The History of Derivatives Trading
Derivatives have a fascinating, 10,000-year-old history. From the ages of Babylonian rulers to medieval times, all the way to present day electronic trading, various forms of derivatives have had a place in humanity’s financial history. Based on an agreement around an underlying asset to exchange cash or other commodities within a specified time frame, derivatives are a way to invest and hedge assets without ever actually needing to possess the asset itself.
In their most modern form, MARKET Protocol brings derivatives to the blockchain, allowing traders to gain price exposure to on and off chain assets, like TSLA stock, for example. But before traders could use their cryptocurrency to trade stock, Sumerian clay tokens represented commodities, the first futures exchange started as a way to hedge Japanese rice, and American farmers used put options to help pay debts in bad crop seasons. Though derivatives weren’t widely and easily traded until the computer age of the 1970s, their history in finance is a rather fascinating one. Let’s start at the beginning.
In Sumer in 8000 B.C., clay tokens were baked into a spherical sort of “envelope” and used as a promise to a counterparty to deliver a quantity of goods by a certain date. Based on the timeframe imprinted into the envelope vessel and the tokens themselves, sellers promised to deliver the assets. This exchange essentially functioned as a sort of forward contract, which was settled once the seller delivered their goods by the date baked onto the token.
Jumping forward to Mesopotamia in the late 1700s B.C., trade and commodity security became dictated by rulers’ codes, which functioned as some of the first recorded contracts. Like those by Hammurabi of Babylon, these contracts were actual written agreements detailing purchasing and sales between merchants and buyers on stone or clay tablets in cuneiform. Some of these contracts functioned as futures, where delivery of future grain harvests was specified prior to planting and the seller promised to deliver a quantity of grain for an agreed upon price at the time of negotiation.
Along with early recorded forwards and futures, the Greek philosopher Thales is credited with negotiating one of the first put options for an olive harvest in the 500s B.C. After predicting a large yield for the coming season, Thales negotiated with olive press owners for the right, but not the obligation, to use their presses at harvest time. He made a cash deposit and when the season did as well as he anticipated, he leased the presses and turned a profit.
The Middle Ages
Forwards, futures, and options continued to evolve during the Middle Ages when entrepreneurs negotiated commercial partnerships for sea and land ventures. In these instances, one party funded the endeavor and the other party traveled the venture with the promise to bring back requested commodities. This partnership was essentially like an early form of venture capitalism with a forward contract.
Later in 13th century Italy, one of the first derivative uses between the government and its people was formed: the monti. Monti shares were supplied by cities as promises to repay debts and raise money, but shortly after their issuance, people began using montis as a form of currency to pay for commodities and services. Since monti value rose and fell with the wealth of the cities it was issued in, it wasn’t a stable currency and eventually ceased to remain significant. But this didn’t matter as some of Europe’s first trade markets were forming.
In the Most Serene Republic of Venice, markets shaped around the demands of different merchant groups. These markets functioned with over-the-counter derivatives, where trade was mainly between the buyer and seller without a formalized exchange. Eventually, these expanded into trade fairs, with one of the most well-known being in Champagne, France where “fair letters” were used as a line of credit between buyer and seller instead of fiat payment. Market culture moved to port cities soon thereafter.
In the 1500s, market society found its home in Antwerp, Belgium, where for the first time a building was formally constructed to house traders for business. Known as the Bourse, the structure held the massive trade market where sellers from around Europe sold their wares. However, unlike the direct sale markets of the past, Antwerp traders no longer purchased commodities. They instead bought and sold the rights of commodities by trading bills of exchange. This allowed merchants to eliminate the risk of transporting their goods, and it was here that a proper European financial market was established.
While financial instruments continued growing in the West, the East had established its own market in Osaka, Japan with the country’s biggest commodity: rice. Harvesters throughout Japan used Osaka’s markets for sale by auction, where rice vouchers were given to buyers in exchange for cash. Around 1730, the Dojima Rice Exchange was formally established in Osaka and allowed for rice exchange. Two ways of exchange emerged: the shomai market, where different grades of rice were sold at spot price and settled with rice vouchers, and the choaimai market, where rice was traded on books with futures based on rice grades per season. In the choaimai market, a clearinghouse settled the record books so buyers and sellers established lines of credits with the house. The clearinghouse became the intermediary for these trade payment guarantees, thus establishing what many have considered to be the very first centralized futures market.
In the 1800s, agricultural demand in the United States required strong trading contracts so the Chicago Board of Trade was formed. The centralized exchange started with the use of forward contracts, and in 1865 counter-party future agreements similar to those of the choaimai rice markets were introduced. The exchange eventually traded dairy and foreign grain along with U.S. agricultural products. This greatly expanded the number of financial instruments available for derivatives trading. Today, the Chicago Board of Trade still exists as the CME group.
The Computer Age
The 1970s were the next spike in derivatives’ popularity as option prices and hedging were better defined with the introduction of the computer. The Chicago Board of Options was formed to trade options with a central clearinghouse and price listing. Trading then became electronic in 1992, allowing for a worldwide expansion in trading derivative, security, and commodity investments. This development paved the way for property derivatives and the eventual subprime derivative crisis of the early 2000s.
The derivative space continues to grow with blockchain technology and the cryptocurrency space. After Satoshi Nakamoto’s development of Bitcoin and Vitalik Buterin’s subsequent creation of Ethereum, MARKET Protocol will bring derivative trading via a decentralized marketplace using the blockchain. MARKET Protocol, a decentralized derivative protocol, allows traders to gain price exposure to assets like oil, stocks, bonds, and bitcoin by using ERC20 tokens as collateral. The protocol allows traders to hedge utility tokens as well by using smart contracts .
Though electronic tokens now replace the ancient clay ones of humanity’s past, it’s easy to see how the history of derivatives has greatly shaped the current financial investment market today. From ruler contracts and oil presses to rice markets and today’s blockchain trading, derivatives play an important role in the world of trade, and MARKET Procol is the next piece of history shaping their future.