The introduction of the International Monetary Market in December 1971 and formal implementation in May 1972 can be traced to the end of Bretton Woods through the 1971 Smithsonian Agreement and Nixon’s suspension of United States dollar convertibility to gold. The increase in international business and trade, currency and interest rate volatility due to floating exchange rates, corporations and speculators lock out in the interbank market and world trade imbalances resulted in the need for the IMM. The IMM Exchange was formed as a separate division of the Chicago Mercantile Exchange whose sole purpose was trade of agricultural futures. With IMM’s 500 chartered members, increased to 750 by 1976 and a $10,000 membership fee increased to $325,000 by 1987, the purpose of the IMM was trade of currency futures, a new product previously studied by academics to open a freely traded exchange market to facilitate trade among nations.
The first futures experimental contracts included trade against the US Dollar such as the British Pound, Swiss Franc, German Deutsch Mark, Canadian Dollar, Japanese Yen and September 1974, the French Franc. This list would later expand to include the Australian Dollar, the Euro, emerging market currencies such as the Russian Ruble, Brazilian Real, Turkish Lira, Hungarian Forint, Polish Zloty, Mexican Peso and South African Rand.. In 1992, the German Deutsche Mark/Japanese Yen was introduced as the first futures cross rate currency. These early successes didn’t come without a price.
The challenging aspects were how to connect values of IMM foreign exchange contracts to the interbank market since the interbank market was the dominant means of currency trading in the 1970’s and how to allow the IMM to be the free floating exchange envisioned by academics. Clearing member firms were incorporated to act as sort of arbitrageurs between banks and the IMM to facilitate orderly markets between bid and ask spreads. Continental Bank of Chicago was later hired as a delivery agent for contracts. These successes bred a futures competition for new products never envisioned in this short term duration.
The Chicago Board Options Exchange competed and received the right to trade US 30 year Bond Futures while the IMM secured the right to trade Eurodollar contracts, a 90 day interest rate contract settled in cash rather than physical delivery. US dollar deposits in European banks and other continents came to be known as Eurodollars. Eurodollars came to be known as the Eurocurrency market used mainly by the Organization for Petroleum Exporting Countries because OPEC always required payment for oil in US dollars. This cash settlement aspect would later pave the way for index futures such as world stock market indices and the IMM Index. Cash settlement would also allow the IMM to be later known as the cash markets because of its trade in short term interest rate sensitive instruments such as 30 day Fed Funds futures, 13 week T-Bills, 2 and 10 year Notes, Libor, EURO/YEN Tibor and 3 month OIS Futures. a swap that allows spread trades between a 3 month money market asset and the overnight cost of financing the asset over the 3 month period.
With new competition, a transaction system was desperately needed. The CME and Reuters Holdings created the PMT, Post Market Trade to allow a global electronic automated transaction system to act as a single clearing entity and link the world’s financial centers such as Tokyo and London. PMT is today known as Globex who facilitates not only clearing but electronic trading for traders around the world. In 1975, US T-Bills were born and traded on the IMM in January 1976 with T-Bill futures trading in April 1986 with approval from the Commodities Futures Trading Commission.
The real success would come in the mid 1980’s when options began trading on currency futures. The Deutsche Mark began January 1984, British Pound and Swiss Franc February 1985, Japanese Yen March 1986, French Franc 1984, Canadian Dollar June 1986, European Currency Unit January 1986 and Australian Dollar 1987. By 2003, Foreign Exchange trading had a notional value of $347.5 billion.
The 1990’s saw explosive growth for the IMM due to three world events. The first was Basel 1 in July 1988 where the 12 nation European Central Bank Governors agreed to standardize guidelines for banks. Bank capital had to be equal to 4% of assets. The second was the 1992 Single European Act that allowed not only capital to flow freely throughout national borders but all banks were allowed to incorporate in any EU nation. Basel 2 is geared to control risk by preventing losses, a current work in progress.
A banks role is to channel funds from depositors to borrowers. With these news acts, depositors could be governments, governmental agencies and multinational corporations. The role for banks in this new international arena exploded so to meet the demands of financing capital requirements, new loan structures and new interest rate structures such as overnight lending rates, they increasingly used the IMM for all finance needs. Plus a whole host of new trading instruments were introduced such as money market swaps to lock in or reduce borrowing costs, swaps for arbitrage against futures or hedge risk. Swaps would not be introduced until the the 2000’s however. Types of trades changed as well such as calendar spreads, overnight trades and spread trades. Further, bank relationships to central bankers solidified completely with these new arrangements. No better example than crisis.
In financial crisis situations, central bankers must provide liquidity to stabilize markets because risk may trade at premiums to a bank’s target rates, called money rates that central bankers can’t control. Central bankers then provide liquidity to banks who trade and control rates. These are called repo rates that are traded through the IMM. Repo markets allow participants to undertake rapid refinancing in the interbank market independent of credit limits to stabilize the system. A borrower pledges securitized assets such as stocks in exchange for cash to allow their operations to continue.
Asian money markets linked to the IMM because Asian governments, banks and businesses needed to facilitate business and trade in a faster way rather than borrow US Dollar deposits from European banks. Asian banks like European banks were saddled with dollar denominated deposits because all trades were dollar denominated due to the US dollar’s dominance. Extra trades were needed to facilitate trade in another currency, particularly Euros, other than US Dollars taking more time than necessary. These two continents would share not only an explosion of trade but these are two of the most widely traded world currencies on the IMM. For this reason, the Japanese Yen is quoted in US cents while Eurodollar futures are quoted based on the IMM Index, a function of the 3 month Libor Rate.
The IMM Index base of 100 is subtracted from the 3 month Libor rate to ensure bid prices would be below the asked price. These are normal market prevailing procedures used in other widely traded instruments on the IMM to insure market stabilization and normal traded markets. For example, price quotes for T-Bill futures contracts are based on the IMM Index. Subtract the discount yield of the T-Bill from the IMM’s base of 100, a 9.75 yield would equal a 90.25 IMM Index. Index values move in the same direction as futures prices. Same with the EURO Index. Widely traded instruments are tracked by the IMM Index.
As of June 2000, the IMM switched from a not for profit to a profit, membership and shareholder owned entity. It opens for trading at 8:20 Eastern time to reflect major US economic releases reported at 8:30. The IMM is the largest financial market in the world. Banks, central bankers, multinational corporations, traders, speculators and other institutions all use its various products to borrow, lend, trade, profit, finance, speculate and hedge risks.
November 2009 Brian Twomey
Brian Twomey is a currency trader and Adjunct Professor of Political Science at Gardner-Webb University