HOW THE FUTURES MARKET WORKS
A futures market, like any market, is a place where buyers and sellers
meet in order to transact. For every buyer, there is a seller and for
every seller, there is a buyer. Matching these two together so that a
trade can be consummated requires the participation of a host of
individuals and organizations, each having specific roles, which in the
aggregate make the futures market the efficient mechanism that it is
today. Throughout this section, reference is made solely to the futures
market only for convenience and simplicity of presentation. The market
for options on futures is structured in very much the same manner.
The
Futures and Options Exchange
The central player of a futures market is a futures exchange. A futures
exchange is a meeting place where futures contracts are bought and
sold. Trading occurs against a background of regulatory surveillance
and guidelines from the exchange itself and from the Commodity Futures
Trading Commission (CFTC). Each exchange has its own list of products
that it trades, and each product is traded in a designated futures
trading pit. A trading pit is an area of floor, usually round with
concentric steps leading down into the center. The trading pits are
each divided into a number of sections designated for trading in
particular contract months. No trading may occur outside a contract's
assigned pit, nor is trading permitted at any time other than during
those hours which have been designated by the exchange. (Some exchanges
also use automated trading facilities or computer networks which serve
as trading pits.)
In addition to providing the market place for trading futures and
regulating trading within its pits, futures exchanges also design and
specify their futures contracts. Futures contracts are very specific in
terms of the quality and quantity of goods underlying the contract. You
may have wondered who determines these specifications. The answer is
the futures exchange. Working with participants in the industry such as
traders, fund managers and natural hedgers, a futures exchange designs
a contract to meet the greatest need. If the exchange succeeds, it will
have designed a futures product that many players can use or trade, and
volume in the futures will grow. Contract specifications can sometimes
be changed by the exchange, and is usually done to keep the contract
viable. For this reason, it is a good idea to periodically check the
specifications of the contracts that you trade or want to trade.
The
Futures Broker
Buying or selling a futures contract or an option on a futures contract
can only be done in one place: the trading pit on the floor of a
futures exchange. To stand in a trading pit, you need to buy an
exchange membership, pay annual dues, and register with various
regulatory agencies. Naturally, few people would trade futures if it
required that they stand in the trading pit. To solve this problem, in
steps the futures broker. Your broker acts as a communication link
between the trading pit and you, taking orders from you, the customer,
and executing them in the futures pit.
This is the traditional path that a futures order takes as it passes
through the system (there are some exciting new developments in the
world of trading, such as online trading where you place the order
through an online broker or via specialized software):
You, the
customer, decide to buy or sell a futures contract.
You phone
your order to the futures order desk of our Futures
Commission Merchant (FCM).
The order
desk relays by telephone your order to the phone clerk on the
exchange floor.
The clerk
writes the futures order, time stamps it, and delivers it to
the executing floor broker in the trading pit. If a market order, the
order is executed. If any other kind of order, it is placed in a "deck"
along with other orders ready to be executed if triggered by price
movements.
Once
executed, the floor broker informs the clerk who informs the order
desk who, in turn, informs you. You now have a futures position.
The FCM
prepares a trade confirmation report and mails it to you.
The FCM
marks-to-market your futures position against the margin in
your trading account.
As you can see, there are several players, each having different roles,
who are involved in the process. Despite the steps involved, the
process has become very efficient - orders can often be executed within
a minute or two while you wait on the phone.
You may wonder why a futures broker requires an FCM to complete this
process. By law, futures brokers do not have the authority to take
customer funds and hold them in deposit. Only an FCM can do this. For
this reason, a futures broker needs to team up with an FCM in order to
provide order execution services to its customers.
The Futures
Commission Merchant
The Futures Commission Merchant (FCM) is responsible for holding
customer funds of the margin account, clearing the futures trade, and
performing all back-office recording functions such as
marking-to-market your futures account, sending trade confirmations and
account summaries, and year-end tax forms. Customers who open a futures
trading account deposit their margin funds at an FCM.
The
Clearing Corporation
The clearing corporation guarantees the performance of every buyer and
seller of a futures or options contract. In a literal sense, it stands
as a buyer to every seller and a seller to every buyer. As a futures
trader, that means that you don't have to worry about any default of a
futures counterparty. For instance, say that you purchase several Swiss
franc futures and the price goes up so that you have accrued a $4,500
profit. Whoever sold those futures contracts (and there is a seller for
every buyer, and vice-versa) has incurred a loss of $4,500. What
happens if that person can't pay? Do you sacrifice your profit? The
answer is "NO". The clearing corporation guarantees the transaction.
The clearing corporation's elimination of such counterparty credit risk
provides a great benefit to the futures and options markets.
You may
wonder how the clearing corporation does this. The answer lies in the
margin deposit that you and every other futures trader must make before
trading any contract. This margin is available to the clearing
corporation and, together with other reserve cash and various
protection funds, are used to cover any customer default. A clearing
corporation is composed of clearing members, most of which are large
FCM's. It is a mark of distinction for an FCM to be a clearing member.
Regulation
of the Futures Market
All futures industry-related operations, including exchanges, brokers
and FCMs are regulated and licensed by the Commodity Futures Trading
Commission (CFTC), a federal agency with jurisdiction over the United
States commodities markets. The CFTC regulates in conjunction with the
National Futures Association (NFA), the industry's only national
association. The primary purpose of the NFA is to ensure, through
self-regulation, high standards of professional conduct and financial
responsibility on the part of the individuals and organizations that
are its members: Futures Commission Merchants, Introducing Brokers,
Commodity Trading Advisors, Commodity Pool Operators, and Associated
Persons. In connection with its regulatory responsibilities, the NFA
conducts periodic audits of its members' financial and other records,
monitors sales practices and provides a mechanism for the arbitration
of futures related disputes between NFA members and the investing
public.
Information
on the NFA and CFTC can be directed by post to:
National Futures Association
200 West Madison Street
Chicago, IL 60606
(800) 621-3570
Commodity Futures Trading Commission
2033 K Street Northwest
Washington, D.C. 20581
(202) 254-8630
Fees
Described above is a network of individuals and organizations which
exist to serve you, the futures trader. These participants require
payment for their services. Payment takes the form of commission and
other fees which are expressed as a fixed dollar amount per round-turn
contract traded. A round-turn transaction means a completed and closed
transaction - a buy followed later buy a sell, or a sell followed later
by a buy.
The clerk and floor broker receive a transaction fee for executing the
customer's order. Fees are also paid to the futures commission
merchant, the clearing corporation, the National Futures Association
(NFA) and the futures exchange on which the contract trades. Taken
together, these fees can range anywhere from $25 per contract for
discount brokers who offer very little if any customer services, to
over $95 per contract for full-service brokers. Additional services
provided by full-service brokers consist of market commentaries,
identification of trading opportunities, and trading tips or advice.
In addition to its clearing and processing fees, the FCM typically
receives interest income on customer cash margin deposits; the customer
receives no interest income. However, those customers who typically
hold considerable excess margin in their trading account can use some
of this money to purchase a treasury bill which receives interest
income.
|
