The Liverpool Cotton Futures Market
Contents of this page:
- Widespread and Extensive Use of Liverpool Cotton Futures Contracts
- The Purpose of Futures Markets
- The Use of Futures by Those Trading Cotton
- The Factors that Can Lead to the Evolution of a Futures Market and the Existence of these Factors at Liverpool
- Forward Trading of Cotton at Liverpool before the Development of a Futures Market
- The Effects of the American Civil War and its Aftermath: The Emergence of the Futures Market
1. Widespread and Extensive Use of Liverpool Cotton Futures Contracts
The Liverpool cotton market is remarkable in being the first commodity market in Europe to develop futures trading (sometimes called ‘derivatives’), considerably ahead of the London markets which still trade futures contracts today. By the late nineteenth century, all branches of the British cotton trade – importers, brokers, spinners and weavers - were widely using the Liverpool cotton futures market. For instance, in terms of the industry, in January 1912, the Facit Mill Company of Rochdale stated that its policy was to use Liverpool futures contracts to cover all its supplies of raw cotton (Facit Mill Company Ltd., Directors Minutes, 25 January 1912, in the Lancashire Record Office, Preston: DDX 639/1/2), in the 1890s, the Sun Mill Company of Oldham covered half its supplies of cotton with Liverpool futures (Sun Mill Co. Ltd., Minutes, 8 June 1891, in the John Rylands University of Manchester Library: SM/1/3), other spinning companies, such as John Hawkins & Sons Ltd. of Preston, varied the extent to which they covered supplies with Liverpool futures (see for instance: John Hawkins & Sons Ltd., Directors Minute Book, pages 10-11 and passim, in the Lancashire Record Office, Preston: DDX 868 27/2). In 1904, the industry journal Cotton commented that the practice of merchants importing cotton without using Liverpool futures was ‘defunct’ (Cotton, 17 September 1904, page 9). The size of the Liverpool futures market became such that some Liverpool cotton broking firms actually made more money from brokerage on cotton futures than on the actual physical ‘spot’ cotton itself.
2. The Purpose of Futures Markets
Futures contracts are, in a sense, a form of ‘paper currency’ for a commodity. Futures contracts promise delivery of a set quantity of a commodity at some stage in the future. They have various uses, for speculators they are an ideal instrument because one is dealing in ‘promises to supply’ rather than having to handle the bulky physical commodity. For other, more ‘legitimate’ traders, their value is that they can be used to guard against price changes - this is known as ‘hedging’. For instance, when an importer contracts to buy a commodity overseas he can guard himself against the value of this commodity falling while in his possession, by immediately selling futures contracts. When he comes actually to sell the physical commodity, he buys back his futures contracts (at the then current market price). By so doing, he is guarded against price changes.
3. The Use of Futures by Those Trading Cotton
Cotton merchants, brokers and spinners all came to use the process of ‘hedging’ to safeguard themselves against a fall in the price of their stock. While holding cotton at sea, in warehouses or at their mills, they sold futures contracts against them, with the intention of buying these contracts back when they came to sell or spin their actual stock. A considerable number of those who bought the futures contracts were speculators and hence were not interested in actually having cotton delivered under the futures contracts and were (except in exceptional circumstance) happy to let the seller buy them back. The speculator would, of course, hope that the price of cotton would have risen, so leading to the seller (merchant, spinner or broker) having to pay more to buy the futures contracts back than they were worth when they sold them.
4. The Factors that Can Lead to the Evolution of a Futures Market and the Existence of these Factors at Liverpool
A variety of factors can lead to the development of a futures market. The key circumstances are variability to the point of instability in the price of a commodity, uncertainty and lack of information concerning the scale of supply, the ability to specify a standard grade of the commodity and the existence of a body able to regulate effectively such a market. With few exceptions, futures markets develop out of existing ‘forward’ markets. To clarify the distinction: a forward market is one in which it is a common practice for specific lots of a commodity to be contracted for before they are available for delivery, as opposed to a futures market in which contracts are highly standardized and do not refer to a particular cargo or lot of a commodity (see: Barry A. Goss (ed.), Futures Markets: Their Establishment and Performance, London: 1986, page 1; Barry A. Goss, The Theory of Futures Markets, London: 1972, pages 4-5; Cento G. Veijanovski in Goss (ed.) Futures Markets, Chapter 1. C. W. Morgan, Price Instability, Trade and Futures Markets, Nottingham: 1994), page 7).
The Liverpool cotton market satisfied all these major preconditions. The Liverpool Cotton Brokers Association existed as potential regulatory body. The uncertainty relating to the supply and price of cotton could place those handling this commodity at risk of financial loss, hence they had a desire to find some mechanism that could guard themselves against price fluctuations. There is ample documentary evidence of cotton importers in the first half of the nineteenth century (before the evolution of the futures market) incurring losses due to a fall in the price of cotton while in transit or when holding stocks in Liverpool. For instance in 1841, a sharp fall in the price of cotton caused many importers to incur losses, bringing some to the brink of bankruptcy (Bank of England, Liverpool Branch, Letter Book, 27 July and 7 August 1841, in the Bank of England Archive, London: C129/2, pages 270, 293-4). Early in February of 1842, the Liverpool cotton broker and importer George Holt wrote to his cotton shipping agent in New Orleans: ‘Everybody is losing money & have lost it & with it have lost heart, all traders & importers are poorer’ (George Holt to John Arrowsmith, 3 February 1842, copy of letter in the possession of Nigel Hall). It is interesting to note that in this crisis the credit normally supplied by banks and brokers to assist in the holding of stocks dried up, no doubt due to their nervousness concerning the serious commercial situation (Bank of England, Liverpool Branch, Letter Book, 27 July 1841, in the Bank of England Archive, London: C129/2).
The volatility of the price of cotton can be demonstrated by graph. The graph below indicates the price of middling quality American cotton in Liverpool over two example years, from January1850 to December 1851, emplyoying the weekly price data collected by Liverpool's cotton brokers in the period:
Weekly Price of Middling Quality American Cotton in Liverpool,
January 1850 to December 1851
Weekly Price of Middling Quality American Cotton in Liverpool,
January 1850 to December 1851
(Source: Weekly Cotton Market Reports (manuscript) in the Liverpool Record Office: 380 MD 130. These reports provide the price of 'Orleans'/American cotton with the price range from 'low middling' to 'middling fair' qualities. The graph above is construced using the median of these two prices)
5. Forward Trading of Cotton at Liverpool before the Development of a Futures Market
A forward market in cotton had developed at Liverpool out of which a futures market could develop. Evidence suggests that forward selling of specific cargoes of cotton certainly took place at various points from the early to mid-nineteenth century in Liverpool. For instance, in the period of high cotton prices and speculation during the War of 1812 between Britain and the United States, the cotton sales book of the Liverpool cotton broker, George Holt, indicates that he traded various lots of cotton before they were landed in the port (for instance George Holt purchased of 150 bales of United States cotton on 26 December 1814, to arrive in Liverpool on or before 26 January 1815. George Holt and Co., Daily Cotton Purchases and Sales Book, 1814-1815, in the Liverpool Record Office: MD 230-9). At around the same time the Liverpool brokers M. & J. Pool were also making forward sales, many months before cotton might be delivered. The firm noted on 15 January 1815 that it had sold fifty bales of American cotton ‘ … deliverable any time before 1 Aug next, to be equal to sample in Campbell’s hands [another broker] & to be paid for in 10 d[ay]s after our notice [with] … good bills on London @ 3 m[onth]s …’ (M. & J. Pool, Journal & Ledger, 15 January 1815, in the Wiltshire Record Office, Trowbridge: 946/283). In less hectic times, in the years following the war, this form of trade appears to have been far less common, with little or no indication of it in the surviving records of Liverpool’s merchants and brokers. There may have been another period of buying cotton before it was landed in Liverpool, associated with the cotton speculations and high cotton prices in the year 1825 (see for instance a court case relating to one such sale in The Liverpool Mercury, 17 March 1826, page 295).
Improved knowledge of cotton shipments which developed in the second quarter of the nineteenth century aided the development of forward selling, particularly through the faster mail ships, especially those of the Cunard line. W. F. Machin (who wrote a short history of the Liverpool cotton market) states that these ships in particular spurred forward selling of cotton (W. F. Machin, ‘A short History of the Liverpool Cotton Market’, in Liverpool Raw Cotton Annual, 1957, pages 257-269). Some surviving evidence, such as the letters of James Brown, a captain of a Liverpool merchant’s ship, indicate how in the 1840s he was able to provide his merchant employer with plentiful information regarding his cotton shipments from New Orleans a considerable time before they were landed in Liverpool, using mail ships. This would have enabled the merchant, John Croft, to trade his cotton in Liverpool before it arrived if he so wished. For instance, on one voyage, Croft’s ship arrived in New Orleans in early October 1844 and sailed for Liverpool around 30 November. While in port in America, Brown wrote five times to Croft in Liverpool advising him of prices in New Orleans and the amount of cotton he had freighted the ship with. It is interesting to note in Brown’s letter of 8 October 1843 that he states he is writing it in a hurry so that the letter can catch the Great Western before it departed for England (Letter Book of James Brown, 8, 19 October, 4, 17, 30 November 1843, in the Liverpool Record Office: 387 MD 48).
In 1857, a conjunction of high cotton prices, speculation and the partial completion of the telegraph to India (permitting knowledge of shipments of Indian cotton) produced a mini-boom in forward trading in Liverpool, and there are numerous references to this in contemporary newspapers and archival sources (see for instance: the Liverpool Daily Post, 14 February 1857, page 8; The Liverpool Mail, 21 February 1857, page 4, 11 July 1857, page 5). This came to a sudden halt in late October 1857 with news of the financial panic of this year in the United States, which spread to Europe, and seriously affected the Liverpool cotton market (Weekly Cotton Market Reports (manuscript), 1857, in the Liverpool Record Office: 380 MD 130).
Forward trading of cotton was therefore taking place in the years before the outbreak of the American Civil War (a period when it grew enormously), but seems to have been most common in times of high prices and speculation. The logical conclusion that much forward cotton was bought by speculators is significant - it is a necessary prerequisite for a futures market that some market operators are willing to adopt a ‘long’ position, in order to buy the futures contracts put out as hedges by those holding stocks of actual, ‘spot’ cotton.
6. The Effects of the American Civil War and its Aftermath: The Emergence of the Futures Market
The period of extremely high cotton prices and speculation associated with the ‘Cotton Famine’ of the American Civil War (1861-65), followed by generally falling prices over a period of years, provided the conditions which ingrained forward trading and began the process whereby some forward trading of cotton at Liverpool mutated into what we would today recognise as futures trading. The major distinguishing feature between forward contracts and futures contracts is standardization of terms. That is to say, in a futures contract there is a fixed quantity and quality set for the commodity which permits contracts to be bought and sold rapidly between traders who know exactly what it is they are buying and selling (hence, crucially, the market is highly ‘liquid’); only one part of the contract is negotiable - the price (John Buckley (ed.), Guide To World Commodity Markets, 7th ed., London: 1996, page 14. Cento G. Veijanovski in Barry A. Goss (ed.), The Theory of Futures Markets, London: 1972 pages 30-1). The other key point is that under futures contracts, the commodity is rarely (if ever) delivered - the contract is generally bought back at maturity by the seller (Goss, Futures Markets, page 28).
Some forward selling of cotton began in Liverpool almost as soon as the American war broke out (see: Gore’s General Advertiser, 26 September 1861), but it commenced in earnest in 1863, particularly in the autumn, with the price of spot cotton between three and four times the pre-war level due to the war-time shortage. Speculation was spurred by recovering demand for cotton goods from the key Indian market, which had been somewhat glutted with goods around the start of the war. It should be noted that at this stage the forward selling was generally in Indian cotton due to the shortage of the American type, aided by the telegraph communication with the sub-continent. Forward prices for cotton began to be quoted regularly in the Liverpool trade press in late 1863 (Annual Circulars of Cunningham & Hinshaw and John Wrigley & Sons (cotton brokers), 1863, in the Liverpool Record Office: MD 230-22. Gore’s General Advertiser, 1 October 1863. See the reminiscences of the war time cotton trader, Auguste Wiener following the giving of the following paper: S. J. Chapman and Douglas Knoop, ‘Dealings in Futures on the Cotton Market’ in Journal of the Royal Statistical Society, volume 69, (1906), page 365. For information on war time trading conditions at Liverpool see: N. Hall, ‘The Liverpool Cotton Market and the American Civil War’ in Northern History, volume 34 (1998), pages 149-69).
Part of Liverpool cotton market newspaper report from October 1863
discussing extensive forward trading of cotton
(The Liverpool Mercury, 3 October 1863, page 6)
The names 'Dhollera', 'Compta', 'Broach', 'Oomrawuttee', Tinnevelly' were
varieties of Indian cotton
The forward cotton market in Liverpool moved a step closer to a futures market with individuals beginning to make contracts when they were not in possession of actual cotton, in other words not referring to specific shipments and acting as what we would call ‘bears’. The commencement of this was also noted as taking place in 1863, by the broking firm of Smith, Edwards & Co. (Smith, Edwards & Co.’s Annual Cotton Circular for 1864, in the Liverpool Record Office: MD 230-22). The forward market became what might be termed ‘institutionalized’, again in 1863, through the Liverpool Cotton Brokers Association producing a standard form of contract for traders to use for forward sales – this contract was reproduced and discussed in The Times, on 12 November 1863 (page 6).
There was a reduction in forward trading caused by sharp falls in the price of cotton in the late summer of 1864 (sparked by the raising of the discount rate and rumours of peace in America) but forward trading had become firmly established as a permanent feature in the Liverpool market and continued after the close of the conflict.
The reason for the continued extensive use of forward selling in the years following the American Civil War was the difficult market conditions which Liverpool cotton merchants faced. From the end of the American Civil War and into the 1870s, the international price of cotton steadily fell. This was because of the recovery of the United States after the disruption of the war to its previous level of cotton production. Gradually, year on year, the United States recovered a little more, supplies of cotton increased and prices fell. Merchants importing cotton were therefore at serious and prolonged risk of the value of their cotton stock falling between the date they purchased it in the United States and when they came to sell it in the Liverpool market. The Liverpool merchant, Thomas Bower Forwood, warned his son, William Bower Forwood, in August 1866: ‘ … the most dangerous trade you can go into is cotton, and it will be so for years to come.’(Thomas Bower Forwood to William Bower Forwood, 13 August 1866, in the Hampshire Record Office, Wnchester: 19M62/9/13). Hence, there existed good reason for importers to try to guard themselves against price falls by making forward sales as soon as they had made their purchases in America. Speculators and others purchased the forward sold cotton either to safeguard their future supply or in the hope of profiting if the price of cotton did rise while in transit.