A futures market or futures exchange is a central financial exchange where people can trade standardized futures contracts defined by the exchange. Futures contracts are derivatives contracts to buy or sell specific quantities of a commodity or financial instrument at a specified price with delivery set at a specified time in the future. Futures exchanges provide physical or electronic trading venues, details of standardized contracts, market and price data, clearing houses, exchange self-regulations, margin mechanisms, settlement procedures, delivery times, delivery procedures and other services to foster trading in futures contracts. Futures exchanges can be organized as non-profit member-owned organizations or as for-profit organizations. Futures exchanges can be integrated under the same brand name or organization with other types of exchanges, such as stock markets, options markets, and bond markets. Non-profit member-owned futures exchanges benefit their members, who earn commissions and revenue acting as brokers or market makers. For-profit futures exchanges earn most of their revenue from trading and clearing fees.
Futures Exchange Role in Futures Contracts Standardization
Futures exchanges establishes standardized contracts for trading on their trading venues, and they usually specifies the following: assets to be delivered in the contract, delivery arrangements, delivery months, pricing formula for daily and final settlement, contract size, and price position and limits. For assets to be delivered, futures exchanges usually specify one or more grades of a commodity acceptable for delivery and for any price adjustments applied to delivery. For example, the standard deliverable grade for CME Group’s corn futures contract is “No. 2 Yellow”, but holders of short positions in the contract can deliver “No. 3 Yellow” corn for 1.5 cents less the delivery price per bushel. The location where assets are delivered are also specified by the futures exchanges, and they may also specify alternative delivery locations and any price adjustments available when delivering to alternative locations. Delivery locations accommodate the particular delivery, storage, and marketing needs of the deliverable asset. For example, ICE frozen concentrate orange juice contracts specify delivery locations as exchange-licensed warehouses in Florida, New Jersey, or Delaware, while in the case of CME live cattle contracts, delivery is to exchange-approved livestock yards and slaughter plants in the Midwest. The futures exchange also determines the amount of deliverable assets for each contract, which determines a contract’s size. Contract sizes that are too large will dissuade trading and hedging of small positions, while contract sizes that are too small will increase transaction costs since there are costs associated with each contract. In some cases, futures exchanges have created “mini” contracts to attract smaller traders. For example, the CME Group’s Mini Nasdaq 100 contract is on 20 times the Nasdaq 100 index.
Futures Market Clearing and Margin Mechanisms
Futures exchanges provide access to clearing houses that stands in the middle of every trade. Suppose trader A purchases $145,000 of gold futures contracts from trader B, trader A really bought a futures contract to buy $145,000 of gold from the clearing house at a future time, and trader B really has a contract to sell $145,000 to the clearing house at that same time. Since the clearing house took on the obligation of both sides of that trade, trader A do not have worry about trader B becoming unable or unwilling to settle the contract – they do not have to worry about trader B’s credit risk. Trader A only has to worry about the ability of the clearing house to fulfill their contracts.
Even though clearing houses are exposed to every trade on the exchange, they have more tools to manage credit risk. Clearing houses can issue Margin Calls to demand traders to deposit Initial Margin moneys when they open a position, and deposit Variation Margin (or Mark-to-Market Margin) moneys when existing positions experience daily losses. A margin in general is collateral that the holder of a financial instrument has to deposit to cover some or all of the credit risk of their counterparty, in this case the central counterparty clearing houses. Traders on both sides of a trade has to deposit Initial Margin, and this amount is kept by the clearing house and not remitted to other traders. Clearing houses calculate day-to-day profit and loss amounts by ‘marking-to-market’ all positions by setting their new cost to the previous day’s settlement value, and computing the difference between their current day settlement value and new cost. When traders accumulate losses on their position such that the balance of their existing posted margin and their new debits from losses is below a thresh-hold called a maintenance margin (usually a fraction of the initial margin) at the end of a day, they have to send Variation Margin to the exchange who passes that money to traders making profits on the opposite side of that position. When traders accumulate profits on their positions such that their margin balance is above the maintenance margin, they are entitled to withdraw the excess balance.
The margin system ensures that on any given day, if all parties in a trade closed their positions after variation margin payments after settlement, nobody would need to make any further payments as the losing side of the position would have already sent the whole amount they owe to the profiting side of the position. The clearinghouse do not keep any variation margin. When traders cannot pay the variation margin they owe or are otherwise in default the clearing house closes their positions and tries to cover their remaining obligations to other traders using their posted initial margin and any reserves available to the clearing house. Several popular methods are used to compute initial margins. They include the CME-owned SPAN (a grid simulation method used by the CME and about 70 other exchanges), STANS (a Monte Carlo simulation based methodology used by the Options Clearing Corporation (OCC)), TIMS (earlier used by the OCC, and still being used by a few other exchanges).
Traders do not interact directly with the exchange, they interact with clearing house members, usually futures brokers, that pass contracts and margin payments on to the exchange. Clearing house members are directly responsible for initial margin and variation margin requirements at the exchange even if their clients default on their obligations, so they may require more initial margin (but not variation margin) from their clients than is required by the exchange to protect themselves. Since clearing house members usually have many clients, they can net out margin payments from their client’s offsetting positions. For example, if a clearing house member have half of their clients holding a total of 1000 long position in a contract, and half of their clients holding a total of 500 short position in a contract, the clearing house member is only responsible for the initial and variation margin of a net 500 contracts.
Nature of Contracts in Futures Market
Exchange-traded contracts are standardized by the exchanges where they trade. The contract details what asset is to be bought or sold, and how, when, where and in what quantity it is to be delivered. The terms also specify the currency in which the contract will trade, minimum tick value, and the last trading day and expiry or delivery month. Standardized commodity futures contracts may also contain provisions for adjusting the contracted price based on deviations from the “standard” commodity, for example, a contract might specify delivery of heavier USDA Number 1 oats at par value but permit delivery of Number 2 oats for a certain seller’s penalty per bushel.
Before the market opens on the first day of trading a new futures contract, there is a specification but no actual contracts exist. Futures contracts are not issued like other securities, but are “created” whenever open interest increases; that is, when one party first buys (goes long) a contract from another party (who goes short). Contracts are also “destroyed” in the opposite manner whenever open interest decreases because traders resell to reduce their long positions or rebuy to reduce their short positions.
Speculators on futures price fluctuations who do not intend to make or take ultimate delivery must take care to “zero their positions” prior to the contract’s expiry. After expiry, each contract will be settled, either by physical delivery (typically for commodity underlyings) or by a cash settlement (typically for financial underlyings). The contracts ultimately are not between the original buyer and the original seller, but between the holders at expiry and the exchange. Because a contract may pass through many hands after it is created by its initial purchase and sale, or even be liquidated, settling parties do not know with whom they have ultimately traded.
Futures Market Regulators
Each exchange is normally regulated by a national governmental (or semi-governmental) regulatory agency:
In Australia, this role is performed by the Australian Securities and Investments Commission.
In the Chinese mainland, by the China Securities Regulatory Commission.
In Hong Kong, by the Securities and Futures Commission.
In India, by the Securities and Exchange Board of India
In South Korea, by the Financial Supervisory Service.
In Japan, by the Financial Services Agency.
In Pakistan, by the Securities and Exchange Commission of Pakistan.
In Singapore by the Monetary Authority of Singapore.
In the UK, futures exchanges are regulated by the Financial Conduct Authority.
In the US, by the Commodity Futures Trading Commission.
In Malaysia, by the Securities Commission Malaysia.
In Spain, by the Comisión Nacional del Mercado de Valores (CNMV).
In Brazil, by the Comissão de Valores Mobiliários (CVM).
In South Africa, by the Financial Sector Conduct Authority (South Africa).
In Mauritius, by the Financial Services Commission (FSC)
In Indonesia, by the Commodity Futures Trading Regulatory Agency (BAPPEPTI)