Merton H. Miller, Leon Carroll MarshallDistinguished Service Professor of Finance inthe University of Chicago Graduate School of Busi-ness, has written or coauthored many books andpapers on finance, among them the much-citedModigliani-Miller articles on capital structure anddividend policy. Before joining the GraduateSchool of Business faculty in 1961, ProfessorMiller had been an economist with the U.S. Trea-sury Department and with the Board of Governorsof the Federal Reserve System, a lecturer at theLondon School of Economics, and a faculty mem-ber of Carnegie Institute of Technology’s GraduateSchool of Industrial Administration. He receivedhis A.B. degree magna cum laude from Harvardin 1943 and his Ph.D. from Johns Hopkins in1952. He is the recent recipient of an honorarydoctorate in economics and business from theKatholieke Universiteit te Leuven in Belgium. Heis a former president of the American FinanceAssociation and is a fellow of the EconometricSociety. He serves as coeditor of the Journal ofBusiness. Professor Miller presented earlier versionsof this paper at a conference on financial innova-tion in Leuven, Belgium, in May 1986 and as the1986 Distinguished Speaker at the annual meetingof the Western Finance Association in ColoradoSprings, June 1986.

FinancialInnovation:The LastTwenty Yearsand the Next

The Recent Surge of SignificantFinancial Innovations

No word is more overworked these days than“revolution.” Yet in its original sense of amajor break with the past, the word revolu-tion is entirely appropriate for describing thechanges in financial institutions and instru-ments that have occurred since my lastextended stay in Belgium just a shorttwenty years ago.

As one small example of how far we havecome since then, I can still recall the shockand incredulity of my Belgian friends onlearning that I, as an American citizen,could not then legally own monetary gold.Nowadays, of course, we can hold and tradenot only gold coins, gold bullion, goldfutures, and gold options but literally hun-dreds of other financial instruments thateither didn’t exist in 1966 or existed only inrudimentary form. A partial list of majornovelties would include, in no particularorder: negotiable CDs, Eurodollar accounts,Eurobonds, sushi bonds, floating-rate bonds,puttable bonds, zero-coupon bonds, strippedbonds, options, financial futures, options onfutures, options on indexes, money-marketfunds, cash-management accounts, incomewarrants, collateralized mortgages, home-equity loans, currency swaps, floor-ceiling

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swaps, exchangeable bonds, and on and on.The mind boggles.

Can any twenty-year period in recordedhistory have witnessed even a tenth as muchnew development? As we review the list-and I remind you again that it is only a par-tial list-we can only wonder whether andwhen this unprecedented innovative surgewill begin to lose its force. Are even morefinancial innovations in prospect and whereare they likely to arise?

To organize our thinking about likelyfuture financial innovations I propose first tolook to the processes that produced theremarkable flood of new instruments andinstitutions. An understanding of the under-lying driving mechanisms may give cluesabout where the machine is likely to go. Youwill recognize my approach as the standardoccupational response of an academic theo-rist. But to keep my discussion from becom-ing too academic, let me restate the questionas it was recently posed to me by a reporterfrom one of our leading financial journals.The journal was considering an award-inthe spirit of the Hollywood Oscars-for “themost significant and successful financialinnovation” of the last twenty years. Severalacademic and industry finance specialistswere to be invited to submit nominationsand, of course, a brief supporting defense ofthe choice. I, too, have a candidate for theaward. And I will get to it in due course,after sketching out briefly the criteria Iapplied in making my selection.

We must begin, of course, by definingterms. What is an “innovation”? What is a“successful” one? And what is a “significant,successful” one?

Merton H.Miller

As for the term “innovation” and how itdiffers from just plain improvement, modernstatistics provides us with some helpful dis-tinctions. Time-series analysts break into twoparts the change over time in the value ofany series such as the Gross National Productor consumer prices. One part is the changethat could, in principle at least, have beenforecasted by extrapolating known past infor-mation. The other part is thus the unantic-ipated, unforecastable change, the “surprise”as it were. It is these surprises thar havebeen aptly dubbed the “innovations” in thetime series. And it is to their counterpartsamong the recent surge of financial instru-ments and institutions that I will bedirecting attention.

To say that financial innovations, likeinnovations generally, are basically unfore-castable improvements is not to suggest, ofcourse, that their emergence is merely amatter of chance or of artistic creativeimpulse. Such creativity does indeed occur inbusiness; and, in the case of some financialinnovations, the artist has even left us hissignature. But that is certainly not alwaysthe case. Many of the financial innovationson my earlier list already existed in one formor another for many years before they spranginto prominence. They were lying, as itwere, like seeds beneath the snow, waitingfor some change in the environment to bringthem to life.

What process stimulated the new andenergized the dormant innovations in financeover the past twenty years? I wish I couldsay that it was the flood of M.B.A. 's out ofour business schools over this period. Thatwas certainly part of the story, but not the

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decisive part. The major impulses to success-ful financial innovations over the past twentyyears have come from regulations and taxes.

Taxes and Regulations asImpulses to Regulation

The income tax system of virtually everycountry that is advanced enough to have oneseeks to maintain (or perhaps, in view ofpending U.S. tax reform legislation, I shouldsay “has sought to maintain”) different ratesof tax for different sources (and uses) ofincome-between income from capital andincome from labor; between interest and div-idends; between dividends and capital gains;between personal income and corporateincome; between business income paid outand business income retained; betweenincome earned at home and abroad; and soon. At the same time, modern finance the-ory assures us, as practitioners have longknown, that securities can be used to trans-mute one form (or use or recipient) ofincome into another-in particular highertaxed forms to lower taxed ones. Thesetransformations, of course, are not withoutcost, particularly when pushed to extremes.Were any country actually to leave its taxsystem unchanged for a generation or so, anequilibrium might emerge in which noincentives were left for further shiftingincome. The gains from exploiting theremaining rate differentials would be exactlybalanced by the costs of transformation atthe margin. The total revenue raised wouldtend to stabilize, subject only to the inevi-table slow attrition coming from the normal,extrapolative, trend-related flow of improve-ments in transactions technology. But, ofcourse, we will never know that Nirvana-like

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state of equilibrium. For a variety ofreasons-including especially the desire toblunt the force of previous successful innova-tions by taxpayers-most governments (or,more properly, the shifting coalitions ofinterest groups using that vehicle for protec-tion and advantage) prefer to keep changingthe structure, thereby altering the internalrate differentials and creating new oppor-tunities for financial innovation. This endlesssequence of action and reaction has beenaptly dubbed by Edward Kane of Ohio StateUniversity the “regulatory dialectic.”

Note that changing the tax structure bothmotivates and defines a “successful” innova-tion. Each innovation that does its job suc-cessfully earns an immediate reward for itsadopters in the form of tax money saved.The government is virtually subsidizing theprocess of financial innovation just as it sub-sidizes the development of new seeds and fer-tilizers, but with the important differencethat in financial innovation the government’scontribution is typically inadvertent. Thereare cases, of course, particularly in the polit-ically sensitive housing area, where the U.S.government has been the major pioneer ofnew financial instruments. For the mostpart, however, the role of government inproducing the pearls of financial innovationover the past twenty years has been essen-tially that of the grain of sand in the oyster.

Although I have chosen to emphasize taxchanges as an initiating force in financialinnovation, the same process can be seen atwork in any financial area subject to govern-ment regulation, which is to say, still virtu-ally everywhere. The pressures to innovatearound prohibited types of profitable transac-tions or around newly imposed, or newly-

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become-effective interest-rate ceilings areparticularly strong but, as we have come tosee lately, even what purports to be deregula-tion can sometimes trigger changes that gofar beyond the intentions of the originalsponsors .

We now have definitions for “innovations”and “successful innovations” and someinsight into what produces them. But whichones merit the accolade “significant” innova-tions? Here again, we can get valuable cluesfrom the language of modern statistics.Time-series analysts and economists distin-guish between those innovations whoseeffects are “permanent” and those whoseeffects are only “transitory.” Similarly withfinancial innovations. Some have a period ofsuccess and then disappear, or virtually so,once the specific tax or regulatory changethat fueled their initial success has beenremoved. Their effects have thus been basi-cally transitory, though they may wellcontinue to sleep on under the snow, readyto spring up once again should favoringcircumstances arise.

But a few innovations manage not only tosurvive but to continue to grow, sometimesvery substant ial ly, even af ter their in i t ia t ingforce has been removed. These are the trulysignificant innovations.

Many instances of such nontransitory, sig-nificant innovations can be found amongthose on my earlier list. The Eurodollar mar-ket, for example, owed its origin to a curiousU.S. restriction known as Regulation Q. Theregulation, among other things, placed a ceil-ing on the rate of interest that commercialbanks could offer on their time deposits.Over much of the postwar period that rateceiling was, if not actually above, at least

not drastically below the market-clearinglevel. But that changed in the late 1960s andearly 1970s with the rise in U.S. and worldinterest rates. The U.S. money-center com-mercial banks soon noticed that the restric-tions of Regulation Q did not apply to thedollar denominated time deposits in theiroverseas and especially Western Europeanbranches. (These dollar denominatedaccounts, in turn, owed their origin to stillearlier sets of government restrictions; butthat is another story.) The U.S. banks andtheir foreign rivals could and did bid com-petitively for short-term dollar denominatedaccounts; and they continue to do so on ahuge scale today even though Regulation Qhas long since become a dead letter.

The currently huge Eurobond market wasset off by a tax rather than a regulatorychange. It sprang up initially in response toour government’s institution in the late1960s of a 30 percent withholding tax oninterest payments on bonds sold in the U.S.to overseas investors. The locus of the mar-ket for dollar-denominated bonds for non-U.S. citizens thereupon moved from NewYork to London and other money centers onthe Continent. The withholding provisionhas since been repealed, but the Eurobondmarket it induced has continued to thrive, inpart no doubt because it also served tobypass the cumbersome new-issue prospectusrequirements imposed by our Securities andExchange Commission on public issues ofsecurities by even the best-known U.S.firms. Another adaptation to that same with-holding tax by some U.S. banks and firmswas the creation of a Netherlands Antillessubsidiary corporation as a treaty-protectedwithholding-exempt financing arm. That

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adaptation, however, appears, at this time,not to be passing the survival test for perma-nence and hence “significance” by mydefinition.

In singling out these two particular exam-ples of the innovation process, I did notmean to slight the contributions to innova-tion of governments other than my own.There is plenty of glory to go around. Thecurrent vogue for “swaps,” for example, wasset in motion some years back by firms seek-ing ways to avoid British government restric-tions on dollar financing by British firms andon sterling financing by non-British firms.Other important innovations have involvedthe simultaneous inadvertent contributions oftwo or more countries. The ideal example isthe zero-coupon bond. No single innovationepitomizes so neatly the many strange andoften unplanned elements that come togetherto produce a significant financial innovation.

The explosion in the issue of deep-discount bonds by U.S. corporations in 198 1was occasioned not strictly by a tax changebut by the recognition of a hitherto unsus-pected technical flaw in the TreasuryDepartment regulations that interpret theU.S. tax law. Zero-coupon securities werealready in existence, of course, notable exam-ples being Treasury bills and even the Trea-sury’s own Series E Savings Bonds. Butlong-term deep-discount instruments hadrarely, if ever, been issued by taxable corpo-rations until the Treasury’s blunder wasappreciated. So gross was that blunder-which permitted a linear approximation forcomputing the implicit interest and henceinflated the present value of the interestdeductions-that a taxable corporation could

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adaptation, however, appears, at this time,not to be passing the survival test for perma-nence and hence “significance” by mydefinition.

In singling out these two particular exam-ples of the innovation process, I did notmean to slight the contributions to innova-tion of governments other than my own.There is plenty of glory to go around. Thecurrent vogue for “swaps,” for example, wasset in motion some years back by firms seek-ing ways to avoid British government restric-tions on dollar financing by British firms andon sterling financing by non-British firms.Other important innovations have involvedthe simultaneous inadvertent contributions oftwo or more countries. The ideal example isthe zero-coupon bond. No single innovationepitomizes so neatly the many strange andoften unplanned elements that come togetherto produce a significant financial innovation.

The explosion in the issue of deep-discount bonds by U.S. corporations in 198 1was occasioned not strictly by a tax changebut by the recognition of a hitherto unsus-pected technical flaw in the TreasuryDepartment regulations that interpret theU.S. tax law. Zero-coupon securities werealready in existence, of course, notable exam-ples being Treasury bills and even the Trea-sury’s own Series E Savings Bonds. Butlong-term deep-discount instruments hadrarely, if ever, been issued by taxable corpo-rations until the Treasury’s blunder wasappreciated. So gross was that blunder-which permitted a linear approximation forcomputing the implicit interest and henceinflated the present value of the interestdeductions-that a taxable corporation could

actually come out ahead by issuing a zero-coupon bond and giving it away!

The Treasury reacted after a couple ofyears with legislation closing off the avenue,and the supply of new zeroes by U.S. corpo-rations abruptly ceased. But the demandersfor zero-coupon instruments that the firstinnovation had uncovered were still thereand begging for more. Much, though cer-tainly not all, of this demand was sustainedby the corresponding blunder of the Japanesetax authorities in treating all of the apprecia-tion not as deferred taxable interest, whichwould have been advantageous enough to theholder, but as capital gain. And capital gainsunder Japanese law were exempt from tax.Zero-coupon bonds, moreover, were a neatway of blunting the force of Ministry ofFinance restrictions on the value of foreignbond holdings by Japanese pension funds.Despite minor adjustments recently, theserules and the demand for zeroes they createstill remain. Meanwhile, with the corporatesupply dried up, our own innovators havebeen busily creating a synthetic supply ofzero-coupon bonds for Japanese buyers (andfor tax-exempt domestic pension-fund portfo-lio “immunizers”) by stripping the couponsfrom U.S. Treasury bonds and selling themseparately as zeroes.

So much then for my criteria for definingsignificantly successful financial innovations.Now comes the hard part. Any surviving,successful innovation must have reduceddead-weight transaction costs and expandedthe reach of the market. Otherwise, itwouldn’t have been successful, let alone sig-nificant. But which of the many possiblecandidates merits the award of most signifi-

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cant? And how is relative significance to bescaled? Not, I think, just by sheer volumeof business. On that score, the Eurobondand, even more, what is fast becoming theEurocapital market would be an easy winner.Size is part of the story, but not all of it. Toqualify as most significant, an innovationmust be important not only in and of itselfbut must have stimulated substantial furtherinnovations as well. It must have set off achain reaction, as it were, if that is still apermissible analogy in the light of recentevents. By this standard, my nomination forthe most significant financial innovation ofthe last twenty years is: financial futures--thefutures exchange style trading of financialinstruments.

Financial Futures: Origins andEarly Development

You may be surprised that I did not singleout options trading as the prime innovation.Options are certainly the darling of theacademic finance community. They representthe one case where we can translate ourunderlying theoretical notions into an exact

pricing relation-the justly famous Black-Scholes formula and its numerous extensions.Options are also more basic and fundamentalsecurities than futures contracts in that withoptions (and Treasury bills) one can alwayscreate synthetic futures, but not the otherway around. It can also be shown that manyof the fancy instruments in my earlier listingare really just options in disguise. But myconcern here is with innovation, and thatrequires getting events into the proper his-torical sequence. In that sense, financialfutures come before options; only a fewmonths ahead, it is true, but still, ahead.

Merton H.

That first truly successful innovation infinancial futures can be pinpointed quite pre-cisely, as can the name of its inventor, or atleast its prime mover. He was Leo Melamedof the CME (the Chicago MercantileExchange), though Leo Melamed himselfoften modestly gives credit for the originalinspiration to Milton Friedman who, at thetime, was a member of the Department ofEconomics at the University of Chicago.

Milton Friedman, for some reason which Idon’t know but can suspect, came to believesometime in 1971 or so that the Britishpound was overvalued. No Chicago bank,however, would accommodate him byallowing him to sell the pound short. Hehappened to mention this on some socialoccasion to Leo Melamed, who then, as now,had close ties to the University of Chicago.And that mention registered with Melamedbecause the symmetry of futures contracts forshort and long positions had always been oneof the standard claims for advantage of theChicago style futures markets over the NewYork style stock markets. No costly bor-rowing and escrowing of securities wereneeded to go short in Chicago; no senselessup-tick rules had to be observed before ashort sale could be executed. A short inChicago was just the negative of a long.

This potential cost advantage of futurestrading, however, was at that point of purelyacademic and polemical interest since onlyfutures in physical commodities, and a rathersmall set at that, were actually being traded.But the Chicago commodity futuresexchanges in their drive to diversify had, bythe late 1960s amply demonstrated theirwillingness to experiment with imaginative,new kinds of contracts even though most

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were doomed to fail. Some of these experi-ments, like iced broilers and plywood (andgoing back still further to live cattle andpork bellies), actually presented far greaterchallenges to the ingenuity of the contractdesigners than did foreign exchange, which isafter all already a highly standardizedcommodity.

So with some, but not an enormousamount of, fanfare the IMM (the Interna-tional Money Market) was inaugurated in1972 as an offshoot of the CME and the eraof financial futures trading began.

(If this were a formal paper, which, ofcourse, it is not, I would attach a footnote atthis point noting that while the CME justlydeserves credit for being first off the markwith its foreign exchange furures contract, itscrosstown rival, the CBT (the Chicago Boardof Trade), had actually proposed exchangetrading of options on common stocks as earlyas 1969. Such options, however, fell underthe jurisdiction of the SEC (the U.S. Securi-ties and Exchange Commission), at that timea particularly heavy-handed regulatoryagency. Setting to rest the SEC’s professedconcerns about speculation and insider trad-ing in options delayed the opening of theCBOE (the Chicago Board OptionsExchange) for more than five years.

The search for the origins of exchange-traded financial futures is complicated fur-ther by the exchange trading of options atthe CBT as far back as the 1920s. They wereoptions on commodity futures, however, notstocks; and they were banned by Congress inone of its periodic antispeculative convulsionsin the late 1930s. That this previous incar-nation of options trading is not more widelyknown may be simply a matter of unfamiliar

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terminology. What we now call options werethen known as “privileges. ” What is perhapseven less widely known is that commonstocks were also traded on the CBT in thesame era in ways that had at least some ele-ments of futures-style market arrangements.But, to borrow some terminology from thehistorian David Landes of Harvard Univer-sity, these early, aborted episodes were“anticipations,” perhaps, but not true inno-vations in our sense of the term.)

Although I was in Chicago at the openingof the IMM, I am sorry to have to reportthat I was not caught up with any sense thatan event of great historical significance wastaking place. I let the occasion pass. Onereason I failed to read major significance intothe opening may have been my awareness ofthe already existing and well-functioningmarket for foreign currencies. It was not anexchange market, of course, with a singletrading pit but rather a classic “upstairs”market with telephonic connections betweenthe trading desks of the major banks andbetween the banks and the large foreignexchange brokers. Each trading bank received(or solicited) orders for foreign exchange fromits own customers-either businesses withoverseas transactions or smaller banks servic-ing their own customers. Small orders wouldbe filled directly out of inventory by thedesk; in the active currencies, incoming cus-tomer orders could be crossed. For largeorders, for substantial order imbalances, forrebuilding dealer inventories, or perhaps justfor purely speculative reasons, the tradercould tap into the telephone market. Thetrader had the choice either of identifyinghimself immediately to the bank counter-party on the other side of the trade or, as is

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common a result with new contracts. Thesand in the oyster turned out to be the aban-donment in the early 1970s of the BrettonWoods system of fixed exchange rates-fixed, that is, except for periodic convul-sions. Floating rates create precisely thekind of price volatility and hedging demandthat futures trading needs and thrives on.

The coming of exchange trading forforeign currencies did not displace theupstairs, interbank market, of course. Thereally big trades-two or three hundred mil-lion dollars or more at a crack-are stilllikely to be routed upstairs. The IMM’s com-parative advantage would be in the handlingof, say, two hundred trades at around half amillion each. This is not to say, however,that only traders in that range have bene-fited. Evidence gathered subsequently fromother financial futures markets shows thatspreads in the upstairs, big-player spot andforward markets are significantly smallerwhen the futures markets are open thanwhen they are closed. And, at the other endof the order-size spectrum, even those of uswhose transactions in foreign exchange areconfined to airport kiosks are also presum-ably benefiting. Think how much more siz-able dealers’ spread would have to be if theydidn’t have access to reasonably low-costhedging for their own inventory. It is impor-tant to keep that source of benefits in mindbecause the financial futures I am extollingare not typically products that individualsconsume directly. They are essentially indus-trial raw materials.

Instituting futures trading of foreignexchange, in sum, reduced transaction costsand provided thereby all the classical gainsfrom trade. That alone, however, would not

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have earned it my award-nomination, oran honorable mention perhaps, but not thebig prize. What earns it that award is itshaving served as a model and exemplar fortrading in so many instruments in additionto foreign exchange.

It is obvious enough now (though itcertainly was not so obvious then) that thesame conditions that opened the niche forforeign currency futures also were presentelsewhere-to wit, a virtually standardizedproduct already heavily traded but in special-ized markets to which only a small set ofplayers had direct access. The CBT soonthereafter introduced GNMA (GovernmentNational Mortgage Association) futures-acontract that some regard as the first true

futures in the strict sense of theterm. Its claims for this honor may have tobe filed posthumously, however, since currenttrading of even its much revised contract isdown to less than two hundred contracts aday, and falling. Shortly after the GNMA,the CME introduced Treasury bill futures, acontract still very successful, with initialsand in the oyster in that case being pro-vided by some special features of our tax lawthat gave substantial unintended tax benefits(since removed) to futures trading in T-bills.

From short-term T-bills it was an easylogical step to long-term Treasury bonds.(But the practical step was far from trivialbecause of the greater difficulty of standard-izing instruments with difference couponsand maturities and with less regularity in theinfusion of new supplies. The U.S. Treasury,moreover, was anything but supportive.)Long-term T-bonds, traded on the CBT, havenow become far and away the leading finan-cial futures contract in terms of daily trading

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have earned it my award-nomination, oran honorable mention perhaps, but not thebig prize. What earns it that award is itshaving served as a model and exemplar fortrading in so many instruments in additionto foreign exchange.

It is obvious enough now (though itcertainly was not so obvious then) that thesame conditions that opened the niche forforeign currency futures also were presentelsewhere-to wit, a virtually standardizedproduct already heavily traded but in special-ized markets to which only a small set ofplayers had direct access. The CBT soonthereafter introduced GNMA (GovernmentNational Mortgage Association) futures-acontract that some regard as the first truefinancial futures in the strict sense of theterm. Its claims for this honor may have tobe filed posthumously, however, since currenttrading of even its much revised contract isdown to less than two hundred contracts aday, and falling. Shortly after the GNMA,the CME introduced Treasury bill futures, acontract still very successful, with initialsand in the oyster in that case being pro-vided by some special features of our tax lawthat gave substantial unintended tax benefits(since removed) to futures trading in T-bills.

From short-term T-bills it was an easylogical step to long-term Treasury bonds.(But the practical step was far from trivialbecause of the greater difficulty of standard-izing instruments with difference couponsand maturities and with less regularity in theinfusion of new supplies. The U.S. Treasury,moreover, was anything but supportive.)Long-term T-bonds, traded on the CBT, havenow become far and away the leading finan-cial futures contract in terms of daily trading

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volume. From Chicago, government bondfutures trading has now spread to foreignmoney centers such as London where, onesuspects, its impact in lowering transactioncosts is likely to be even greater than it wasin the U.S., given the more heavily car-telized trading structures there. In fact,financial futures must surely be given someof the credit for the wave of deregulation anddecartelization now sweeping through theEuropean (and to some extent even the Jap-anese) capital and money markets.

Had the impulse from the original finan-cial futures innovation stopped at this pointit would have been remarkable enough. Butthen came another extension that createdenormous new potential for financial futures,a potential that has only just begun to betapped.

Cash Settlement and the IncreasingAbstraction of Traded Commodities

The extension was “cash settlement.” Thetypical commodity futures contract gives theholder the right to demand delivery of thecommodity at the agreed-upon price and thetimes, places, and quality grades specified inthe contract. And the short, on the otherside of the contract, has the correspondingobligation to deliver. In practice, relativelylittle physical delivery actually takes place.Most short contracts are liquidated by off-set-i.e., by going into the market and buy-ing an equivalent (standardized) contract.But some physical delivery does take place,and it can be, all things considered, anunnecessary nuisance. Not only must thephysical costs of supporting the delivery sys-tem be incurred, but the right to demanddelivery at contract expiration can confront

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careless or unwary traders with deliverysqueezes or corners when the time for con-tract closeout approaches. Maintaining a reg-ulatory apparatus to deal with such closeoutproblems is one of the costs of futurestrading.

Why then hadn’t the delivery option beendropped in favor of cash settlement long ago?In part, and particularly for the traditionalagricultural commodities, perhaps no spotprices were sufficiently tamper-proof to serveas an accepted basis for settlement. Cash set-tlement in such circumstances would changeonly the form, not the substance, of thesqueeze problem. But that surely cannot havebeen the case for instruments such as foreignexchange or T-bills where large and activespot markets exist.

What prevented cash settlement in thoseinstruments, even if it had been efficient toadopt it, was a provision of law. In many ofthe states in the U.S., notably Illinois,where the big exchanges are located, a con-tract settled by delivery, if only in principle,was a futures contract. But a contract thatcould be settled only in cash was a wager.And in most states (except for Nevada andparts of New Jersey) wagering, even betweenconsenting adults, is illegal (unless, ofcourse, the state owns the casino, as in thestate lotteries, or is at least a major partneras in pari-mutuel betting).

These restrictive state laws, however, weresuperseded in 1974 by the federal regulatorystatute setting up the CFTC (the CommodityFutures Trading Commission) as a successorto the CEA (the Commodities ExchangeAdministration) and giving the CFTC solejurisdiction over futures markets. Since there

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was no federal prohibition of gambling, cashsettlement suddenly, if inadvertently, becameconceivable.

The notion that the CFTC could contrib-ute, even inadvertently, to innovation infutures trading will, of course, bring a smileto the face of anyone familiar with its subse-quent history and reputation. The contribu-tion of the CFTC to progress and innovationin futures markets has almost always been toslow it down and impede it. All new futurescontracts must have CFTC approval beforetrading can begin. Delays in grantingapproval often run to a year or more; andeven when the end is almost in sight and thetraders are virtually lined up waiting for thestarting bell, contracts have been sent backfor further low-order but, at that point,costly revisions. All this, mind you, for newcontracts whose potential had previouslybeen studied in depth by the exchangeswhose members will bear the risks if thecontract fails (as, indeed, most of them do).And the amounts involved in developing newproducts are too large for frivolity. In thecase of just the two recently introduced, andstill largely unsuccessful, Over-the-CounterIndex contracts, the Chicago Board of Tradeand the Chicago Mercantile Exchangeinvested a combined total of five to six mil-lion dollars, an amount on the order of aquarter of the entire CFTC annual budget.

Although the original authorization of theCFTC in 1974 had the unintended side effectof displacing state restrictions on cash settle-ment of futures contracts, the legal steps thatpositively affirmed cash settlement were notfully in place until 198 1. But once the CFTChad removed the major obstacles to this

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innovation (other than itself, of course), twomajor steps forward soon were taken by theindus t ry .

The first, and by far the more importantin terms of current volume of trading, was afutures contract in common stock-not thatof one particular company but of a wholeportfolio of individual stocks. Since the set-tlement for the portfolio of stocks was to bein cash rather than by physical delivery, itwas natural to focus on those portfolios mostrelevant for possible hedging purposes inthe investment community, especially theinstitutional investment segment. And thatsuggested the major market indexes (andpossibly also industry subindexes) of thekind already widely used in performanceevaluation.

That judgment proved sound, but in someother respects there were major surprises.The problems associated with contract close-outs under the delivery system did not disap-pear; they only changed their form. Thecloseout on expiration days now involves notthe shorts scrambling to deliver the spotcommodity to the longs but the so-called“program traders” scrambling to unwindtheir arbitrage positions-either short theindex futures and long the stocks or longthe futures and short the stocks. On somedays-the so-called “triple-witching days”-the actions of the program traders aresometimes reinforced by the similar arbitrage-related actions of the option converters andbig fluctuations occur in the prices of someof the underlying stocks. If, say, the programtraders and the option converters happen tohave predominantly short positions in thestocks as the close approaches, then therewill be a sudden surge in the demand for

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shares to cover those short positions. Thesame excess demand arising at the opening oftrade or during the course of the trading daycan often be accommodated without a largeprice change by delaying trade until enoughpotential sellers have been notified and sol-icited. But when the imbalances pile upunexpectedly just before the close, the timeis sometimes too short to hunt up additionaloutside counterparties. Price concessions tothose on site may be the only balancingmechanism left before the final closing bell isrung. Alternative closeout procedures thatwill obviate these occasional wide pricemoves (and yet not kill the arbitrage demandfor futures and options) are currently thesubject of much active research andcontroversy.

The closeout problems, though they haveattracted much attention, should not obscurethe important economic contribution offinancial futures in directly and indirectlyreducing the costs of transacting in commonstocks. The accomplishment of cash settle-ment futures on that front has been major,but there was one even more startling contri-bution of cash settlement to come.

The stock index futures were at leastbased on potentially tradable baskets ofgoods. And, indeed, the program traders andother arbitrageurs assemble just such baskets.But the next step in financial evolution wasto indexes that were closer to being measuresof abstract concepts than to deliverable bun-dles of commodities. There is futures tradingnow in ocean freight rates; and, more inter-esting yet, in “inflation,” at least as mea-sured by changes in the U.S. ConsumerPrice Index.

The CPI contract is, of course, the econo-

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to start fresh by moving these markets formore generalized hazards out of the U.S. toBritain and Europe where there are alreadyfunctioning models to draw on, such as thefabled Lloyds of London.

Financial Innovation: Is the GreatWave Subsiding?

And that brings me to my final theme. Isthe great wave of financial innovation of thelast twenty years likely to slow down soon?Or must we brace for further and possiblyeven more rapid bursts of innovation ahead?

The answer to these questions will cer-tainly depend on what actually triggered therecent past surge. That the triggering had atleast something to do with tax and regula-tory changes is, I hope, clear enough frommy admittedly somewhat impressionistic sur-vey. But, of course, those triggers havealways been with us. The process of adapta-tion and selective survival in response to taxand regulatory changes has been going onthroughout recorded history, as has beencalled to our attention by the distinguishedeconomic historian, Richard Sylla of NorthCarolina State University. Apparently we oweeven such fundamental financial instrumentsas paper money to the same basic process-the sand in the oyster in that case havingbeen the British government’s prohibition ofthe minting of coins by its then colonialsubjects in North America. But somethingelse seems to have happened about twentyyears ago that shocked the system into aperiod of unprecedented rapid innovation.

I must confess that, despite much ponder-ing, I have yet to come up with a completelysatisfying first cause. There are certainlyplenty of possibilities, both economic and

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technological; but with the exception of thegreat oil shock of 1971-74, most had obvi-ous counterparts at times (and often at sev-eral times) in recent past history. And, as forthe oil shock, many of the key developmentswere under way well before it occurred.

Perhaps, then, there was no single, easilypin-pointed cause, but just the coincidentalcoming together of a whole set of seeminglyunrelated (to borrow still another term fromstatistics) events and circumstances. Most ofthe critical tax and regulatory frameworksthat supplied the motives for the financialinnovations I have been describing were putin place in the 1930s. In that depressed andwar-scared period, and even more so duringthe war and slow recovery years that fol-lowed, there were better outlets for innova-tive talents. We were just too poor and toodistracted with other, more pressing con-cerns. The regulatory and tax constraintswere not the most seriously binding ones.

By the middle and late 1960s, however,the recovery in world wealth (and trade) hadproceeded so far that the taxes, interest rateceilings, foreign exchange restrictions, secu-rity sales regulations, and other anticompeti-tive controls slapped on in the ’30s and ’40swere becoming onerous. It was not so muchthat new tax and regulatory burdens werebeing imposed (though that was happeningtoo) but more that the existing burdens wereincreasingly binding-particularly so giventhe surges in the level and volatility ofprices, interest rates, and exchange rates thatwere erupting in those years. The innovativewave then triggered was much like a snakebursting through its old skin.

If this view is correct, the prospect for thefuture is for a slowing down of the rate of

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financial innovation. Note that I said a slow-ing down of the rate of innovation, not anend to further progress. Clearly much growthand improvement are still in prospect, espe-cially in the important area of real estate andin market competition across countries andover the hours of the day. Nor should thisslowing down in the rate of innovation in thecoming twenty years be deplored. It will begood news, not bad, if it means that manyof the inefficient tax and regulatory struc-tures inherited from the ’30s and ’40s willhave been driven at last from the scene alongwith so many of the obsolete economic andpolitical doctrines that gave rise to them.