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Modern futures trading descends from the practice of negotiating commercial agreements called forward contracts, which are as old as commerce itself. These legally binding agreements, which were entered into by two parties, specified the delivery of a certain amount of a physical commodity at a set price and a predetermined date in the future.
The reasons for entering into this sort of agreement are varied, but all revolve around the unpredictability of future prices. The price of goods and commodities are dependent upon various events and factors that affect supply and demand.
And since nobody can accurately predict what events will transpire in the future to affect these prices it is easy to see why planning ahead was wise.
An Example of a Forward Contract
1A simple example will suffice to explain the advantageous nature of forward contracts. Imagine a miller hundreds of years ago who was in the business of grinding wheat into flour. He used this flour to make bread, or sold it to a baker who did so. The bread was then brought to the market to sell to the end consumers. The miller knew that he needed a regular supply of wheat to carry out his business activities at a consistent level, but he didn't know how much the price of wheat would be in the near or distant future.
2Now, consider the wheat farmer who needed to sell the wheat that he grew. The wheat farmer needed to continually sell a certain amount of wheat in order to earn a living. However, not knowing how the supply and demand situation would affect prices in the future, he sought the opportunity to sell his at a fixed price produce ahead of time.
3These two parties might have opted to negotiate a forward contract in order to lock in an agreeable price. If so, the miller would then have a ‘long’ position, meaning that he had a supply of wheat coming to him at a future date. At the same time the farmer would hold a ’short’ position, meaning that he owed the wheat to the buyer at a future date.
4By doing this both parties were then able to go about their business activities in relative security without having to worry about the fluctuation of market prices. This is a simplified example, but one that explains the motivating factors for planning out future business activities.
The Futures Contract Appears
Early instances of the evolution from forward to futures contracts can be seen in certain Japanese and English markets during the 17th and 18th centuries, but they didn’t truly come into their own until the 19th century, in the American midwest. Because agricultural production is a seasonal activity, with sowing and harvesting taking place at set times of the year, there are natural supply and demand imbalances.
A glut of supplies in the fall would lead to depressed prices, which hurt the farmers. Likewise, dwindling supplies throughout the winter and early spring caused prices to soar, which was bad for the processors and end consumers of agricultural products. Maintaining a steady and predictable business cash flow was difficult for both parties and a central marketplace for entering into forward contracts was needed.
Much of the agriculture of the American heartland was transported through Chicago, with it’s connection to the Great Lakes and the Mississippi River. Being in an ideal location for trade and transportation this city naturally became the location of the first developed futures exchange, the Chicago Board of Trade (CBOT), which was initially founded to facilitate the exchange of forward contracts. However, after a few years the CBOT found it expedient to create a new “futures” contract to replace the growing inadequacy of the forward contract.
The Reasons for Futures Contracts
Producers and consumers needed a way to offset the risks involved in their business ventures. The forward and futures contracts that were introduced on exchanges addressed these concerns.
The reasons for this were numerous. As the number of contracts exchanged increased, the need for standardization grew. This is one of the ways that futures contracts differ from forward contracts.
With forward contracts the terms for type of commodity, amount, and delivery date could be whatever the two parties agreed upon. The CBOT made futures contracts standard by designating specific grades, amounts, and delivery dates of various commodities. This standardization made the opening and exchanging of these contracts much easier.
Futures contracts were also required to be entered into and traded on the exchange only, while forwards could be opened and exchanged privately. A margin system, whereby each party to a contract must put up a certain amount of good faith money, was also developed to ensure contractual obligation by both parties. Finally, holders of futures contracts could easily exit their long or short position prior to expiration by selling or buying it back on the exchange.
This last feature prompted the influx of futures speculators into the arena. Since the contracts are exactly the same and easily interchangeable anyone can buy or sell them prior to their expiration, the motivation for speculators of course being the prospect of profiting from price changes. The entry of speculators into the futures markets increased the trading volume dramatically, reduced price volatility, and provided liquidity - features that are necessary for the efficient operation of futures markets.
The Growth of Futures Exchanges
After the introduction of futures contracts trading grew dramatically as participants now found it easy to exchange commodities in an ordered fashion. Exchanges began popping up around the US and in many European commercial centers. Many of these were centered around single commodities, such as with the New Orleans Cotton Exchange, the Chicago Butter and Egg Board, and the New York Coffee Exchange.
However, during the early 20th century the trend was for consolidating many different commodities on single exchanges due to times of sporadic trading interest in various single commodities. Some exchanges have maintained their niche though. This is certainly the case with the Minneapolis Exchange (MGEX), which is the only one to offer futures for hard red spring wheat. Today there are around 100 futures exchanges globally, with about 15 operating in the US.
Modern Futures Markets
The last three decades have seen the advent of previously unimagined futures contracts, such as those covering financial futures, stock indexes, and single stocks. Although the Chicago Mercantile Exchange (CME) has existed since 1919, it introduced trading in foreign currency futures in the early 70’s. Other financial futures contracts, such as Eurodollars and 30 day Fed Funds, also began to be traded on various exchanges in the 70’s when the world underwent a dramatic shift in collective international monetary policy.
Indeed, the advent of an efficient global financial system has revolutionized and changed forever the face of futures trading. In the early 80’s, taking it’s cue from stock exchanges, futures exchanges also introduced options on futures, which caught on like wildfire. Suffice it to say that the futures markets today have evolved well beyond their agricultural origins.
Trading at the exchanges was for the longest time conducted by open outcry in the trading pits. This practice has dropped off dramatically in the past decade though. Most exchanges have incorporated electronic trading, which accounts for the majority of trading volume today. In addition, the prevailing trend recently is towards partnership or mergers and acquisitions between exchanges, which is quickly providing a ‘total’ trading solution for traders across the globe.