The 2000 year saga of perpetual futures starts in ancient Greece, continues with the emergence of margin trading in modern history, picks up again with the invention of perpetual futures in the 1990s, and reaches the present day with their widespread use in the crypto industry.
Over the course of three posts, we will take you through the history of perpetual futures and explain their underlying core concepts. In this first post we explain how before there were perpetual futures, there were “regular” futures. These are futures that are constrained by time (and by “time,” we mean termination dates on a calendar, not, say, the limits of time travel and quantum physics).
The (Hypothetical) Origin of Futures and Derivatives
Let’s start with an imaginary story.
Once upon a theoretical time, there was a fictional wheat farmer we’ll call Agricultural Alice. Alice had worked hard to increase her harvest year after year. She invested substantial effort in acquiring more land and employing more people to help her expand her business.
But, despite her best efforts to improve yield every year, she couldn’t protect herself against fluctuating prices for wheat in the open market. External factors like weather, diseases, or simply the demand and supply for wheat were out of her control and affected how much money she could get for her wheat. It made planning quite impossible, and Alice rather miserable.
“How can you run a business like this?” she asked herself.
After much pondering, Alice had an idea.
“What if,” she thought, “I could make a contract with Buyer Bob that would let me sell him my wheat for the same price it fetches today, but at a future time, no matter what happens? Like, if Bob agrees to purchase my wheat for $100 a ton a year from now, but the price of wheat has gone down to $90 a ton by then, I’ll be safe and won’t lose any money since Bob will be locked in to the $100 a ton price! That would be great! I wouldn’t have to worry about price fluctuations anymore and I could finally make long-term plans since I’d know how much money I’d be making a year from now!”
Unable to contain her excitement, Agricultural Alice ran the idea past Buyer Bob.
Buyer Bob saw an opportunity as well.
“Y’know,” he said to himself. “I think the price of wheat is going to rise, so I could make a profit here. If Alice and I agree that I’ll pay her $100 per ton of wheat in a year, and the wholesale price goes up to $110, I could turn around, sell it myself, and pocket that extra $10 per ton!”
And so, Buyer Bob and Agricultural Alice agreed, our imaginary first futures contract (with a termination date of one year) was born, and you, dear reader, now have a sense of what futures are.
Futures, in turn, are a subcategory of a class of financial products called “derivatives.” They are called derivatives because the value of the futures contract—the (perhaps digital) piece of paper you hold in your hand—is derived from the underlying asset the contract deals in. In the case of Alice and Bob, the underlying asset was wheat.
The Ancient Greek Side Hustle
An early example of derivatives trade wasn’t actually for wheat, though. It was for olive oil presses, and it happened sometime between 624 and 545 BCE when a Greek philosopher and mathematician named Thales of Miletus had a great idea for a side hustle.
Thales was a student of the weather and predicted that the upcoming olive harvest would be better than expected. Confident that there would be more olives than usual, Thales had a scheme to buy up all the olive presses and thus gain a monopoly on olive oil production.
So, Thales scraped together what little money he had, but he needed more. He borrowed money from other people to enhance his purchasing power (a technique called margin lending), and when he had enough, he approached every single olive press maker in the region and made contracts with all of them.
The deal was that prior to harvest season, he would put small deposits down on all their olive presses. What’s more, he would pay the press makers premiums to make sure they would all honor their agreements (i.e. none of them would sell any presses to any farmers).
Thales was right about the olive harvest–it was indeed better than expected. There were olives everywhere, ready to be made into olive oil, and, thanks to Thales’s machinations, he had the rights to buy all the presses. Olive farmers found that they couldn’t get olive presses anywhere. Thales basically had a monopoly on olive pressing in the region and made a fortune.
The Shogun, the Rice, and the Rise of the Futures Exchange
A couple of thousand years later, guys like Thales no longer had to run around setting up all the meetings and mechanisms themselves for a futures deal. Instead, formal futures exchanges emerged. For example, in 1730, Japan’s Tokugawa shogunate approved the Dojima Rice Exchange. This exchange established membership, a book for tracking trades, and a mechanism for clearing transactions. Additionally, the price of rice at any given moment was determined at the exchange, and this price was communicated across the country.
Now, futures were no longer just deals made between farmers and rice dealers. Traders, who might have nothing to do with the growing or selling of the rice itself, could get in on the game and make (or lose) fortunes simply from speculating on the prices of futures – the pieces of paper that represented the right to buy or sell rice at particular prices at particular points in the future.
The establishment of the Dojima Rice Exchange was a key moment in the evolution of the commodities futures trade. “Commodities” have traditionally been products that can be bought and sold, whether it’s rice, oil, gold, or even pork bellies. (In recent years, however, the term has expanded to also include financial products – like currencies and company shares – as well.)
Commodities are one of the most highly-traded asset classes on futures exchanges. The largest futures exchange in the world today is the Chicago Mercantile Exchange (CME), which averages about $20 trillion in daily trading volume.
It has been a long road since ancient Greece, and the journey to perpetual futures continues in our next installment, in which we will discuss the evolution of margin trading. Keep an eye out for The Rise of Perpetual Futures, Part 2: Getting on the Margin Train.