracts.

It was soon realized however that while the forward method of trading did offer the advantage of greater price certainty to both the buyer and seller of grains, this method of trading also had some issues that needed to be addressed. First and foremost was the issue of settlement of the forward contract. While it was relatively easy to get the two parties to agree initially on the price for future delivery of a specific amount of grain, if the price moved significantly away from the agreed upon price at the time of delivery, then there were often problems with the contract participant on the losing end of the deal backing out.

Second to this was a lack of standardization of forward agreements. Because a forward agreement is made privately between a buyer and a seller the terms of that agreement such as the amount, delivery date, and quality of product involved in the transaction vary from agreement to agreement. This creates a situation where there are a lot of unknowns going into the transaction, and where creating a secondary market where either participant of in the forward contract can “offset” their position difficult. What this means is that if for example, the buyer of grain in a specific forward agreement decides that they no longer want the grain they have agreed to purchase before the delivery date, then finding another buyer to step in and take their place is difficult. Because the forward agreement is not standardized, in this example a buyer would need to be found with the exact same requirements as the original buyer, which would have to happen on a case by case basis.

In 1865 the CBOT began to address these issues by beginning to standardize some of the more actively traded forward contracts. They did this by putting into place rules surrounding how the contract was to be settled, the quantity and quality of product involved in the transaction, grievance procedures if either participant in the contract had an issue, and by requiring participants in the contract to post a portion of money upfront as a performance bond of sorts to make sure that neither participant in the deal defaulted.