A brief history of financial derivatives

A brief history of financial derivatives

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.

Ancient History

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
the 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

Markets in
the Most Serene Republic of Venice was 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.

Derivatives Japan

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
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.

What is 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).

1. Derivatives are used to manage risk while also providing price exposure to an underlying asset.

2. Traders can use derivatives to hedge price risk.