What is a derivative?
A derivative is a contract whose value is derived from something else (an underlying asset). Popular derivatives include forwards, futures, options, and swaps. The base currency and the underlying asset are the two main components of derivatives. As the underlying asset fluctuates, users gain or lose the base currency. For example, the CME’s S&P 500 future trades in dollars (base currency) and derives its value from a basket of S&P 500 stocks (underlying asset).
Derivatives are used to manage risk while also providing price exposure to an underlying asset.
Traders can use derivatives to hedge price risk.
Derivatives, according to Warren Buffett, are “financial weapons of mass destruction.” In the popular press, the much-vaunted – and reviled – financial products have become a filthy word. Financial markets, and the world as we know it, would not function without them. To hedge risk and exploit opportunities, banks, corporations, governments, and supranational organizations rely on these sometimes basic, sometimes immensely sophisticated tools. Consumers, too, are reliant on derivatives, often without realizing it.
Derivatives have a long and fascinating history dating back 10,000 years. Different types of derivatives have had a part in humanity’s financial history, from the time of Babylonian monarchs to medieval periods, and all the way to today’s electronic trading. Clay tokens were baked into a spherical sort of “envelope” in Sumer (Sumer was an ancient civilization that flourished in the Fertile Crescent region of Mesopotamia, between the Tigris and Euphrates rivers) around 8000 B.C. and used as a promise to a counterparty to deliver a quantity of goods by a certain date. Sellers agreed to deliver the assets within the timeframe specified on the envelope vessel and the tokens. This transaction was essentially a forward contract that was settled once the seller delivered their goods by the date specified in the token. Moving forward to Mesopotamia in the late 1700s B.C., trade and commodity security became governed by rulers’ codes, which served as the first recorded contracts. These contracts, like those of Hammurabi of Babylon, were actual written agreements detailing purchases and sales between merchants and buyers on stone or clay tablets in cuneiform. Some of these contracts functioned as futures contracts, in which delivery of future grain harvests was specified prior to planting and the seller agreed to deliver a quantity of grain for an agreed-upon price at the time of negotiation.
The 500 B.C.
Along with the earliest recorded forwards and futures contracts, the Greek philosopher Thales is credited with negotiating one of the first put options for an olive harvest in the 500s B.C. Thales negotiated with olive press owners (An olive press separates the liquid oil and vegetation water from the solid material by applying pressure to olive paste. Standard decantation is then used to separate the oil from the vegetation water) for the right, but not the obligation, to use their presses during harvest after predicting a large yield for the coming season. He made a cash deposit, and when the season went as well as he had hoped, he leased the presses and profited.
Derivatives in the Middle Ages
During the Middle Ages, when entrepreneurs negotiated commercial partnerships for sea and land ventures, forwards, futures, and options continued to evolve. In these cases, one party funded the venture, and the other party traveled with the promise of bringing back requested commodities. This collaboration was essentially a pioneer of venture capitalism (a venture capitalist (VC) is a private equity investor who lends money to companies with high growth potential in exchange for a stake in the company. This could include funding startup ventures or assisting small businesses that want to grow but lack access to equities markets) with a forward contract.
One of the first derivatives used between the government and its people was formed later in 13th century Italy: the Monti. Monti shares were issued by cities as a promise to repay debts and raise funds, but people soon began using them as a form of currency to pay for commodities and services. Because the value of the Monti fluctuated with the wealth of the cities in which it was issued, it was not a stable currency and eventually ceased to be significant. However, this didn’t matter because some of Europe’s first trade markets were emerging.
Derivatives Medieval Europe
The markets in the Most Serene Republic of Venice were built around the needs of various merchant groups. These markets operated on the basis of over-the-counter derivatives, with trade taking place primarily between the buyer and seller without the use of a formalized exchange. These eventually evolved into trade fairs, with one of the most well-known taking place in Champagne, France, where “fair letters” were used as a line of credit between buyer and seller rather than fiat payment. Soon after, market culture spread to port cities. Market society found a home in Antwerp, Belgium, in the 1500s, when for the first time a building was formally constructed to house traders for business. The structure, known as the Bourse (a non-English speaking stock market, France in particular), housed a massive trade market where sellers from all over Europe sold their wares. However, unlike previous direct sale markets, Antwerp traders
no longer bought commodities. Instead, they traded bills of exchange to buy and sell commodity rights. This enabled merchants to eliminate the risk of transporting their goods, and it was at this point that a true European financial market was established.
While financial instruments grew in the West, the East established its own market in Osaka, Japan, with the country’s most important commodity: rice. Harvesters from all over Japan used Osaka’s markets for auction sales, where buyers were given rice vouchers in exchange for cash. Around 1730, the Dojima Rice Exchange in Osaka was formally established, allowing for rice exchange. The shomai market, in which different grades of rice were sold at spot price and settled with rice vouchers, and the choaimai market, in which rice was traded on books with futures based on rice grades per season, emerged. A clearinghouse settled the record books in the choaimai market, so buyers and sellers established lines of credit with the house. The clearinghouse acted as an intermediary for these trade payment guarantees, establishing what many consider to be the world’s first centralized futures market.
Derivatives in Recent History
In the 1800s, in the United States, agricultural demand required the establishment of a Chicago Trade Board by a solid trade contract. In 1865, future contracts were concluded similar to that of the choai rice markets, and the centralized exchange started with the use of futures contracts. In the end, the exchange-traded with US agricultural products the dairy and foreign grains. The number of financial instruments available for derivatives trading has thus been significantly increased. The Chicago Trade Board remains the CME group today.
The digital Age derivatives
As the option prices and hedging were better defined with the computer introduction the 1970s were the next increase in the popularity of derivatives. A trade option with a central clearinghouse and price listing was set up by the Chicago Options Board. The trading system was electronic in 1992, enabling trading derivatives, security, and commodity investments to expand worldwide. This development paved the way for property derivatives and the possible crisis of the beginning of the 2000s.
The derivative space is expanding in parallel with blockchain technology and the cryptocurrency space. Following Satoshi Nakamoto’s creation of Bitcoin and Vitalik Buterin’s subsequent creation of Ethereum, market Protocol will enable derivative trading through a decentralized marketplace based on the blockchain. Market Protocol, a decentralized derivative protocol, enables traders to gain price exposure to assets such as oil, stocks, bonds, and bitcoin by utilizing ERC20 tokens as collateral. Traders can use smart contracts to hedge utility tokens as well.
Though electronic tokens have largely replaced the ancient clay tokens of humanity’s past, it is easy to see how the history of derivatives has significantly shaped the current financial investment market. Derivatives play an important role in the world of trade, from ruler contracts and oil presses to rice markets, and today’s blockchain trading and market Protocol is the next piece of history-shaping their future.