Forwards and Futures
In the nineteenth century, the lemons that grew in the orchards outside Palermo took a long road to a table in London or New York. They passed from hand to hand: commercial agents, wholesalers, packers, shippers. Dickie writes that the whole trade rested on countless financial speculations—money started moving while the fruit was still ripening on the trees. The orchard owners wanted cover against a bad harvest and wanted back what they had put in, and they put in a lot. So, as a rule, the lemons were sold long before they were picked.
That is what the owner of one orchard did. It was called the Fondo Riella, and its owner was the brother-in-law of a Palermo doctor, Gaspare Galati. He sold his crop to brokers in advance. But in the early 1870s the brokers who had bought the crop noticed something odd. Lemons and mandarins were vanishing straight off the trees. All by themselves. The orchard acquired, as Dickie puts it, a highly dubious reputation, and almost nobody doubted that the warden, Carollo, was behind it. Or that the enterprising young man wanted one thing: to knock down the price of the orchard and then buy it.
Selling the Crop Before It’s Grown
Only barter is older than this deal. You sell something that doesn’t exist yet, at a price agreed today. The orchard owner knows what he’ll get, even if lemon prices collapse by autumn. The buyer knows what he’ll pay, even if prices shoot up. Both sleep better. Each hands the other the risk he doesn’t care for.
This deal is called a forward. It is useful and it is honest. But it has two weak spots, and the Riella orchard showed both.
The first is delivery risk: what if they don’t deliver? Two people have agreed on one particular orchard, and everything hangs on what happens to that orchard. The warden steals, the orchard burns, the owner changes his mind—and the buyer is left with nothing. The price is fixed. The lemons are gone.
The second is counterparty risk: what if your partner runs? By autumn lemons are half the price? The buyer who promised to pay the old, high price badly wants not to pay. They’ve doubled? The seller badly wants to sell to someone else. Whoever is losing on a deal is always looking for a way out of it.
From the Orchard to the Exchange
The Japanese and the Americans each solved this in their own way.
In Osaka at the start of the eighteenth century, rice was money: samurai were paid their stipends in rice, and feudal lords settled their debts in rice. At the rice market in the Dojima quarter, people bought and sold receipts for rice sitting in warehouses, and then they began buying and selling contracts: rice of standard quality to be delivered on such-and-such a date. In 1730 the shogunate officially recognised the market. What matters is not that they traded future rice. What matters is how. The contracts were all alike, only members of the exchange could trade, and settlement went through the exchange.
In Chicago, merchants founded a board of trade in 1848. In 1865 they took their scattered agreements about who would deliver grain to whom and when, and turned them into standard exchange contracts, with both sides putting up collateral. That is how futures were born.
How is a future different from a forward? It is standard. Not “the crop of the Riella orchard”, but “five thousand bushels of wheat of such-and-such a grade, for delivery in such-and-such a month”. That means you can sell it to anyone, not just to the man you made the deal with. And between buyer and seller stands a clearing house—sometimes a department of the exchange, sometimes a separate company. Financiers call it the central counterparty: nobody trades with anybody else, everybody trades with it. If someone fails to pay, the clearing house first takes his collateral and his share of the guarantee fund. After that every clearing house has its own order: some put in their own money next, some the other members’ contributions, but all of them keep reserves for the day.
Collateral Every Day
And so that the clearing house doesn’t go bust itself, it takes collateral from everyone—margin. Usually five to fifteen per cent of what the contract is worth. Every evening the exchange works out who won that day and who lost. Lost? Top up your account. Didn’t top up? Your position gets closed.
No warden Carollo could have stolen from an exchange contract like that. You promised to deliver lemons and now you’re trying to wriggle out? Your collateral is already with the clearing house.
Just don’t think the risk has gone away. It has changed shape. Your partner can’t run out on you any more, but something else has appeared. If a big player goes down so hard that the clearing house can’t take it, everyone else will be topping up. The hedger tops up his margin in hard cash every evening, even if his crop is fine and he’ll come out ahead by autumn. And a standard contract trades standard wheat: not your grade, not from your elevator and not on your day. What that can cost you, I’ll tell you in the next essay.
When the Margin Bites
Nobody showed how margin bites better than two Texas billionaires, the brothers Nelson Bunker Hunt and William Herbert Hunt. In the late seventies they began buying up silver—both the metal and futures on it. By the end of 1979, together with their partners, they controlled around one hundred and ninety-five million ounces. In the summer of 1979 an ounce of silver cost less than ten dollars; in January 1980 it went past fifty. More than five times over.
Then the exchange changed the rules. On 7 January it capped how much silver could be held in positions, and on 21 January it allowed old positions only to be closed, not new ones opened. The buyers disappeared and the price went down. On 27 March 1980, a day later called “Silver Thursday”, silver closed at ten dollars eighty cents. Every evening the Hunts were called for fresh margin. They had nothing to pay with. Their positions were sold off by force, and after that one broker alone was left with an uncovered debt on them of around one hundred and twenty-two million dollars. To keep the market from collapsing, thirteen banks lent the Hunts’ family oil company one billion one hundred million.
Neither billions nor confidence helped the Hunts. Margin doesn’t ask how rich you are. It asks how much you’ll put up tonight.
The Don’s Deal
Remember how Don Vincenzo made a five-year deal with the olive mill, fixing both the volume and the price in advance? A forward, pure and simple. And it came with both weak spots: the mill could burn down, and in a very bad year the owner might want to sell his oil to someone else for more.
The Don had no exchange, so he plugged the holes with what he had. The first by asking the owner to insure his warehouse. The second by doing business with him for twenty years and, in a bad year, lending him money himself, interest-free. “The exchange makes sure nobody runs,” the Don used to say. “I don’t have an exchange. So I have to make sure nobody wants to run.”
The Bottom Line
The exchange doesn’t remove the risk in a deal—it changes its shape. Instead of a partner who might run, you have a clearing house and a margin account you have to top up every evening. Keep the money for that evening ready in advance.