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Up until the 1970s, derivatives had been a specialised and arcane area of financial markets. They had largely been employed by producers and consumers of commodities to fix the price at which they would transact in the future, so as to manage the risk of intervening price movements. For example, a farmer could use a futures or forward contract to lock in a price at which he could sell his grain to a store owner. If there was a bumper crop and the price of grain falls due to oversupply, then the farmer will have benefited by having been able to sell his crop at a higher price than he would have gotten otherwise. On the other hand, if there was a drought resulting in widespread crop failures, then the price of grain would be expected to rise, and the store owner will have benefited.

In the US, Chicago has been the traditional hub for derivatives trading, owing to its location close to the farmlands and cattle country of the Midwest and its role as a transportation and distribution hub for agricultural produce. The Chicago Board of Trade (CBOT) was formed in 1848 as a forwards market for corn. The Chicago Produce Board, later renamed the Chicago Butter and Egg Board, was founded in 1874. This was later reorganised as the Chicago Mercantile Exchange (CME) in 1919.

Over in New York, a group of Manhattan dairy merchants launched the Butter and Cheese Exchange of New York in 1872. As the products traded widened to include poultry, dried fruit and canned goods, its name was changed in 1882 to the more grand-sounding New York Mercantile Exchange (NYMEX). Other regional exchanges trading different commodities sprang up around North America. Eventually, most would demutualise and consolidate into larger exchange groups. By 2008, CME, CBOT and NYMEX had been amalgamated to form the CME Group, which is today the largest derivatives exchange in the world.

Derivatives have an even longer history outside the US. In Japan, the Dōjima Rice Exchange was established in Ōsaka in 1697 and began trading a form of futures contract in 1710. In Great Britain, the LME traces its origins back to 1571. Derivatives exchanges have played a critical role in the development of banking systems, trade and commerce around the world. However, President Nixon's 1971 decision to suspend the dollar's convertibility to gold converged with significant breakthroughs in academia and technology that would catalyse massive growth in the use of derivatives and transform financial markets.

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In 1962, a Californian mathematics professor by the name of Edward Thorp published a book entitled Beat the Dealer, in which he applied advances in probability theory to the game of blackjack. His method assigned a value to each card in the deck and required remembering the value of cards that had been played. In simple terms, when the value of the remaining cards in the deck implies favourable odds, the gambler should increase his or her bet sizes to profit from this statistical advantage. The book was a sensation and inspired legions of card counters seeking their fortunes in Las Vegas. Thorp's work on probability to validate his method involved a large number of mathematical calculations that were carried out on an IBM 704, the first mass produced computer. This machine required calculations to be inputted on punch cards and, by today's standards, was painfully slow. Nevertheless, the dawn of the computer age was a critical development that allowed derivatives to take off, for it enabled complex mathematical calculations to be solved quickly and accurately.

Having found himself barred from casinos after his success at the blackjack tables, Thorp went on to apply his energies to financial markets. In 1969, he teamed up with a young New York stockbroker to form Princeton Newport Partners (PNP), an early quantitative hedge fund that went on to produce compound annual returns of almost 20 percent net of fees until it was wound up in 1989.⁶⁵ PNP's extraordinary success was owed to its ability to exploit statistical mispricing of derivatives through arbitrage strategies. Academic honours for the model that accurately priced derivatives would go to others, while Thorp quietly made a fortune for himself and his investors.

The maths for calculating a derivative's price are based on four factors: the price of the underlying asset; the length of time until its expiry date; market interest rates; and volatility. If all of these quantities are known, then the price of a derivative instrument can be calculated with scientific accuracy. However, while the price of the underlying asset, duration and interest rates can be known, future volatility is a prediction based on historic experience. Traders who forget that the past is not always a good guide to what will happen in the future often suffer catastrophic losses. Ironically, Robert Merton and Myron Scholes, the academics who shared the 1997 Nobel Prize in economics for inventing the famous Black-Scholes model for pricing options, learned this lesson the hard way. Just a year after their Nobel award, the hedge fund Long-Term Capital Management (LTCM), in which they were partners, had to be bailed out by Wall Street banks under Fed supervision after suffering spectacular losses.⁶⁶

Notwithstanding its inventors' later misadventures, the advent of the Black-Scholes model in 1973, coupled with developments in computer technology, brought about a revolution in the financial services industry. Before that, trading required few academic qualifications and there were many examples of mailroom clerks who had risen to untold riches in the rough and tumble of the markets. Nowadays, trading rooms have been taken over by mathematicians and scientists holding advanced degrees.

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President Nixon's abandonment of the dollar's fix to gold sparked demand for hedging currency volatility that had previously been subdued by the Bretton Woods system. This was a void that CME's energetic chairman Leo Melamed moved rapidly to fill.

Melamed was born into a Jewish family in Bialystok, Poland in 1932. His father was a mathematics teacher. At the outbreak of WW2, the family fled to Lithuania and were one of the fortunate Jewish families to receive a life-saving transit visa issued by Japanese vice-consul Sugihara Chiune in 1940. After a long passage via Siberia to Japan, the family eventually crossed the Pacific to the US and settled in Chicago. Melamed trained as a lawyer but, while attending John Marshall Law School, he answered a job advertisement for a position at Merrill Lynch, Pierce, Fenner & Beane. Thinking that a firm with such a lengthy name could only be an established law partnership, he inadvertently found himself working as a trading floor order-runner on the CME. He became hooked on the markets and it was not long before he bought his own membership seat on the exchange. By 1969, he had risen to become chairman.

Melamed had long subscribed to the free market theories espoused by University of Chicago economics professor Milton Friedman. He saw that the end of Bretton Woods created the conditions for a market in foreign exchange rates, and immediately began to think about launching currency futures on the CME. However, many of the exchange's members at that time did not believe that financial futures could succeed and thought that the CME should stick to its traditional agricultural futures products. Indeed, the New York Produce Exchange had renamed itself the International Commerce Exchange in April 1970 and launched currency contracts targeted at small-time speculators, but these had not found success. Nevertheless, that had been before Nixon's August 1971 bombshell and Melamed was convinced that that crucial development would enable global currency futures to take off.

To build credibility for his cause, he enlisted Friedman's help. Over breakfast at the Waldorf Astoria in November 1971, Melamed explained his idea to the famed economist. Friedman agreed that, with the suspension of the Bretton Woods Agreement, conditions were ripe for developing a market in currency futures. Melamed asked Friedman if he would be willing to put his opinion in writing, to which the economist answered: ‘Yes, but I am a capitalist’. For a fee of $7,500, Friedman agreed to write a feasibility study on ‘The Need for a Futures Market in Currency’ and submitted it to the CME in December 1971. With this endorsement, Melamed launched the International Monetary Market (IMM) in May 1972 and began offering futures contracts on seven currencies against the US dollar.⁶⁷ The currency futures achieved rapid success and, with the backing of Friedman's academic prestige, the IMM received regulatory support for the launch of interest rate futures on US Treasury bills in 1975.

Volatility ushered in by the end of Bretton Woods was not just restricted to currency markets. As global oil demand increased in the years after WW2, the US had found itself becoming increasingly dependent on oil imports, particularly from the Middle East. Prior to the 1970s, the international oil companies had been vertically integrated operations, carrying out all the functions from oil exploration to distribution to end customers. However, the end of colonialism and rising nationalism had seen a wave of nationalisations of these natural resources by oil-exporting countries. Consequently, the oil companies no longer owned the oil in the ground and the commodity became increasingly traded through world markets. The devaluation of the dollar angered the exporters, who effectively received less in return for their oil. Meanwhile, price controls in the US discouraged new exploration and boosted consumption, leading to tighter supply. When the Arabs initiated an oil embargo in October 1973 in response to US military assistance to Israel during the Yom Kippur War, prices rocketed. Panic buying saw the posted price for Iranian oil shoot up from $2.90 a barrel in mid-1973 to as high as $22.60.⁶⁸

Such a steep increase in energy prices set off global inflation and led to deep economic hardship in much of the developed world. Although the embargo was ended in March 1974, oil prices remained elevated versus their previous level and volatility persisted. The overthrow of the Shah of Iran by Ayatollah Khomeini in 1979 set off a second oil price shock, with oil prices doubling over 12 months to $39.50 a barrel.⁶⁹ Faced with this price volatility, businesses from airlines to utilities scrambled to hedge the cost of their oil. NYMEX started offering trading in futures contracts on home heating oil and gasoline to meet this demand.

In March 1983, NYMEX launched a futures contract on light sweet crude oil delivered to tanks located in Cushing, Oklahoma. This grade of oil, known as West Texas Intermediate (WTI), became a global standard for oil prices. The benefit of a standardised benchmark is that it serves as a reference against which other grades of oil can be priced and concentrates trading liquidity, so as to enable traders to transact large quantities of oil without causing major price swings. In 1988, the International Petroleum Exchange (IPE) in London launched futures contracts on Brent Crude, a heavier grade of oil extracted from the North Sea. The IPE was acquired by the Atlanta-based Intercontinental Exchange (ICE) in 2001 and Brent has now overtaken WTI to become the benchmark used to price over three-quarters of the world's traded oil.

Growth in derivatives trading from the 1980s has been explosive. This was fuelled by a set of factors that each reinforced the others: growth in financial markets; consequent greater demand for hedging tools; product innovations by the financial industry; a larger supply of graduates with the necessary quantitative skills; and technology-enabled electronification of financial trading. The pros and cons of this growth are explored in Chapter 7; however, the development of these derivatives has been critical in consolidating the dollar's global position.

As of the end of 2020, the total notional value outstanding of all derivatives contracts was estimated to be $667 trillion.⁷⁰ This compares to the $110 trillion combined market capitalisation of all stock markets in the world⁷¹ and $139 trillion in total debt outstanding in global bond markets.⁷² It is also roughly 7.9 times the size of global GDP. These contracts are vital to the smooth functioning of international trade and financial markets, as they allow businesses and individuals to manage their risks across foreign exchange, interest rates, credit, stocks and commodity prices. To be effective risk management tools, derivatives must be liquid and, preferably, supported by infrastructure such as clearing houses to help minimise counterparty risks.⁷³ Given the sheer size of this ecosystem of products and infrastructure, it would be extremely difficult for this system to be replaced. And since the vast majority of these derivatives are priced in US dollars, the growth and standardisation of derivatives contracts in the past half-century has powerfully entrenched the role of the US currency.

Unlike stocks, bonds or other assets, derivatives have a peculiar characteristic. Since the value of a futures or options contract is inherently derived by reference to the price of the underlying asset or to a particular event, for every winner on a derivatives contract, there must be a loser. In contrast, investors holding a stock that goes up can all benefit from the increase in the stock's value. However, in order to go long on a derivative (in other words, to bet that its value will go up), there must be someone on the other side of the trade willing to go short (or bet that its value will go down). During the term of the contract, the price of the reference asset may fluctuate significantly. In order to protect against the default of one or other party, when the price moves against one side of the contract, the losing party is usually required to post collateral in order to provide security that they can meet their obligation. The growth of derivatives markets has, therefore, multiplied the demand for high quality assets that can be posted to meet collateral requirements.

Further, not all investors seeking to avoid market volatility risks are able to do so using derivatives. This has spawned demand for secure and highly liquid assets that can be held as insurance against sudden and large funding needs. The largest issuer of such assets in the world is the US Treasury.