Futures exchange
Encyclopedia
A futures exchange or futures market is a central financial exchange where people can trade standardized futures contracts; that is, a contract to buy specific quantities of a commodity
or financial instrument at a specified price with delivery
set at a specified time in the future. These types of contracts fall into the category of derivative
s. Such instruments are priced according to the movement of the underlying asset (stock, physical commodity, index, etc.). The aforementioned category is named "derivatives" because the value of these instruments is derived from another asset class.
's book Politics. He tells the story of Thales
, a poor philosopher from Miletus who developed a "financial device, which involves a principle of universal application". Thales used his skill in forecasting and predicted that the olive harvest would be exceptionally good the next autumn. Confident in his prediction, he made agreements with local olive-press owners to deposit his money with them to guarantee him exclusive use of their olive presses when the harvest was ready. Thales successfully negotiated low prices because the harvest was in the future and no one knew whether the harvest would be plentiful or pathetic and because the olive-press owners were willing to hedge
against the possibility of a poor yield. When the harvest-time came, and a sharp increase in demand for the use of the olive presses outstripped supply, he sold his future use contracts of the olive presses at a rate of his choosing, and made a large quantity of money. It should be noted, however, that this is a very loose example of futures trading and, in fact, more closely resembles an Option contract
, given that Thales was not obliged to use the olive presses if the yield was poor.
The first modern organized futures exchange began in 1710 at the Dojima Rice Exchange
in Osaka, Japan.
The United States
followed in the early 19th century. Chicago
is located at the base of the Great Lakes
, close to the farmlands and cattle country of the U.S. Midwest, making it a natural center for transportation, distribution and trading of agricultural produce. Gluts and shortages of these products caused chaotic fluctuations in price, and this led to the development of a market enabling grain merchants, processors, and agriculture companies to trade in "to arrive" or "cash forward" contracts to insulate them from the risk of adverse price change and enable them to hedge.
Forward contracts were standard at the time. However, most forward contracts weren't honored by both the buyer and the seller. For instance, if the buyer of a corn
forward contract made an agreement to buy corn, and at the time of delivery the price of corn differed dramatically from the original contract price, either the buyer or the seller would back out. Additionally, the forward contracts market was very illiquid and an exchange was needed that would bring together a market to find potential buyers and sellers of a commodity instead of making people bear the burden of finding a buyer or seller.
In 1848, the Chicago Board of Trade
(CBOT–) was formed. Trading was originally in forward contract
s; the first contract (on corn) was written on March 13, 1851. In 1865, standardized futures contract
s were introduced.
The Chicago Produce Exchange was established in 1874, renamed the Chicago Butter and Egg Board
in 1898 and then reorganised into the Chicago Mercantile Exchange
(CME) in 1919. In 1972 the International Monetary Market
(IMM), a division of the CME, was formed to offer futures contracts in foreign currencies: British pound, Canadian dollar
, German mark
, Japanese yen
, Mexican peso
, and Swiss franc
.
In 1881, a regional market was founded in Minneapolis, Minnesota
and in 1883 introduced futures for the first time. Trading continuously since then, today the Minneapolis Grain Exchange
(MGEX) is the only exchange for hard red spring wheat futures and options.
The 1970s saw the development of the financial future
s contracts, which allowed trading in the future value of interest rate
s. These (in particular the 90-day Eurodollar
contract introduced in 1981) had an enormous impact on the development of the interest rate swap
market.
Today, the futures markets have far outgrown their agricultural origins. With the addition of the New York Mercantile Exchange
(NYMEX) the trading and hedging
of financial products using futures dwarfs the traditional commodity markets, and plays a major role in the global financial system
, trading over 1.5 trillion U.S. dollars per day in 2005.
The recent history of these exchanges (Aug 2006) finds the Chicago Mercantile Exchange
trading more than 70% of its Futures contracts on its "Globex" trading platform and this trend is rising daily. It counts for over 45.5 Billion dollars of nominal trade (over 1 million contracts) every single day in "electronic trading
" as opposed to open outcry
trading of Futures, Options and Derivatives.
In June 2001, ICE (IntercontinentalExchange
) acquired the International Petroleum Exchange
(IPE), now ICE Futures, which operated Europe’s leading open-outcry energy futures exchange. Since 2003, ICE has partnered with the Chicago Climate Exchange (CCX) to host its electronic marketplace. In April 2005, the entire ICE portfolio of energy futures became fully electronic.
In 2006, the New York Stock Exchange
teamed up with the Amsterdam-Brussels-Lisbon-Paris Exchanges "Euronext" electronic exchange to form the first transcontinental Futures and Options Exchange. These two developments as well as the sharp growth of internet Futures trading platforms developed by a number of trading companies clearly points to a race to total internet trading of Futures and Options in the coming years.
In terms of trading volume, the National Stock Exchange of India
in Mumbai
is the largest stock futures trading exchange in the world, followed by JSE Limited in Sandton, Gauteng
, South Africa
.
. 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.
Compare this with other securities, in which there is a primary market when an issuer issues the security, and a secondary market where the security is later traded independently of the issuer. Legally, the security represents an obligation of the issuer rather than the buyer and seller; even if the issuer buys back some securities, they still exist. Only if they are legally cancelled they can disappear.
). To make sure liquidity is high, there is only a limited number of standardized contracts.
(OCC) and LCH.Clearnet
(London Clearing House) respectively are the clearing corporations for CBOE and LIFFE. A well known exception to this is the case of Chicago Mercantile Exchange
and ICE
, which clear trades themselves.
. As a result, trading firms take no risk on the actual counterparty to the trade, but on the clearing corporation. The clearing corporation is able to take on this risk by adopting an efficient margining process.
margin (also referred to as Variation Margin).
The Initial Margin is the sum of money (or collateral) to be deposited by a firm to the clearing corporation to cover possible future loss in the positions (the set of positions held is also called the portfolio) held by a firm.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 OCC), TIMS (earlier used by the OCC, and still being used by a few other exchanges like the Bursa Malaysia
).
The Mark-to-Market Margin (MTM margin) on the other hand is the margin collected to offset losses (if any) that have already been incurred on the positions held by a firm. This is computed as the difference between the cost of the position held and the current market value of that position. If the resulting amount is a loss, the amount is collected from the firm; else, the amount may be returned to the firm (the case with most clearing houses) or kept in reserve depending on local practice. In either case, the positions are 'marked-to-market' by setting their new cost to the market value used in computing this difference. The positions held by the clients of the exchange are marked-to-market daily and the MTM difference computation for the next day would use the new cost figure in its calculation.
Clients hold a margin account with the exchange, and every day the swings in the value of their positions is added to or deducted from their margin account. If the margin account gets too low, they have to replenish it. In this way it is highly unlikely that the client will not be able to fulfill his obligations arising from the contracts. As the clearing house is the counterparty to all their trades, they only have to have one margin account. This is in contrast with OTC derivatives, where issues such as margin accounts have to be negotiated with all counterparties.
Commodity
In economics, a commodity is the generic term for any marketable item produced to satisfy wants or needs. Economic commodities comprise goods and services....
or financial instrument at a specified price with delivery
Delivery (commerce)
Delivery is the process of transporting goods. Most goods are delivered through a transportation network. Cargo are primarily delivered via roads and railroads on land, shipping lanes on the sea and airline networks in the air...
set at a specified time in the future. These types of contracts fall into the category of derivative
Derivative (finance)
A derivative instrument is a contract between two parties that specifies conditions—in particular, dates and the resulting values of the underlying variables—under which payments, or payoffs, are to be made between the parties.Under U.S...
s. Such instruments are priced according to the movement of the underlying asset (stock, physical commodity, index, etc.). The aforementioned category is named "derivatives" because the value of these instruments is derived from another asset class.
History of futures exchanges
One of the earliest written records of futures trading is in AristotleAristotle
Aristotle was a Greek philosopher and polymath, a student of Plato and teacher of Alexander the Great. His writings cover many subjects, including physics, metaphysics, poetry, theater, music, logic, rhetoric, linguistics, politics, government, ethics, biology, and zoology...
's book Politics. He tells the story of Thales
Thales
Thales of Miletus was a pre-Socratic Greek philosopher from Miletus in Asia Minor, and one of the Seven Sages of Greece. Many, most notably Aristotle, regard him as the first philosopher in the Greek tradition...
, a poor philosopher from Miletus who developed a "financial device, which involves a principle of universal application". Thales used his skill in forecasting and predicted that the olive harvest would be exceptionally good the next autumn. Confident in his prediction, he made agreements with local olive-press owners to deposit his money with them to guarantee him exclusive use of their olive presses when the harvest was ready. Thales successfully negotiated low prices because the harvest was in the future and no one knew whether the harvest would be plentiful or pathetic and because the olive-press owners were willing to hedge
Hedge (finance)
A hedge is an investment position intended to offset potential losses that may be incurred by a companion investment.A hedge can be constructed from many types of financial instruments, including stocks, exchange-traded funds, insurance, forward contracts, swaps, options, many types of...
against the possibility of a poor yield. When the harvest-time came, and a sharp increase in demand for the use of the olive presses outstripped supply, he sold his future use contracts of the olive presses at a rate of his choosing, and made a large quantity of money. It should be noted, however, that this is a very loose example of futures trading and, in fact, more closely resembles an Option contract
Option contract
An option contract is defined as "a promise which meets the requirements for the formation of a contract and limits the promisor's power to revoke an offer." Restatement of Contracts § 25 ....
, given that Thales was not obliged to use the olive presses if the yield was poor.
The first modern organized futures exchange began in 1710 at the Dojima Rice Exchange
Dojima Rice Exchange
The Dōjima Rice Exchange , located in Osaka, was the center of Japan's system of rice brokers, which developed independently and privately in the Edo period and would be seen as the forerunners to a modern banking system...
in Osaka, Japan.
The United States
United States
The United States of America is a federal constitutional republic comprising fifty states and a federal district...
followed in the early 19th century. Chicago
Chicago
Chicago is the largest city in the US state of Illinois. With nearly 2.7 million residents, it is the most populous city in the Midwestern United States and the third most populous in the US, after New York City and Los Angeles...
is located at the base of the Great Lakes
Great Lakes
The Great Lakes are a collection of freshwater lakes located in northeastern North America, on the Canada – United States border. Consisting of Lakes Superior, Michigan, Huron, Erie, and Ontario, they form the largest group of freshwater lakes on Earth by total surface, coming in second by volume...
, close to the farmlands and cattle country of the U.S. Midwest, making it a natural center for transportation, distribution and trading of agricultural produce. Gluts and shortages of these products caused chaotic fluctuations in price, and this led to the development of a market enabling grain merchants, processors, and agriculture companies to trade in "to arrive" or "cash forward" contracts to insulate them from the risk of adverse price change and enable them to hedge.
Forward contracts were standard at the time. However, most forward contracts weren't honored by both the buyer and the seller. For instance, if the buyer of a corn
Maize
Maize known in many English-speaking countries as corn or mielie/mealie, is a grain domesticated by indigenous peoples in Mesoamerica in prehistoric times. The leafy stalk produces ears which contain seeds called kernels. Though technically a grain, maize kernels are used in cooking as a vegetable...
forward contract made an agreement to buy corn, and at the time of delivery the price of corn differed dramatically from the original contract price, either the buyer or the seller would back out. Additionally, the forward contracts market was very illiquid and an exchange was needed that would bring together a market to find potential buyers and sellers of a commodity instead of making people bear the burden of finding a buyer or seller.
In 1848, the Chicago Board of Trade
Chicago Board of Trade
The Chicago Board of Trade , established in 1848, is the world's oldest futures and options exchange. More than 50 different options and futures contracts are traded by over 3,600 CBOT members through open outcry and eTrading. Volumes at the exchange in 2003 were a record breaking 454 million...
(CBOT–) was formed. Trading was originally in forward contract
Forward contract
In finance, a forward contract or simply a forward is a non-standardized contract between two parties to buy or sell an asset at a specified future time at a price agreed today. This is in contrast to a spot contract, which is an agreement to buy or sell an asset today. It costs nothing to enter a...
s; the first contract (on corn) was written on March 13, 1851. In 1865, standardized futures contract
Futures contract
In finance, a futures contract is a standardized contract between two parties to exchange a specified asset of standardized quantity and quality for a price agreed today with delivery occurring at a specified future date, the delivery date. The contracts are traded on a futures exchange...
s were introduced.
The Chicago Produce Exchange was established in 1874, renamed the Chicago Butter and Egg Board
Chicago Butter and Egg Board
The Chicago Butter and Egg Board, founded in 1898, was a spin-off entity of the Chicago Board of Trade . In the year 1919, it was re-organized as the Chicago Mercantile Exchange . Roots of the Chicago Butter and Egg Board are traceable to the 19th century.Initially, the Chicago Butter and Egg Board...
in 1898 and then reorganised into the Chicago Mercantile Exchange
Chicago Mercantile Exchange
The Chicago Mercantile Exchange is an American financial and commodity derivative exchange based in Chicago. The CME was founded in 1898 as the Chicago Butter and Egg Board. Originally, the exchange was a non-profit organization...
(CME) in 1919. In 1972 the International Monetary Market
International Monetary Market
The International Monetary Market , a spin-off from the old Chicago Mercantile Exchange and largely the creation of Leo Melamed, is today one of three divisions of the Chicago Mercantile Exchange , the largest futures exchange in the United States and the second largest in the world after Eurex,...
(IMM), a division of the CME, was formed to offer futures contracts in foreign currencies: British pound, Canadian dollar
Canadian dollar
The Canadian dollar is the currency of Canada. As of 2007, the Canadian dollar is the 7th most traded currency in the world. It is abbreviated with the dollar sign $, or C$ to distinguish it from other dollar-denominated currencies...
, German mark
German mark
The Deutsche Mark |mark]], abbreviated "DM") was the official currency of West Germany and Germany until the adoption of the euro in 2002. It is commonly called the "Deutschmark" in English but not in German. Germans often say "Mark" or "D-Mark"...
, Japanese yen
Japanese yen
The is the official currency of Japan. It is the third most traded currency in the foreign exchange market after the United States dollar and the euro. It is also widely used as a reserve currency after the U.S. dollar, the euro and the pound sterling...
, Mexican peso
Mexican peso
The peso is the currency of Mexico. Modern peso and dollar currencies have a common origin in the 15th–19th century Spanish dollar, most continuing to use its sign, "$". The Mexican peso is the 12th most traded currency in the world, the third most traded in the Americas, and by far the most...
, and Swiss franc
Swiss franc
The franc is the currency and legal tender of Switzerland and Liechtenstein; it is also legal tender in the Italian exclave Campione d'Italia. Although not formally legal tender in the German exclave Büsingen , it is in wide daily use there...
.
In 1881, a regional market was founded in Minneapolis, Minnesota
Minneapolis, Minnesota
Minneapolis , nicknamed "City of Lakes" and the "Mill City," is the county seat of Hennepin County, the largest city in the U.S. state of Minnesota, and the 48th largest in the United States...
and in 1883 introduced futures for the first time. Trading continuously since then, today the Minneapolis Grain Exchange
Minneapolis Grain Exchange
The Minneapolis Grain Exchange was formed in 1881 as a regional cash marketplace to promote fair trade and to prevent trade abuses in wheat, oats and corn....
(MGEX) is the only exchange for hard red spring wheat futures and options.
The 1970s saw the development of the financial future
Financial future
A financial future is a futures contract on a short term interest rate . Contracts vary, but are often defined on an interest rate index such as 3-month sterling or US dollar LIBOR....
s contracts, which allowed trading in the future value of interest rate
Interest rate
An interest rate is the rate at which interest is paid by a borrower for the use of money that they borrow from a lender. For example, a small company borrows capital from a bank to buy new assets for their business, and in return the lender receives interest at a predetermined interest rate for...
s. These (in particular the 90-day Eurodollar
Eurodollar
Eurodollars are time deposits denominated in U.S. dollars at banks outside the United States, and thus are not under the jurisdiction of the Federal Reserve. Consequently, such deposits are subject to much less regulation than similar deposits within the U.S., allowing for higher margins. The term...
contract introduced in 1981) had an enormous impact on the development of the interest rate swap
Interest rate swap
An interest rate swap is a popular and highly liquid financial derivative instrument in which two parties agree to exchange interest rate cash flows, based on a specified notional amount from a fixed rate to a floating rate or from one floating rate to another...
market.
Today, the futures markets have far outgrown their agricultural origins. With the addition of the New York Mercantile Exchange
New York Mercantile Exchange
The New York Mercantile Exchange is the world's largest physical commodity futures exchange. It is located at One North End Avenue in the World Financial Center in the Battery Park City section of Manhattan, New York City...
(NYMEX) the trading and hedging
Hedge (finance)
A hedge is an investment position intended to offset potential losses that may be incurred by a companion investment.A hedge can be constructed from many types of financial instruments, including stocks, exchange-traded funds, insurance, forward contracts, swaps, options, many types of...
of financial products using futures dwarfs the traditional commodity markets, and plays a major role in the global financial system
Global financial system
The global financial system is the financial system consisting of institutions and regulators that act on the international level, as opposed to those that act on a national or regional level...
, trading over 1.5 trillion U.S. dollars per day in 2005.
The recent history of these exchanges (Aug 2006) finds the Chicago Mercantile Exchange
Chicago Mercantile Exchange
The Chicago Mercantile Exchange is an American financial and commodity derivative exchange based in Chicago. The CME was founded in 1898 as the Chicago Butter and Egg Board. Originally, the exchange was a non-profit organization...
trading more than 70% of its Futures contracts on its "Globex" trading platform and this trend is rising daily. It counts for over 45.5 Billion dollars of nominal trade (over 1 million contracts) every single day in "electronic trading
Electronic trading
Electronic trading, sometimes called etrading, is a method of trading securities , foreign exchange or financial derivatives electronically...
" as opposed to open outcry
Open outcry
Open outcry is the name of a method of communication between professionals on a stock exchange or futures exchange. It involves shouting and the use of hand signals to transfer information primarily about buy and sell orders...
trading of Futures, Options and Derivatives.
In June 2001, ICE (IntercontinentalExchange
IntercontinentalExchange
IntercontinentalExchange, Inc., known as ICE, is an American financial company that operates Internet-based marketplaces which trade futures and over-the-counter energy and commodity contracts as well as derivative financial products...
) acquired the International Petroleum Exchange
International Petroleum Exchange
The International Petroleum Exchange, based in London, was one of the world's largest energy futures and options exchanges. Its flagship commodity, Brent Crude was a world benchmark for oil prices, but the exchange also handled futures contracts and options on fuel oil, natural gas, electricity ,...
(IPE), now ICE Futures, which operated Europe’s leading open-outcry energy futures exchange. Since 2003, ICE has partnered with the Chicago Climate Exchange (CCX) to host its electronic marketplace. In April 2005, the entire ICE portfolio of energy futures became fully electronic.
In 2006, the New York Stock Exchange
New York Stock Exchange
The New York Stock Exchange is a stock exchange located at 11 Wall Street in Lower Manhattan, New York City, USA. It is by far the world's largest stock exchange by market capitalization of its listed companies at 13.39 trillion as of Dec 2010...
teamed up with the Amsterdam-Brussels-Lisbon-Paris Exchanges "Euronext" electronic exchange to form the first transcontinental Futures and Options Exchange. These two developments as well as the sharp growth of internet Futures trading platforms developed by a number of trading companies clearly points to a race to total internet trading of Futures and Options in the coming years.
In terms of trading volume, the National Stock Exchange of India
National Stock Exchange of India
The National Stock Exchange is a stock exchange located at Mumbai, Maharashtra, India. It is the 9th largest stock exchange in the world by market capitalization and largest in India by daily turnover and number of trades, for both equities and derivative trading. NSE has a market capitalization...
in Mumbai
Mumbai
Mumbai , formerly known as Bombay in English, is the capital of the Indian state of Maharashtra. It is the most populous city in India, and the fourth most populous city in the world, with a total metropolitan area population of approximately 20.5 million...
is the largest stock futures trading exchange in the world, followed by JSE Limited in Sandton, Gauteng
Sandton, Gauteng
Sandton is a wealthy area situated within the metro of Johannesburg, Gauteng, South Africa. The name comes from the combination of two of its suburbs, Sandown and Bryanston...
, South Africa
South Africa
The Republic of South Africa is a country in southern Africa. Located at the southern tip of Africa, it is divided into nine provinces, with of coastline on the Atlantic and Indian oceans...
.
Nature of contracts
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 monthDelivery month
For futures contracts specifying physical delivery, the delivery month is the month in which the seller must deliver, and the buyer must accept and pay for, the underlying. For contracts specifying cash settlement, the delivery month is the month of a final mark-to-market...
. 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
Open interest
Open interest refers to the total number of derivative contracts, like futures and options, that have not been settled in the immediately previous time period for a specific underlying security...
increases; that is, when one party first buys (goes long
Long (finance)
In finance, a long position in a security, such as a stock or a bond, or equivalently to be long in a security, means the holder of the position owns the security and will profit if the price of the security goes up. Going long is the more conventional practice of investing and is contrasted with...
) a contract from another party (who goes short). Contracts are also "destroyed" in the opposite manner whenever Open interest
Open interest
Open interest refers to the total number of derivative contracts, like futures and options, that have not been settled in the immediately previous time period for a specific underlying security...
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.
Compare this with other securities, in which there is a primary market when an issuer issues the security, and a secondary market where the security is later traded independently of the issuer. Legally, the security represents an obligation of the issuer rather than the buyer and seller; even if the issuer buys back some securities, they still exist. Only if they are legally cancelled they can disappear.
Standardization
The contracts traded on futures exchanges are always standardized. In principle, the parameters to define a contract are endless (see for instance in futures contractFutures contract
In finance, a futures contract is a standardized contract between two parties to exchange a specified asset of standardized quantity and quality for a price agreed today with delivery occurring at a specified future date, the delivery date. The contracts are traded on a futures exchange...
). To make sure liquidity is high, there is only a limited number of standardized contracts.
Derivatives Clearing
There is usually a division of responsibility between provision of trading facility and settlement of those trades. While derivative exchanges like the CBOE and LIFFE take responsibility for providing efficient, transparent and orderly trading environments, settlement of the resulting trades are usually handled by Clearing Corporations, also known as Clearing Houses, that serve as central counterparties to trades done in the respective exchanges. For instance, the Options Clearing CorporationOptions Clearing Corporation
Options Clearing Corporation or OCC, founded in 1973, is the world's largest equity derivatives clearing organization, providing central counterparty clearing and settlement services to 14 exchanges and platforms for options, financial and commodity futures, security futures and securities...
(OCC) and LCH.Clearnet
LCH.Clearnet
LCH.Clearnet is an independent clearing house based in Europe that serves major international exchanges and platforms, as well as a range of OTC markets...
(London Clearing House) respectively are the clearing corporations for CBOE and LIFFE. A well known exception to this is the case of Chicago Mercantile Exchange
Chicago Mercantile Exchange
The Chicago Mercantile Exchange is an American financial and commodity derivative exchange based in Chicago. The CME was founded in 1898 as the Chicago Butter and Egg Board. Originally, the exchange was a non-profit organization...
and ICE
Ice
Ice is water frozen into the solid state. Usually ice is the phase known as ice Ih, which is the most abundant of the varying solid phases on the Earth's surface. It can appear transparent or opaque bluish-white color, depending on the presence of impurities or air inclusions...
, which clear trades themselves.
Central Counterparty
Derivative contracts are leveraged positions whose value is volatile. They are usually more volatile than their underlying asset. This can lead to situations where one party to a trade loses a big sum of money and is unable to honor its settlement obligation. In a safe trading environment, the parties to a trade need to be assured that their counterparty will honor the trade, no matter how the market has moved. This requirement can lead to messy arrangements like credit assessment, setting of trading limits and so on for each counterparty, and take away most of the advantages of a centralised trading facility. To prevent this, Clearing corporations interpose themselves as counterparties to every trade and extend guarantee that the trade will be settled as originally intended. This action is called NovationNovation
In contract law and business law, novation is the act of either replacing an obligation to perform with a new obligation, or replacing a party to an agreement with a new party...
. As a result, trading firms take no risk on the actual counterparty to the trade, but on the clearing corporation. The clearing corporation is able to take on this risk by adopting an efficient margining process.
Margin and Mark-to-Market
Clearing houses charge two types of margins: the Initial Margin and the Mark-To-MarketMark to market
Mark-to-market or fair value accounting refers to accounting for the fair value of an asset or liability based on the current market price of the asset or liability, or for similar assets and liabilities, or based on another objectively assessed "fair" value...
margin (also referred to as Variation Margin).
The Initial Margin is the sum of money (or collateral) to be deposited by a firm to the clearing corporation to cover possible future loss in the positions (the set of positions held is also called the portfolio) held by a firm.Several popular methods are used to compute initial margins. They include the CME-owned SPAN
CME SPAN
The Standard Portfolio Analysis of Risk, or SPAN, is a system for calculating margin requirements for futures and options on futures. It was developed and implemented by the Chicago Mercantile Exchange in 1988....
(a grid simulation method used by the CME and about 70 other exchanges), STANS (a Monte Carlo simulation based methodology used by the OCC), TIMS (earlier used by the OCC, and still being used by a few other exchanges like the Bursa Malaysia
Bursa Malaysia
Bursa Malaysia is an exchange holding company approved under Section 15 of the Capital Markets and Services Act 2007. It operates a fully integrated exchange, offering the complete range of exchange-related services including trading, clearing, settlement and depository services.- History :Bursa...
).
The Mark-to-Market Margin (MTM margin) on the other hand is the margin collected to offset losses (if any) that have already been incurred on the positions held by a firm. This is computed as the difference between the cost of the position held and the current market value of that position. If the resulting amount is a loss, the amount is collected from the firm; else, the amount may be returned to the firm (the case with most clearing houses) or kept in reserve depending on local practice. In either case, the positions are 'marked-to-market' by setting their new cost to the market value used in computing this difference. The positions held by the clients of the exchange are marked-to-market daily and the MTM difference computation for the next day would use the new cost figure in its calculation.
Clients hold a margin account with the exchange, and every day the swings in the value of their positions is added to or deducted from their margin account. If the margin account gets too low, they have to replenish it. In this way it is highly unlikely that the client will not be able to fulfill his obligations arising from the contracts. As the clearing house is the counterparty to all their trades, they only have to have one margin account. This is in contrast with OTC derivatives, where issues such as margin accounts have to be negotiated with all counterparties.
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 CommissionAustralian Securities and Investments CommissionThe Australian Securities & Investments Commission is an independent Australian government body that acts as Australia's corporate regulator...
. - In the Chinese mainland, by the China Securities Regulatory CommissionChina Securities Regulatory CommissionThe China Securities Regulatory Commission is an institution of the State Council of the People's Republic of China , with ministry-level rank...
. - In Hong Kong, by the Securities and Futures Commission.
- In India, by the Securities and Exchange Board of IndiaSecurities and Exchange Board of IndiaThe Securities and Exchange Board of India is the regulator for the securities market in India.-History:It was formed officially by the Government of India in 1992 with SEBI Act 1992 being passed by the Indian Parliament...
and Forward Markets Commission (FMC) - In Japan, by the Financial Services AgencyFinancial Services AgencyThe is a Japanese government organization responsible for overseeing banking, securities and exchange, and insurance in order to ensure the stability of the financial system of Japan. The agency operates with a commissioner and reports to the Minister of Finance. It oversees the Securities and...
. - In Pakistan, by the Securities and Exchange Commission of PakistanSecurities and Exchange Commission of PakistanThe Securities and Exchange Commission of Pakistan is an autonomous body whose purpose is to develop a modern and efficient corporate sector and a capital market based on sound regulatory principles, in order to foster economic growth and prosperity in Pakistan.-History:The Securities and Exchange...
. - In Singapore by the Monetary Authority of SingaporeMonetary Authority of SingaporeThe Monetary Authority of Singapore is Singapore's central bank and financial regulatory authority...
. - In the UK, futures exchanges are regulated by the Financial Services AuthorityFinancial Services AuthorityThe Financial Services Authority is a quasi-judicial body responsible for the regulation of the financial services industry in the United Kingdom. Its board is appointed by the Treasury and the organisation is structured as a company limited by guarantee and owned by the UK government. Its main...
. - In the USA, by the Commodity Futures Trading CommissionCommodity Futures Trading CommissionThe U.S. Commodity Futures Trading Commission is an independent agency of the United States government that regulates futures and option markets....
. - In Malaysia, by the Securities Commission Malaysia.
- In Spain, by the Comisión Nacional del Mercado de ValoresComisión Nacional del Mercado de ValoresThe Comisión Nacional del Mercado de Valores is the Spanish government agency responsible for regulating the financial securities markets in Spain...
(CNMV). - In Brazil, by the Comissão de Valores Mobiliários (CVM).
- In South Africa, by the Financial Services Board (South Africa)Financial Services Board (South Africa)The Financial Services Board is the government of South Africa financial regulatory agency responsible for the non-banking financial services industry in South Africa. It is an independent body that supervises and regulates the financial services industry in the public interest...
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See also
- Bond marketBond marketThe bond market is a financial market where participants can issue new debt, known as the primary market, or buy and sell debt securities, known as the Secondary market, usually in the form of bonds. The primary goal of the bond market is to provide a mechanism for long term funding of public and...
- Commodity marketsCommodity marketsCommodity markets are markets where raw or primary products are exchanged. These raw commodities are traded on regulated commodities exchanges, in which they are bought and sold in standardized contracts....
- Currency market
- List of futures exchanges
- List of traded commodities
- Paper tradingPaper tradingPaper trading is a simulated trading process in which would-be investors can 'practice' investing without committing real money....
- Prediction marketPrediction marketPrediction markets are speculative markets created for the purpose of making predictions...
- Stock marketStock marketA stock market or equity market is a public entity for the trading of company stock and derivatives at an agreed price; these are securities listed on a stock exchange as well as those only traded privately.The size of the world stock market was estimated at about $36.6 trillion...
- Trader (finance)Trader (finance)A trader is someone in finance who buys and sells financial instruments such as stocks, bonds, commodities and derivatives. A broker who simply fills buy or sell orders is not a trader, as they are merely executing instructions given to them. According to the Wall Street Journal in 2004, a managing...