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The World According to Leo Melamed

Interview by Joe Kolman

Leo Melamed is commonly characterized as "the father of financial futures." He served as chairman of the Chicago Mercantile Exchange for more than two decades, transforming an agricultural futures exchange into the financial powerhouse it is today.

His memoirs, Escape From the Futures, will be published by Wiley in May. The book details his childhood flight from Nazi Germany, his early apprenticeship among the Merc's produce moguls, and his tireless efforts to establish the financial futures industry.

Melamed is now CEO of Sakura Dellsher Inc., a global futures brokerage firm. He talked recently about the origins of the financial futures markets with editor Joe Kolman.

Derivatives Strategy: How did you get your start in the futures market?

Leo Melamed: It was all an accident. The hand of fate. I was in law school looking for a law clerk job and answered a want ad. The firm in question, Merrill, Lynch, Pierce, Fenner & Bean, was looking for a "runner" to work between the hours of 9:00 and 1:00, which was perfect for my class schedule. With that many names, how could this firm be anything but an established law firm looking for a clerk to run to court?

Let's face it, I was very innocent. So I ended up on the floor of the Chicago Mercantile Exchange and my life changed. There was a life force on that floor that was magical and exciting, and though I didn't understand what was going on, I wanted to be a part of it. I had no doubts or illusions that this was a law office. But it immediately got into my bloodstream and it paid $25 a week. Throughout the rest of law school, I worked as a runner, running egg market orders, and later onion orders-always produce. I learned about the futures markets from the bottom up.

DS: How do you think the training you got differs from the training that someone would get at a place like Morgan Stanley today?

LM: The difference between then and now is like Earth and Mars. When I began the robber barons of produce still ran the Merc. This was an era when might made right-whatever could be grabbed off the table, or squeezed, or cornered. The floor was loaded with colorful characters. Like, for instance, Sam Schneider, who owned an egg-breaking plant that supplied bakeries, restaurants and other commercial users with egg yolks or whites, depending on their needs. The eggs would be broken by hand by his workers. Schneider would sit on a stool on top of a table tapping his cane in rhythm so that the workers would keep producing. Schneider once told me how he handled government health inspectors. "When the federalists came to inspect my plant," he said in his heavy Eastern European accent, "I threw them down the stairs." That's how you dealt with the law in those days.

Today everything is organized and understood. There are rules and there are federal agencies, the SEC, CFTC, the Federal Reserve Board. And while there's still room for manipulators-we all know what Salomon Brothers did in the Treasury bill market a few years back-by any comparison today's markets are rule-abiding.

Back when I started at the Merc, that world had no rules but those of the futures market jungle. Today you are trained, you learn what you can do and what you cannot do. Today there are courses on how the market works, about supply and demand, about technical analysis, about the fundamentals. Back then-and this was not so long ago-you learned by the seat of your pants.

That era is gone. I was 20 years old and in law school. And it didn't take me long to recognize that there was something wrong with the way the system worked.

DS: It sounds like you, as an attorney, came into an arena that had very little use for a law book, and that you really imposed a set of rules and ultimately helped clean up the market.

LM: When I took over the Exchange in 1967, I was a lawyer whose star subject in law school had been Constitutional Law. But that wasn't the history at the Chicago Merc. At the Merc I learned that the rules of the Exchange existed mostly in the memory of one man, Ken MacKay. Whatever he said or remembered was the rule. And the rulebook was put together with glue, scotch tape, staples, fading handwriting, fading paper and the fading memory of Mr. MacKay.

I would agree that they were desperate for a lawyer. Maybe they didn't know it at the time; maybe they didn't want it either. But it is exactly what was needed.

DS: But that is the theme of your whole career, isn't it? To get the futures markets regularized, getting them formalized to...

LM: ...to let the economic forces of supply and demand work. Yes, but to reach that goal I had to do several things. My first mission was to establish a modern set of rules. You had to have rules that everyone could live by equally and fairly. Law and order instead of might makes right. So I ran a constitutional convention. It took a year-and-a-half to rewrite the rulebook from top to bottom and turn it into the model rulebook upon which the modern Chicago Mercantile Exchange was built.

Next, the Exchange did not have a departmental infrastructure. They didn't have anything like an economics department, a compliance department or a public relations department, so I had to create their structure and hire professional staff. I think we were the first exchange to actually install an economist in our research department.

Above all, we had to clean up the image of the Exchange. The former president of the Merc had confided to me: "The Exchange is a whorehouse. We provide the beds, the traders do the rest." This was how it was. He painted it correctly. If you were able to rape the market and get away with it, you did it. To change this image required more than new rules. We had to become open and above board and responsive to the public and the press. When I inherited the Merc, its board didn't talk to the press. The press was the enemy. We had to prove that day was over. We had nothing to hide. That was the reason for creating a public relations department: so that it could openly respond to the press, the public and the members.

DS: At the same time, of course, you were looking around for new contracts for the Exchange.

LM: Because of what I had seen the US Congress do to the onion contract, I wanted to ensure that we would never again be a one-commodity exchange.

DS: The onion contract?

LM: As I said, the way the Exchange was run, one could get away with almost anything. The Exchange had an onion contract that was doing very well, with lots of business. But they allowed market manipulations to occur year after year. One particular year the onion manipulation drove onion prices to the moon. And in the process they talked the farmers-not into hedging the higher prices, which would have been fine-but into buying the futures paper. So the farmers were both long in the ground and long in the paper-what's known as a Texas hedge. Everything was fine until the farmers tried to take their profit-then the roof caved in. Everybody was long and wrong, and nobody could get out. The price of onions came crashing down, below the level of the burlap bags in which they were shipped. The onions were worthless and the farmers were incensed. The blame was of course on the CME, which in this case was where it really belonged.

The farmers drove their tractors to Washington demanding, "Kill the bastards, or at least close their market down." Congress responded. Farmers get their way in the United States. To this day I believe the law passed by Congress banning onions from futures markets was unconstitutional, but it never went to the Supreme Court. It stopped short of that and onions were the only commodity to ever be banned from the futures markets. Today you can have a futures market in widgets, but not in onions.

DS: So that experience inspired you to look elsewhere...

LM: After the collapse of the onions, the Merc was in its death throes. Eggs were dying, onions were gone, and the board had to support the price of memberships at $3,000, because everybody wanted to unload. I realized that if an exchange was dependent on one commodity and if something bad happened to that commodity, you had no exchange. I vowed to diversify the Merc.

DS: What happened to eggs?

LM: It used to be that there were seasonal fluctuations in the price of eggs-in the spring the chickens laid eggs and in the fall they didn't. Then modern science invented the 24-hour cycle of egg production. Farmers would put these little bulbs in the chicken coop and the chickens didn't know whether it was night or day, summer or winter, so there was a constant flow of eggs and no fluctuation in the price. If you had the same price all year round, you didn't need an egg futures market.

So in my head was this overriding mission: diversification of products. At first I went with the regular routine-agriculture. First came the meats; that happened just before I took over. Meats held promise, especially pork bellies. The price of pork bellies, which are uncured bacon, were very volatile and produced five or six bull and bear markets each year. It was a great market. But meats represented only one type of product. I wanted something different, so we tried apples, potatoes, shrimp, scrap steel, boneless beef. But none of these products worked.

DS: How did you get from boneless beef to futures on the British pound?

LM: Well, I didn't wake up one morning and say, "Eureka! Let's trade currencies!" That's not how it happened. It was a mental metamorphosis that took some time. But it was all around me, in the environment, in the news, in my history. After all, it is quite a leap to go from agriculture to finance.

If I had to pinpoint the exact time, it was toward the end of 1970. Around that time currency had become a hot topic on the business pages. The British were holding up the value of the pound and fighting speculation against the pound. The big issue of the day was whether Bretton Woods, the fixed exchange rate system, could stay in effect. Should the system be abandoned? Does it work?

This heated controversy made me very conscious of the currency market. My friend Dick Boerke, who was a very astute trader, wanted to short the British pound. He found a way to do it through his father, who was in real estate. He made some money, and that got me very interested in wanting to short the British pound also.

Then one day I read that Milton Friedman, who was to me an economic demigod, was also trying to short the British pound. He knew that the British pound had to be devalued and that there was a great deal of money to be made. But as an individual, he was not allowed to short the pound in the interbank market.

DS: Because he was an individual.

LM: Right! Only commercial interests could trade FX. Individuals were excluded. So there I was, chairman of an exchange, looking to diversify our product line and trying all these crazy contracts, and here was this famous economist trying to short the British pound and he didn't have a market in which to do it. It wasn't too hard for me to put two and two together. Dick Boerke urged me on.

By then I had an economist working for the Exchange whose name was Mark Powers. I'd hired him as the first economics department chief because he had written his dissertation on the pork belly market. I said to him, "Forget pork bellies, forget scrap metal, we are going for the real thing here-money. Write a letter to Milton Friedman and ask him what he thinks of a futures market in currency. After all he's just down the street at the University of Chicago. If we get any encouragement from him, I know what we're going to do."

So two weeks later we got a letter from Milton Friedman saying it was too soon because there was this Bretton Woods system, but it was a good idea. That's all I needed. Eventually I met with Friedman and one thing led to another. On August 15, 1971, Nixon closed the gold window and whammo!-the Bretton Woods system started dying.

Of course, I was not blind to the magnitude of what I was about to do. I knew the difference between cattle and currencies and I knew that we were entering the sacred temples of finance. This was going to be a battle royal. But I also knew that if it worked in currencies, the sky was the limit. I was like a kid in a candy store. We couldn't invent another meat, the grain markets were accounted for, in agriculture there was nothing left. But in finance...my God! There was everything out there! Nobody had done this. If it worked in currencies we would go for interest rates.

DS: What was the reaction of the market when you went on the road to promote the currency contract?

LM: Everyone was skeptical. Hostile is more like it. First of all we were from Chicago. And everyone knew that New York was the capital of finance. Anything of importance that was going to happen was going to happen in New York. So they automatically knew that this could not be very important. Nor was it going to work. Futures are for pork bellies, for grains. I was considered a first-class nut.

But I was a determined nut. I criss-crossed the country hundreds of times during a period of three or four years in an attempt to reach my audience. Of course I had hundreds of soldiers who helped me brave the onslaught of enemies. Eventually the concept took hold because the idea was so enormously strong. And it was perfect timing. After we launched the currency contracts, we had the oil embargo, then inflation, then every kind of upheaval in finance imaginable. Our new markets were ideally suited for both the speculator and the hedger in times of upheaval.

DS: And when you went back to the market with the T-bill contract...

LM: The same negative reaction, maybe worse. Currencies are one thing, but interest rates are the holiest of instruments on Wall Street. I mean, this is where Salomon Brothers and Goldman Sachs lived. This was their bread and butter. What? An interest rate futures market in Chicago? Ridiculous! The day it was launched Milton Friedman was the bell ringer, and the contract was an instant success.

DS: And Salomon and everybody else were the first users?

LM: No, not the first. Mostly the local brokerage community were first to use T-bill futures. It took approximately 12 months for the big dealers like Salomon Brothers and Goldman Sachs to recognize the value of this futures instrument, but as soon as they did, they became the dominant players.

DS: Because they could do the arbitrage?

LM: Well, mainly because they could use it to hedge. You see, they could go into a Monday morning Treasury auction to bid on the government debt knowing they had a secondary market to lay off their risk. As a result they could be more aggressive in their bids. Of course this resulted in lowering interest rates to the public. Later, as the market became better understood, a number of more sophisticated uses developed, including arbitrage, forward hedging and so forth.

DS: Did you think of an equities contract at the same time as currencies and interest rates?

LM: No, that took a long time. A stock index was always the most enticing idea to me. I first heard about it from a little guy called Elmer Falker, a technician who took me under his wing when I was maybe 22. I used to talk to him about the kind of contracts the Exchange might list. He was a little guy who'd chomp this big cigar and say, "The ultimate contract is Dow Jones futures." I instantly knew what he meant.

DS: He said this in the 1950s, 1960s?

LM: Probably the early 1960s. So I asked, "Why haven't they done that?" You know, I was a kid. And he replied, "You can't make delivery. How are you going to deliver 30 Dow stocks that keep changing? You can't do it." He said the idea had been around for a hundred years, but no one could do it. But the idea wouldn't leave me. I used to ask myself, "But what if you don't have to make delivery?"

Since time immemorial, when a futures contract matured, you had be able to deliver the product. Without a mechanism for delivery we would be just a gambling institution, subject to the gambling laws and probably banned from most states. Even for the currency contracts I had to go to the Continental Bank and talk them into creating a delivery facility for us. So if you took delivery of yen, you got delivery in Tokyo, or if it was deutsche marks, in Frankfurt.

But certain products I wanted to trade couldn't be delivered. One of them was Eurodollars. I knew Eurodollars was probably the most important short-term interest rate benchmark of all. But you can't deliver an interest rate. All you can do is measure the value of the interest rate at the time you bought the contract and at the time it matured and the difference in the value in cash, but you couldn't deliver the interest rate.

I decided that it would take a federal agency to give me the right and the cover of legitimacy for "cash settlement." In 1974 we worked towards the creation of the Commodity Futures Trading Commission. Then in 1977 we began working with the CFTC on the idea of cash settlement, and it finally was approved in 1981.

Once there was cash settlement, I knew that the sky was the limit. Now it was possible to list futures contracts on any kind of index. The first cash-settled futures contract was Eurodollars. Then we listed S&P futures in 1982. It was an enormous breakthrough-a hedging mechanism, a risk management instrument of enormous potential.

DS: Now the currency markets you helped create are suffering.

LM: Well, the currency futures market is suffering, but not the currency market per se. What has happened is that our idea of currency futures has been transferred to the over-the-counter market. Between 1990 and 1995 there was a 500 percent increase in currency transactions in the OTC market. But for a variety of reasons, the futures have not participated in this increase. To me that spells something wrong with the way futures markets handled things, especially in those five years.

DS: What's the future of the futures market? What's going to happen to the level of innovation in the next 20 years?

LM: That's the big question. Long ago we captured all the agricultural markets we could. We have captured the soul of the financial markets today: FX, interest rates, stock index markets. But if you think that the innovative mind of the human being has stopped thinking, you are probably underestimating.

Recently in New York the NYMEX thought of electricity futures. That's a brand new ball game-an interesting, novel idea. The Chicago Board of Trade thought of insurance futures. That, too, is different and interesting. The Merc is thinking about clearing swaps. That would be very different. So I'm not convinced there's nothing left to invent.

But I'm convinced that 20 years from now we will not be trading the way we trade today. What will drive the change is technology. The transaction process will be different and driven by technological changes. But will there be markets? Of course! I believe derivatives are here to stay because they are the only way to manage risks. Will financial risk always be around? I believe so. The business cycle will always be there, so I'm not worried about that. I am just worried about whether the transaction process will be carried out on the futures exchanges. That is our challenge.