The Institution of Futures Trading: the Futures Exchange, Clearinghouse, and the Futures Commission Merchant (FCM)

There are 3 major organizations that compose the institution of futures trading: the exchange, the clearinghouse, and the futures commission merchant.

The futures exchange, usually owned by its members, determines what contracts will be traded, what the terms of the contracts will be, the trading hours, and how and when futures can be traded. The exchange also is the main regulator of the futures business conducted at the exchange. It houses the trading floor for floor trading, and the computers used for electronic trading.

The clearinghouse is a department of the exchange whose main function is the settling of and marking to market of the exchange members' accounts, guarantees the other side of all futures trades, and oversees contract performance.

The futures commission merchant is the intermediary between the exchanges and the public investor, acting as a broker for the buying and selling of futures, and as the custodian of the customers funds.

History

The 1st futures exchanges were organized in Chicago, because futures were 1st based on agricultural commodities, and the Midwest was a major producer of agricultural products, and, thus, Chicago was a major center for trading agricultural products, and many processing plants for agricultural products were located there.

The Chicago Board of Trade (CBOT) was the 1st organized exchange for grain. The Chicago Mercantile Exchange (CME) started in 1874 as the Chicago Produce Exchange, then renamed itself the Chicago Butter and Egg Board because that was what was listed on the exchange. As the number of commodities traded increased—including hides, onions and potatoes—it was inevitable the exchange would adopt its present, more general name in 1919. CBOT and CME are in the process of merging—the combined exchanges will be named the CME Group.

Futures for frozen pork bellies began trading in 1961, the 1st year futures on stored meat was traded. Live cattle was added in 1964, which was the 1st futures contract for live animals.

In 1972, the CME introduced financial futures that consisted of 8 currency futures. The 1st cash-settled futures contract—CME Eurodollar—was introduced in 1981. The establishment of cash settlement rather than physical delivery allowed the futures market to expand into products that either can't be delivered or would be difficult to deliver physically, such as futures based on stock indexes, such as the S&P 500 stock index, that was introduced in 1982. Offering cash-settled futures is simply eliminating the unnecessary component of physical delivery for most traders, while providing the 2 important qualities of futures: the ability to hedge portfolios and to profit from speculation.

Today, its diversity of products includes agricultural commodities, foreign exchange products, interest rate products, equity products largely based on major indexes, alternative investment products, which includes energy, weather, economic derivatives, and housing index products, and TRAKRS (Total Return Asset Contracts), which are based on commodities, euro currency, and gold, for instance.

Regulation

The futures market is regulated in the United States by the Securities and Exchange Commission (SEC), the Commodity Futures Trading Commission (CFTC), the National Futures Association (NFA) and by the exchanges themselves. The CFTC, created by the Commodity Futures Trading Commission Act of 1974, is a federal agency that regulates all futures trading in the United States, and oversees the NFA. It is headed by 5 commissioners appointed by the President of the United States. It has economists and regulatory officials that research the commodity markets to see what improvements can be made. As a regulator, the CFTC can sue any person or organization for violating the CFTC Act, can issue cease-and-desist orders, and can take over a futures market, if necessary, to restore order in an emergency situation.

The exchanges must obtain approval for any regulatory changes, and for the introduction of any new futures or options on futures. All futures exchanges must have trading rules, contracts, and disciplinary procedures approved by the CFTC.

The CFTC replaced the Commodity Exchange Authority (CEA), which was established by the Commodity Exchange Authority Act of 1936 as a regulatory authority of the U.S. Department of Agriculture, to oversee and regulate the agricultural commodity business.

The NFA, a self-regulatory agency created by Section 17 of the Commodity Exchange Act of 1981, regulates the activities of its members, which includes any brokers trading futures and their agents. NFA's responsibilities include screening, testing and registering persons applying to conduct business in the futures industry. NFA and the exchanges have responsibility for auditing and enforcing compliance with industry rules, such as financial requirements, segregation of customers' funds, accounting procedures, sales activities, and floor trading practices.

Futures Exchanges

The futures exchanges are the main organizations for the trading of futures and options on futures. Only members of the exchange can trade orders for futures on that exchange. The exchange determines the underlying commodities that will be traded, the contract size and delivery or settlement months, and daily price limits as well as the minimum price tick—the minimum change in price of a futures contract. Trading hours, and whether to use floor trading or electronic trading or both, and at what hours for either are also determined by the exchanges. The exchange also sets the minimum margin requirement and the maintenance margin requirement for each type of contract traded on the exchange.

The Trading Platform for Futures

The exchanges provide the buildings, computers, and methods for trading futures. This is seen most prominently in the trading floor of the exchange, a relic of the past that is still persistent in most of the American futures exchanges. The trading floor has 2 principal participants: floor brokers and floor traders. Floor brokers act as agents for the investing public, executing trades in their behalf, and are affiliated with FCM's. Floor traders mostly trade for their own accounts, but can also act as floor brokers as well. However, floor traders may not give their own orders priority over customers' orders.

The old method of trading futures, and still commonly used, is the open outcry method. After a customer sends an order to a broker, the broker sends it to the trading floor of a futures exchange for that particular futures contract, where floor traders and exchange members, through hand and visual signals transmit buy and sell orders. Open outcry trading also uses electronic tickers and display boards, hand-held computers, and electronic entry and reporting of transactions. The display boards also show quotes from other American futures exchanges.

Exchanges that use the open outcry method have trading pits, where buyers and sellers standing on steps that descend into the pit shout orders and signal the orders with their hands. Each pit specializes in a specific commodity, and is the only place to trade that commodity. Options on that futures commodity are typically located in an adjacent pit. Workstations surround each pit provide members of the exchange a communication link to brokers and large institutional investors. These orders are then either flashed to the trading specialist through hand signals, or delivered to the pit by runners. Different sections of the pit correspond to different contract expiration months, with the nearest month, by far the most actively traded, occupying the largest section.

Electronic trading is the predominant form of trading worldwide, and in the United States, where buy and sell orders are matched or queued in computerized trading systems. Any matches are executed immediately, with the rest of the orders queued by price and on a first in/first out basis. The buy order with the highest price is listed as the current bid price, and the sell order with the lowest price as the current ask price.

65% of all futures exchanges are outside of the United States, and most trade electronically. Because of the competitive pressure from abroad, the futures exchanges in the United States are starting to go electronic. Electronic trading is faster and cheaper. However, open outcry trading still has significant volume, as exchange members hang onto their vested interest in floor trading. At CME, for instance, some contracts—designated as Side-by-Side—are traded simultaneously on the floor and electronically, some contracts—After-Hours Electronic—are traded on the floor during the exchange hours, then electronically other times. Some contracts—Electronic Only—are only traded electronically.

The CME Globex, first operational in 1992, was the 1st electronic derivatives market, and is operational at all hours from Sunday evening to Friday afternoon except for 4 PM to 5 PM Central Standard Time.

Partial List of Futures Exchanges
 

The Clearinghouse

Every exchange has a clearinghouse which is used by the clearing members of the exchange. When a buyer and seller agree to the price, quantity, expiration month, and the underlying asset, the clearinghouse then assumes the obligation to buy the seller's contract, and to sell it to the buyer. Because the clearinghouse is the trader to both parties, they don't have to worry about performance of the contract. Furthermore, the clearinghouse allows each trader to close out his position independently of the other.

Diagram depicting the buying and selling relationship of traders of futures with the clearinghouse.

To guarantee the financial integrity of the futures exchange, the clearinghouse requires clearing members to post a guaranty bond in the form of cash or a letter of credit, which would cover a clearing member in the event of a default. If the money is insufficient, then the clearinghouse can assess a pro-rata levy on the remaining members to cover the difference.

At the end of each trading day, each clearing member's account is marked to market with the closing prices of that day. If additional margin is required of any account, then the clearing member of that account must post additional margin before a specific time in the next business day.

The clearinghouse also supervises the delivery of the futures contract after the last trading day. Any trader who has not closed out his position by the last day of trading must either provide delivery, if he is short, or take delivery and pay the full amount, if he is long. If it is a cash-settled contract, then only the difference between the cash price and the futures price must be paid.

Actual delivery procedures vary among the exchanges, but, generally, the short traders ask their brokers, any time during the delivery period, to prepare a delivery notice for the clearinghouse, which then assigns the notice to a clearing member who is long in the contract. The clearing member subsequently assigns the notice to a customer who is long in the contract.

The Futures Commission Merchant (FCM)

The FCM provides direct services to the public customer to trade futures. Similar to a broker for stocks, the FCM holds and manages the customer's account, executes the customer's trades, and maintains all records required to do business with the customer, including keeping a record of all open positions in futures and the balance in the account. All FCM's must be registered with the CFTC.

The FCM provides and receives the forms for opening an account to trade futures. The FCM will need to know the personal information of the customer, including his income and net worth to determine whether the customer has sufficient assets to trade futures.

The customer must also sign a commodity account agreement, which identifies the owner, and whether the account will be used for hedging or for speculating. This agreement also includes a transfer-of-funds authorization to allow the FCM to transfer funds from other accounts to maintain margin requirements, or to close out the futures positions that increased the margin requirements.

Introducing Broker (IB), Associated Person (AP)

An introducing broker is a firm or individual that solicits and accepts orders for futures for an FCM, but does not hold the futures account for the customer. The FCM opens and maintains the account, and executes the customer's trades. An independent introducing broker can use any FCM to service a customer's account and trades, but a guaranteed introducing broker works with an affiliated FCM.

An associated person, who must be registered with the CFTC, is a salesperson for futures accounts, who works with an FCM, an introducing broker, a commodity trading advisor, or a commodity pool operator.

Commodity Trading Adviser (CTA)

As with most investments, individuals can invest in commodities directly, or they can use the services of professionals, such as the commodity trading adviser, or invest in commodity pools.

The commodity trading adviser is much like the full-service stockbroker. The CTA receives pay for advice on buying and selling futures contracts, and options on futures, and will execute the trades for the client.

The CTA, who can be an individual or an organization, must be registered with the Commodities Futures Trading Commission, and must be a member of the National Futures Association. While such registration is not an endorsement of the CTA, it does signify that the CTA has the experience, education, finances, and the business affiliation to conduct futures trading.

If a CTA is also a futures commission merchant, then the CTA can hold the client's account; otherwise, the FCM to whom the CTA is affiliated will hold the client's account.

CTA's charge a performance fee based on the profits of the account, and a maintenance fee, though generally smaller, is charged regardless of profit or loss.

Risk Disclosure Document

Every customer must be given a risk disclosure document before opening an account that explains the risks of trading; the business background covering the past 5 years of the CTA and his principals; and the CTA's trading program, and how the CTA is compensated.

Commodity Pool Operator (CPO)

Commodity pools are much like mutual funds for futures—they allow small investors to invest in futures with limited risk and money, with investment decisions made by professionals. A greater diversification is achieved than would be possible for a small investor.

Generally, a much smaller amount of money is needed to invest in a commodity pool than needed for a CTA, with some commodity pools being sold in units of $1,000.

Commodity pools are limited partnerships with the commodity pool operator (CPO) as the general partner, and the public customers as limited partners. A limited partner cannot lose more than his investment in the commodity pool.

The CPO picks the trading adviser for the pool, who does the actual trading for the pool.

When considering investing in a commodity pool, an investor should examine the track record of the pool, and whether the published performance is from actual trades, or by a computer simulation of what the performance would have been, based on historical data, if the trades had actually been made. However, computer simulation may not necessarily render an accurate picture of potential profits, since it does not account for market dynamics that may have been changed if the trades had actually been executed. Furthermore, such simulation will almost assuredly have been picked because it did predict big profits, since this would be a great marketing tool that would help to draw in money, but it is no predictor of future success.

Before investing in a commodity pool, an investor should know how to get out of the pool, because, sometimes, rules are quite restrictive. Some pools stipulate that a customer can only get out on the last day of a quarter, for instance.

Risk Disclosure Document

The risk disclosure document, which must be given to every potential investor, identifies the pool; states the business background of the past 5 years for the commodity pool operator and his principals; discusses any possible conflict of interest; details how profits are distributed, and discloses the trading performance for the past 3 years, or the life of the CPO, whichever is shorter. The trading adviser for the CPO is also named. The amount of accounting, administrative, and legal expenses, and how they are paid must be disclosed. Many CPO's have an initial up-front sales charge, as well.