How Futures and Options Markets Work [Back to the top]
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 [Back to the top]
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 surveliance 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.
The Futures Broker [Back
to the top]
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, a trader
needs 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. A futures broker acts
as a communication link between the trading pit and the trader, taking
orders from the customer, and executing them in the futures pit. 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 [Back to the top]
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 a customer's futures account, sending trade confirmations and account summaries, and year-end tax forms.
The Clearing Corporation [Back
to the top]
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. That means that a futures trader does not have
to worry about any default of a futures counterparty. For example, say
that trader A purchase several Swiss franc futures and the price goes up
so that she has 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 cannot pay? Does A sacrifice
her 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.
One may wonder how the clearing corporation does this. The answer lies
in the margin deposit that 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
[Back to the top]
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.