Today’s post was written in partnership with Kalshi, the first federally regulated exchange for trading event contracts. I am very excited to be working with Kalshi because I believe they represent an important milestone in the evolution of derivatives, and are another example of how financial instruments evolve / modernize alongside the economy. Like farmers in the 19th century developed sophisticated futures markets, today’s information economy requires new hedging tools to manage risk. I hope you enjoy this piece, and make sure to check out Kalshi!
In Plato’s The Republic, published circa 360 B.C.E., the Athenian philosopher stated: “our need will be our creator.” Later English translations of Plato’s famed work re-worded this to:
“Necessity is the mother of invention.”
This maxim is particularly applicable to the fields of finance and technology, as many modern financial instruments originated from a need to reduce uncertainty and manage risk.
Treasury Inflation-Protected Securities (TIPS), for example, were first auctioned in 1997, but inflation-indexed bonds date back to America’s founding. During the Revolutionary War, as morale among American troops were low due to a lack of food, clothing, and pay. There were concerns that the army would crumble if American leaders did not address the inflation eroding soldier’s pay.[1]
In response, Massachusetts issued inflation-indexed bonds to soldiers as a method of “deferred compensation” for their service in 1780. To insulate the payments from inflation, the values were tied to a consumer price index. Crisis breeds innovation.
The World’s First Inflation-Indexed Bond
The area of finance that best-represents this notion of necessity creating invention is derivatives (futures, options, forwards, and swaps). For millennia, derivatives have driven economic growth by providing key industries with the tools to manage risk.
This essay highlights the ancient origins of derivatives, analyzes case studies on key milestones in their evolution, and argue why we are now experiencing another inflection point in the modernization of derivatives.
THE LONG HISTORY OF DERIVATIVES
Ancient Origins
Derivatives have existed since the ancient world. In ancient Greece, one of Plato’s students, Aristotle, described what many today would consider a type of derivative contract:
“There is, for example, the story which is told of Thales of Miletus. It is a story about a scheme for making money, which is fathered on Thales owing to his reputation for wisdom; but it involves a principle of general application.
He was reproached for his poverty which was supposed to show the usefulness of philosophy; but observing from his knowledge of meteorology (so the story goes) that there was likely to be a heavy crop of olives [next summer], and having a small sum at his command, he paid down earnest-money, early in the year, for the hire of all the olive-presses in Miletus and Chios; and he managed, in the absence of any higher offer, to secure them at a low rate.
When the season came, and there was a sudden and simultaneous demand for a number of presses, he let out the stock he had collected at any rate he chose to fix; and making a considerable fortune he succeeded in proving that it is easy for philosophers to become rich if they so desire, though it is not the business which they are really about.”[2]
Even Ancient Mesopotamia (circa 1,400 B.C.E.) offers instances of contracts related for purchasing crops that shared similarities with modern forward contracts. Many of these contracts included qualities like forward contracts today. For example, contracts stipulated the quantity of grains a seller would deliver on a future date at a fixed price agreed upon at the time of contract.[3]
Medieval Europe
“A View of Genoa”
Fast forwarding to the Middle Ages, merchants frequently used derivatives to manage the risks of trading by sea. As explorers discovered new trade routes across the globe, exciting opportunities for commerce emerged. However, there were also greater risks associated with long-distance travel (i.e., pirates, storms, mutiny, etc.).
A financial innovation in medieval Venice and Genoa demonstrates how merchants addressed the issue of financing expensive voyages without any means for managing the risks of long-distance trade. Their solution? The commenda contract.
Commenda contracts were an agreement between financiers and merchants that provided funding for the merchant and potential profits for the financier. There were two main variations of the commenda contract: Bilateral & Unilateral Commendas.
Focusing on the Bilateral commenda, a financier contributed 66% of the capital and was responsible for 66% of the losses. If the merchant safely returned from his voyage, profits were divided 50-50.
This commenda contract innovation benefitted both parties. The financier could only lose what he contributed, avoided the treacherous sea journey, and received 50% of any profits. Merchants, on the other hand, reduced their risk by taking outside funding in exchange for splitting the profits. Previously, merchants were responsible for 100% of losses and had to embark on dangerous long-distance voyages.
The lesson that financial instruments could help reduce the inherent risks of dangerous commercial activities like long-distance trading was instrumental to Europe’s economic development.
From Fairs to Bourses
Antwerp Bourse
Another inflection point in the evolution of derivatives was the transition from medieval “trade fairs” in cities like Champagne to traditional “exchanges”. Like commenda contracts for sea travel, derivatives greased the wheels of commerce in Europe by facilitating long-distance trade for merchants and farmers. Since these merchants and famers traveling to medieval fairs could not feasibly transport their entire inventory with them, transactions at these fairs began incorporating features similar to forward contracts today.
Transactions included agreements to purchase specified quantities of goods at a future date. To protect buyers, agreements often “traded on sample”, meaning buyers could refuse delivery if the goods were not of the same quality presented at the original agreement.
As merchants at these fairs continued to convene in the same cities to conduct business each year, over time more traditional exchanges evolved to trade year-round. The most famous of these exchanges was the Antwerp Bourse, which opened in 1531 and focused on trading commodities. It did not take long for basic iterations of modern derivatives like options to develop on the exchange.
‘GAMBLING’ VS. HEDGING: THE DOJIMA RICE EXCHANGE
Dojima Rice Exchange
Despite their clearly effective use-cases, throughout history derivatives have been frequently maligned and used as a scapegoat following market crashes. These criticisms ignore the role derivatives play in stimulating economic growth. Like most financial instruments, derivatives can certainly be used for speculation, but they primarily help professionals manage risk. The development of Dojima’s Rice Exchange in 18th century Japan illustrates how derivatives played a key role in addressing the risks associated with Japan’s rapidly modernizing economy.
The Role of Rice
“All wise rulers in all ages have valued cereals [i.e., rice] and despised money.” – Japanese Proverb from the Tokugawa Era
The significance of rice in 18th century Japan’s economy cannot be overstated. The grain often acted as a “substitute currency” due to its abundant supply and transportability relative to Japan’s metal currencies.[4] In fact, rice “was the measure by which the shogunate [government] figured its annual budget.”[5]
Rice accounted for a staggering 90% of government revenues in 1716, and each year the state paid “bannermen” (members of the samurai class working in civil and military administration roles) with a fixed amount of rice. Since samurais earned money from selling this government rice stipend, their income was directly tied to the price of rice.
The chart below shows how problematic this dependency on volatile rice prices could be for samurais’ income. In just two years (1702-1704), for example, bannermen’s income fell 55% due to falling rice prices.
Urbanization & Rise of the Merchant Class in Japan
Japan’s economy was also revolutionized in this period by government reforms causing rapid urbanization and increased trade. The Tokugawa government established Edo (now Tokyo) as the nation’s capital, and made daimyo (elite landlord samurais) families relocate to Edo. The government further required the daimyo themselves to live in Edo every other year, and that their families remain in Edo whenever the daimyo returned to their rural estates.
This meant that the samurai landlords were forced to maintain two separate households (one in Edo and one in their rural estate), significantly increasing their expenses without an equivalent rise in income. The samurai’s economic position became fragile.
“Edo became the center of the nation as it not only housed the ruling families, but also opened high levels of consumerism and demand for this new economically dependent population… The establishment of Edo as the capital would, in turn, transform and revolutionize Japanese society more than ever before.”[6]
As Edo’s population ballooned from migrating daimyo families, the economic power balance shifted away from rural areas towards urban centers. Merchants benefitted from this economic upheaval. Conversely, rural landowning samurais suffered. Merchants became increasingly important as they met demand for goods in Edo through trading, manufacturing, or financing. Most relevant for our discussion, this entrepreneurial merchant class created the world’s first futures market.
Rice, Futures and Forward Contracts
The port city of Osaka was Japan’s unofficial “rice capital”, receiving rice from all over Japan, where it was stored in warehouses and eventually sold at auction. In the 17th century, Osaka merchants experimented with early versions of forward contracts allowing buyers and sellers to lock in agreements for future delivery at pre-determined prices.
These “rice bills” were incredibly valuable for samurais enduring volatile levels of income. Eventually, a new type of forward contract called “prepayment bills” became popular as they were agreements based on rice that had not yet been harvested. For the land-owning samurai class that depended on the price of rice for their income, these “prepayment bills” enabled them to manage their cash-flow needs and risk by selling crops sometimes years in advance.
The Dojima Rice Exchange
An unofficial market for trading rice bills quickly developed in Osaka outside the house of Saburaemon Yodoya, a successful merchant. An Osaka novelist wrote in 1688 that this market “sometimes had speculative transactions of 50,000 kan [42.6 tons] in a two-hour period.”[7]
In fact, this unofficial rice bills market became so popular that there were frequently traffic jams near Yodoya’s house, and the government asked the traders to relocate to the nearby island of Dojima. Thus, in 1697, the unofficial Dojima Rice Exchange was born.[8]
Despite their benefits for merchants and samurais, government officials strongly opposed this rice bills market, particularly the trading of rice futures. The state viewed futures as gambling and believed that futures artificially inflated rice prices. Since the government’s revenues and overall Japanese economy were closely tied to the grain, rising rice prices could cause broader inflation. In the late 1690s, government officials formally banned rice futures:
“There are people who say they are just buying / selling rice, but instead set up a venue, invite many people, ask the participants to pay fees, set a due date, and speculate on prices in the market. As this is almost like gambling, we ordered them to stop this immediately… we have heard that these people are gathering again and frequently participating in this activity, which is totally outrageous behavior…”
These merchants, however, were not deterred and continued trading rice futures and forward contracts. Trading even persisted after Yodoya’s business was shut down during a government crackdown on rice futures in 1705.
Yet, for as much as the government detested rice bill trading for allegedly pushing rice prices higher, they were more sensitive to lower rice prices.
As the chart above illustrates, rice prices significantly declined from 1714 to 1718. In 1715 the Japanese government attempted to raise prices by reluctantly approving two Edo merchants’ application for an official rice bills market in Dojima. Thus, in 1715 the first iteration of the Dojima Rice Exchange was established. Importantly, however, futures trading remained banned. Only forward contracts would be permitted. Trading on this exchange was sophisticated and operationally impressive.
Like the opening/closing bells on stock exchanges today, the Dojima Exchange had a unique method for signaling the start and end to trading: fire. Officials started the trading day by setting a wooden box and fuse cord on fire. Trading continued until the fire was extinguished, at which point all trading stopped. The official closing price was simply the price at the time of extinguishment. To deter traders still transacting after the fire went out, officials would pour buckets of water on such mischievous traders.[9]
For fifteen years, the Tokugawa government proceeded to alternate between tightening and loosening derivative regulations based on the price of rice. In 1721, for example, when rice prices hit a three-year high, the government blamed illegal futures trading for high prices and closed the Dojima Rice Exchange. Yet, when rice prices fell 40% just one year later, the government legalized futures transactions for specified amounts of rice.
While its actions were hypocritical, the Tokugawa government had clearly recognized that these rice derivatives served an important function in society. Finally, in 1728 the government lifted its ban on futures transactions, and in 1730 it officially authorized a group of Osaka merchants to establish a new Dojima Exchange that allowed trading in futures.
WHY ECONOMIES NEED DERIVATIVES: THE CHICAGO BOARD OF TRADE
Despite being established roughly two-hundred years apart, the Dojima Rice Exchange and Chicago Board of Trade share many similarities.
Like 18th century Japan, the 19th century was a transformative period for America. From an economic perspective, innovations in transportation like canals and railways encouraged western expansion and facilitated long-distance trade. Business evolved from the local to national level as merchants transacted with customers they had not met from towns they had not visited.
As railways and canals connected vast swathes of America, cities like Chicago became important trading hubs due to their favorable geographic locations. Upon completion of the Erie Canal in 1825, for example, the “sleepy” little city of Chicago was transformed into a commercial trading hub connecting the Midwest with the Atlantic Ocean. In July 1857, the Madeira Pet ship entered Chicago directly from England by using the expanding network of canals. This marked the first time that a ship had arrived in Chicago directly from the ocean.
Chicago quickly became the center of America’s grain trade. Merchants operating on the waterways and canals to Chicago purchased grain from farmers, held it in storage over the fall/winter and then sold it in spring. This was a risky and costly business, however, since merchants had to pay for the actual grain, but also the transportation and storage costs until it could be sold in spring.[10]
The obvious problem for merchants, then, was that after paying all the up-front expenses they were still exposed to serious price risks (i.e., what if price had fallen dramatically come springtime?). To hedge this risk of price volatility, merchants traveled to Chicago and entered into contracts for future delivery of their grains at the prevailing prices on that day.
The first of these “time contracts” (forward contract) in Chicago was written on March 13, 1851 and arranged for 3,000 bushels of corn to be delivered in June at a price $0.01 below the cash price on March 13th (day the contract was written).[11] It did not take long for this idea to spread.
The Chicago Board of Trade
The Chicago Board of Trade was founded with 82 individuals on April 3, 1848. Initially, the organization merely promoted trade amongst its members, “functioned as a meeting place for merchants to resolve contract disputes and discuss commercial matters of mutual concern.”[12] Two pivotal moments in 1858 and 1859 changed the trajectory of the CBOT forever.
First, in 1858, a new department was created to focus on “classifying and certifying grades of grain… [which] created confidence for the buyers but also the basis for the development of the market”.[13] A year later, the CBOT became a state-chartered private association, which authorized the organization to implement rules for trading amongst its members and oversee the regulation/inspection of grains being traded.[14] In short, the CBOT could regulate itself. Accordingly, the CBOT declared formal rules and procedures for trading forwards on its exchange in March 1863.
The defining moment in the CBOT’s history arrived in May 1865, when the exchange “began to transform actively traded and reasonably homogenous forward contracts into futures contracts.”[15] Today, the Chicago Board of Trade remains one of the world’s oldest futures exchanges.
FINAL THOUGHTS: MODERNIZING DERIVATIVES FOR THE INFORMATION ECONOMY
The stories of Chicago and Dojima demonstrate how derivatives evolved to facilitate economic growth during periods of intense societal and economic transformation.
As Japan experienced rapid urbanization that altered the economic balance of power, samurais used forward contracts and futures to manage the risks associated with their volatile method of compensation dependent on rice prices.
In America, a national transportation revolution boosted trade to previously unthinkable levels, turning ‘local’ business ‘national’. The farming industry became commercialized, and farmers utilized forward/futures traded on the Chicago Board of Trade to manage price risk and gauge demand.
Derivatives and financial instruments should evolve alongside the economy and serve the needs of modern markets. Today we are experiencing another inflection point with information economy. Today’s information economy does not require new derivatives and other hedging tools to manage risk for physical goods on physical exchanges. In this digital age we now require tools to manage information and data risks. If “data is the new oil” then the information economy requires similar hedging capabilities.
Event Contracts
A major recent development in this space is the CFTC approving “event contract” trading on Kalshi. An event contract is a new type of asset class that gives investors the ability to make trades on their opinions about a specific yes-or-no question. This milestone is particularly exciting because it is democratizing access to hedging and risk management tools for the average investor, not just institutions.
This is a significant decision because it establishes Kalshi as the first regulated financial exchange dedicated to event contracts in history. Just as farmers and merchants used the CBOT for managing price risks for grains, professionals today can use event contracts to manage the risks unique to the information economy.
For example, modern software and technology companies are highly exposed to regulatory risks like Net Neutrality and Section 230 of the Communications Act (the law that immunizes internet companies from liability for hosting third-party content). Using the Kalshi marketplace, companies and individuals could purchase event contracts to hedge their risks in the chance that either laws were passed / changed.
The history and evolution of derivatives can be characterized by the idea that “necessity is the mother of invention”. As society and technology changes, so should the tools for managing the risks associated with these changes. Kalshi’s innovations in event contracts marks the next modernization of hedging tools for the information economy.
[1] Robert Shiller, The Invention of Inflation-Indexed Bonds in 18th Century America (December 2003)
[2] Aristotle, Politics (Book I, Chapter 11, Sections 5-10)
[3] Christian Pauletto & Steve Kummer, The History of Derivatives: A Few Milestones (2012)
[4] Mark West, “Private Ordering at the World’s First Futures Exchange”, Michigan Law Review, Vol. 98, No. 8 (2000)
[5] Ibid.
[6] Jonathan Wang, The Roots of Proto-Industrialization in Japan (2011).
[7] West, “Private Ordering at the World’s First Futures Exchange”, (2000)
[8] Harvard Business School Case Studies, The Dojima Rice Market and the Origins of Futures Trading (November 2010)
[9] Harvard Business School Case Studies, The Dojima Rice Market and the Origins of Futures Trading (November 2010)
[10] Geoffrey Poitras, From Antwerp to Chicago: The History of Exchange Traded Derivative Security Contracts (February 2009)
[11] Geoffrey Poitras, From Antwerp to Chicago: The History of Exchange Traded Derivative Security Contracts (February 2009)
[12] Joseph Santos, “A History of Futures Trading in the United States”, EH.Net Encyclopedia (March 16, 2008)
[13] Christian Pauletto & Steve Kummer, The History of Derivatives: A Few Milestones (2012)
[14] Joseph Santos, “A History of Futures Trading in the United States”, EH.Net Encyclopedia (March 16, 2008)
[15] Joseph Santos, “A History of Futures Trading in the United States”, EH.Net Encyclopedia (March 16, 2008)
