Ulrike Schaede – The Origin of Futures [Osaka]

An interview with Professor Ulrike Schaede, Professor of Japanese Economics at the University of California, for In-Residence #2 magazine (as part of Vermeir & Heiremann’s Masquerade project), on the Dojima Rice Exchange, in Osaka, during the 17th century, and its role as the origin of futures trading and the modern banking system today

[Image: Utagawa Hiroshige, The Rice Market at Dojima, c. 1835]

The Dojima Rice Exchange in Osaka, established in 1697, is often cited as the first ever futures market and, as such, the forerunner of the modern banking system today. During the Edo[1] period (1603-1868), the Japanese economy grew rapidly, and rice merchants prospered like never before. Since members of the samurai class, including daimyo (feudal lords), had traditionally been paid in rice, not coins, the rice brokers and moneychangers played a crucial, and incredibly profitable, role in the emerging early modern economy of Japan. Over the course of the Edo period, the entire economy would not only shift from rice to coin, but would also see the introduction and spread of paper money initiated and facilitated by the rice brokers of Dojima. The Osaka merchants developed an increasingly monopolistic grasp on the rice trade, determining prices across the country, and also introduced the concept of trading in rice futures. The origin of the Dojima Rice Exchange itself, and the shift to the paper currency of “rice bills”, is said to have developed outside the house of the prominent merchant, Yodoya, on Dojima Island, in the centre of the city of Osaka.

Tom Trevor: Could you describe the context in which the Dojima Rice Exchange emerged, and how it operated? What were the different motivations and social attitudes that contributed to the development of the market at the end of the 17th century?

Ulrike Schaede: At that time there was still a strong class system in Japanese society, with the samurai and feudal lords at the top, then the farmers, the craftsmen of the cities, and finally the merchants at the bottom. And then of course the feudal lords were always poor, so whenever merchants flaunted their wealth, as they were seriously rich, the daimyo would just cook up a reason to expropriate the trader. The merchants would get around this by buying a lot of very expensive things for their wives. So Mrs Yodoya’s wealth, for example, was measured by the quality of the silk in her kimono. The feudal lord could not appropriate the kimono, as it was the property of Yodoya’s wife, and would have the family crest on it. The reason I am telling this story is to convey the idea that currency is something other than just coins and paper, but anything that people agree has value when bartered into something else. So a piece of paper can be bartered, but likewise, so can kimonos. Mr Yodoya had a house by the bridge to Dojima Island, which had been a red light district. Trading in rice at Mr Yodoya’s house became so popular that the government said he had to move his business off the bridge as it was causing a traffic hazard. They ended up moving the red light district further north instead, and made Dojima Island the place for business and money trading in Osaka. Mr Yodoya proposed that the Rice Exchange should have regular hours. Despite the shogunate’s attempts to regulate it and intervene in the workings of the market, the Exchange was a self-organised agreement of its members to engage in transactions. It developed quite organically, without any government involvement, along with all the various institutions of an emerging banking system.

TT: So why did the rice trade centre in Osaka, and how did this develop into futures trading?

US: Originally Osaka had canals throughout the city, a bit like Bruges or Venice, though they have mostly been concreted over now. In those days, waterways went through the city, to the port and out into the Inland Sea. The main trading foodstuff in the Japanese economy was rice.The various feudal domains, from all over Japan, would first take what they needed from the rice harvest, then take the rest to sell at the market, so as to be able to buy commodities and luxury goods. Dojima became that market. Everyone put their surplus on a boat to Osaka, and each feudal domain lord would have a warehouse in Osaka, and a person managing the warehouse, a bit like in a modern-day port. There were lots of different types of rice, short grain, long grain… Trading actual rice is a bit clumsy as it is in large sacks and needs to be stored, so the warehouses issued pieces of paper, or rice bills, instead, where one bill would be equal to one koku, or a ton of rice. This would be valid for say 6 months. Initially warehouse managers would just issue as much paper as they had rice, and then wait for traders to pick up the rice. This would be like banks just giving out as much money as what they have in their coffers. But then the traders thought, there will always be more rice in the future, we can be sure of that, so why don’t we issue a piece of paper that’s effectively an IOU, based on future rice harvests. These were effectively un-backed pre-payment bills that would be worth one koku of rice, next year or the year after. Buying this piece of paper, how much does a trader pay for it? Maybe if rice is cheaper right now he will buy it now, and then sell it for more next year? Before you know it you have a bunch of people with lots of pieces of paper, speculating on how best to make a profit.

TT: The most basic institution of the early rice market was the warehouse, as you have described, which accepted rice from the daimyo’s domain, sold it to rice traders, reimbursed the lord, and recorded all transactions. However, a number of financial institutions evolved alongside these warehouses, including credit houses and the clearing house, as well as the Rice Exchange itself. How did these institutions function, and how far have they defined the modern day apparatus of the global financial markets?

US: Most of the time people ask about Dojima because they are interested in this particular aspect, as it was basically set up then in the same way as we still do it today. So the clearing house is the basic institutional mechanism to ensure the market will work. Its function is to make a regular adjustment of the speculative price to what is actually going on in the market. Going back to our earlier example, a trader comes to a warehouse and he gets a piece of paper that says this is good for a koku of rice in two years from now. The price is purely speculative. This happens today all the time, for example in the oil market, where airlines buy oil for next year at a speculative price. But people are trading all the time, on this season’s rice, next season’s rice and two years time. It does not need to happen at the Exchange, we could just trade right there on the streets. These bills are not backed by anything,but the promise of a future delivery of a sack of rice. The purpose of the clearing house was to reduce the risk of one party (or more) failing to honour their trade settlement obligations. The term ‘clearing’ denotes all activities from the time a commitment is made for a transaction until it is settled. Once a trade has been executed by two parties, it can be handed over to a clearing house, which then steps between the two original traders and assumes the legal risks. By taking on this liability at a fee, the Dojima money-changers effectively stepped up to become bankers. As this was risky for the new bankers, they insisted that every ten days their clients would settle the ledger, and pay up what was owing. So three times a month, on fixed days – there was no clock in Japan, so basically this was done by the phases of the moon – all debts were settled up. And this is basically the same system that still continues today.

TT: Could you explain how this development prefigures the modern banking system?

US: An incredible proportion of the nation’s financial transactions were handled through the independent merchants of Dōjima, who stored rice for most of the daimyo. Dōjima held what were in essence “bank accounts” for a great number of samurai and daimyo, managing deposits, withdrawals, loans, and tax payments. There were many ways in which to become a banker. One prominent example, related to the first big bank, was actually the back room customer services of one of the largest department stores. Say, for example, a samurai was to go to the store with his wife to buy a kimono. He picks the cloth and the store promises to make a kimono. In the back of the department store he would make a deal, the money-changer would measure his silver or gold coins and decide if it was real money, then give him his change, and close the deal. These money-changers were essentially experts in figuring out good money from bad money, and knowing who all the rich people were in town.

TT: Despite the shogunate’s attempts to maintain the dominant position of the samurai, the financial power of the merchant class continued to increase. As merchants grew richer and began to flaunt their wealth, the samurai responded in kind, attempting to keep up. When the price of rice dropped, however, the samurai’s income fell sharply and many discovered that their income was insufficient to support their heavy consumption of luxury goods. As a result their debts to the merchants grew rapidly, leading to resentment and retaliatory measures by the shogunate, with the cancellation of samurai debts and the confiscation of merchants’ property, on the grounds that their display of wealth was excessive. Could you talk about the ways in which the rise of the merchant class disempowered the samurai, and how this led to a transformation of society? And why was there such a fascination with luxury during this time?

US: The image we have from the movies is of the samurai as great swordsmen. But sometime between 1600-1620 Japan was unified, by shogun Tokugawa, who disallowed weapons of all kinds. After 200 years of civil war, the battle of 1603 was won by a unifier and this led to 260 years of peace. With no weapons available there was no fighting which allowed for economic development. So the samurai had no swords, other than as symbolic status symbols, but they still liked to dress up. They became bureaucrats in the government instead. Paper shufflers. Even today in Japanese society the bureaucrats are ranked very highly.

TT: Did the samurai look down on the merchants, despite their great wealth?

US: What is not OK is being rich. If you have it, you can’t show it, you have to put it in your pockets. The shogunate expropriated merchants’ wealth but that was primarily because the samurai were poor. Possibly also to support the social hierarchy, but it was mainly due to government debt. Perhaps this was done under the guise of social hierarchy, to provide some kind of moral high ground for the government’s actions.

TT: In Bunryu Nishiki’s account of the money changer Yomiji Sumiya, written in 1706, he describes an elaborate system of communications, involving express messengers wearing red gloves and red hats, secretly signaling from the Exchange, over ten miles away, to their master, so as to enable Yomiji to monitor the fluctuations in the rice market and set his prices accordingly. Nowadays such information is transmitted electronically around the planet in an instant, narrowing the window of opportunity for speculation. Could you describe how the shogunate attempted to monitor and regulate the merchants, and to what extent the market was self-regulating and autonomous from government control?

US: There were all sorts of ways to play the market at ground level. The primary question was, how to set the starting price of rice each day? The way futures prices are set now is decided by the closing price at the end of the previous trading day, at 5pm. This originates in Dojima too, but they did not have clocks at that time in Japan so how to decide when the trading day ends? Clearly if a merchant had a great day he would have been very interested in that price, but if he had had a bad day, he was not interested in setting a price at all. With no clock present the actual close of trading was open to ambiguity. The way they decided to set the closing price in the Dojima Rice Exchange was to hang a box with a wick from the roof, and when it was nearing the close of trading, to set fire to the wick, which would then burn for 5 to10 minutes. The fire meant today’s trading is about to end, then when the fire went out that secured the end price. However, if the box did not burn out for some reason, then no closing price could be decided. Interruptions, intentional or accidental, were a regular occurrence, which is one of the reasons why the market eventually broke down as too many days in a row ended without a closing price.

TT: Futures trading is a contract between two parties to buy or sell an asset for a price agreed upon today, but with delivery and payment at a future date. Such an abstract trade could be said to rely upon confidence, and a mutual trust in the market. How did this work in the Tokugawan period, and to what extent does it differ today?

US: Institution building was the key to establishing confidence. Legal recourse meant transactions could become more complicated, as people trusted they would be honoured. Today we trade futures on agricultural goods, like pork belly futures or corn futures, at the Chicago Board of Trade Futures, or raw materials, like zinc and copper, which are the real thing, and then there are also “financial futures” or even “weather futures” which are traded at a large number of stock exchanges around the world. A lot of the mechanisms that the Japanese traders set up in Dojima are still the same today. From an economist’s perspective, their’s has proven to be the best way to structure the market. The Dojima rice brokers did it by trial and error, but today we still clear every ten days, though probably not by the moon phases anymore. And every three months we end the season, just like they did. So a lot of the basic set up, and contracts, are still in place. You might ask why a season is three months long, or why there are three season’s of pork bellies, and the answer is, it’s the way they did it in Dojima.

[1] Edo, literally “bay-entrance” or “estuary“, is the former name of Tokyo. It was the seat of power for the Tokugawa shogunate, which ruled Japan from 1603 to 1868. During this period, it grew to become one of the largest cities in the world and home to an urban culture centered on the notion of a “floating world“.