How Futures Markets Work

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The organization of futures markets is controlled by four entities.  Although there are countless people who perform various tasks to ensure the smooth operation of futures markets, all of them work for or are represented by one of these four entities.  

Although there may be thousands of individual speculators and hedgers invovled in the market at any given time, fundamentally, there are only three significant entities that actually operate in the futures markets: the exchange, a clearing house, and the exchange members (brokers). 

The fourth entity, The Commodity Futures Trading Commission, is a government agency responsible for regulating the futures markets. 

Futures Brokers

Every trader, unless you are wealthy enough to buy a membership on an exchange, does their trading through a broker.  These brokers or brokerage houses are exchange members and execute trades for their many clients.  There are also floor traders, who are members of an exchange, but they trade on their own behalf, not for clients.  Brokers or brokerage firms are members of an exchange because they have bought a seat on the exchange and therefore have the right to trade futures on that exchange.  There are different types of brokers, but the type that will concern most traders is the FCM (Futures Commission Merchant).  Most FCM's are members of several futures exchanges, so their clients can trade a wide array of contracts through them.  Remember, it is not the indvidual trader but the broker or FCM that is ultimately responsible for fulfilling all financial obligations to the exchange's clearing house.

 

The Clearing House

A clearing house clears trades.  In this capacity it acts much like a bank.  It simply settles and measures up accounts - debiting here and crediting there, without knowing who the actual account holders are.  They do this at the end of each trading day and sometimes periodically during the trading day for rapidly fluctuating markets.  This process is called "marked to market" as was explained in the last lesson.  The purpose of the clearing house is simply to maintain the integrity and financial soundness of a futures exchange.  This concept may be difficult to understand at first, read this for a more complete explanation.  In essence, due to the rapidity and number of trades, it is necessary for a thrid party (the clearing house) to settle all accounts in a timely and accurate fashion.  It would be unfeasible for the exchange members to do this between themselves, so a central organization that is uninvolved in the trading process performs this task.  All exchange members are required to report all of their trading positions at the end of each day and submit the required margin money.  These totals for each exchange member are, of course, comprised of the the total trades and margin requirements of all of their clients - the individual traders.

The Futures Exchange

A futures exchange is simply a venue or arena where traders can gather together to exchange contracts.  As mentioned in the article on futures contracts, the exchange defines all of the specifics for each standardized futures contract.  An important thing to remember is that each exchange only hosts certain futures contracts.  For instance, coffee futures are traded on the NYMEX while silver futures are traded on COMEX.  The futures exchange is a place where participants can trade these contracts in a fair and orderly fashion.  Apart from providing a well-defined forum for the trading of contracts, the exchange also is responsible for the accurate collection and reporting of price information, which is so invaluable to traders and other business concerns throughout the world.  One should also keep in mind that an exchange is essentially a business, interested in generating profits.  They generate profits by charging exchange fees for every contract traded and by collecting membership fees from its exchange members.  For many years, there were numerous exchanges throughout the US and the world.  But, recently, the trend has been to merge and consolidate the exchanges under fewer parent companies.  The most notable example is the recently formed CME group, which consolidated the formerly independent CBOT, CME, NYMEX, and COMEX exchanges.

 

The Commodity Futures Trading Commission

The CFTC was established by Congress in the 1970's after the dramatic growth of futures trading and many examples of unethical practices.  The CFTC has sole jurisdiction over futures trading and is charged with the mission of protecting all market participants against manipulation, unfair trading practices, and fraud.  Many of the existing rules regarding trading practices, orders, marking to market, and clearing trades are due to CFTC regulations.  These regulations are designed to maintain a even playing field and maintain the integrity of futures markets.  The CFTC does have the power to order an exchange to take certain actions to restore orderliness in the rare case of an emergency.  Apart from this, the CFTC does not directly participate in the actual operations of futures markets.

Understanding how these entitiies make the futures markets work may seem a bit confusing at first.  But, as you continue reading and learning about the mechanics of commodity trading the interelations of these four entities will become more apparent.