A futures exchange, or futures and options exchange is a corporation or mutual organization which provides the facilities to trade derivatives such as futures contracts and options.
This type of exchange originated from exchanges where future contracts on commodities were traded, so called commodity exchanges. Later, future contracts on other products, such as short term interest rates or bonds, were offered. Nowadays, the contracts traded are not just futures, but also options, options on futures, and other varieties. The method of trading is called exchange trading, as opposed to over-the-counter (OTC) trading. Although strictly speaking derivatives exchange would be a more appropriate name, most exchanges of this type still refer to themselves as a futures or a futures and options exchange. The term derivatives may lead to confusion, as most derivatives are traded OTC, and most derivatives, such as swaps are rarely exchange traded.
The contracts traded on futures exchanges are always standardized. In principle, the parameters to define a contract are endless (see for instance in futures contract). To make sure liquidity is high, there is only a limited number of standardized contracts.
Nature of contracts
Exchange traded contracts are not issued like securities, but they are "created" when one party buys (goes long) a contract from another party (who goes short). To start with there are no contracts, so the number of contracts that clients are long must equal the number of contracts that clients are short. This always goes through the exchange, which means that the exchange is the counterparty for all trades. However, the exchange does not take any net positions. In this way clients do not know who they have ultimately traded with. Compare this with securities. There, an issuer issues the security. After that, it is a legal entity that is traded independently of the issuer. Even if the issuer buys back some securities, they still exist. Only if they are legally cancelled then they disappear.
Margin and Mark-to-market
The positions held by the clients of the exchange are marked-to-market daily. 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 fulfil his obligations arising from the contracts. As the exchange 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.
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 Commission
- In Hong Kong, by the Securities and Futures Commission
- In Singapore by the Monetary Authority of Singapore
- In the U.K., futures exchanges are regulated by the Financial Services Authority.
- In the USA, by the Commodity Futures Trading Commission.
History of futures exchanges
Though the origins of futures trading can be supposedly traced to Ancient Greek or Phoenician times, the history of modern futures trading begins in Chicago, United States in the early 1800s. 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. 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.
In 1848, the Chicago Board of Trade (CBOT), the world's first futures exchange, was formed. Trading was originally in forward contracts; the first contract (on corn) being written on March 13, 1851. In 1865, standardized futures contracts were introduced.
The Chicago Produce Exchange was established in 1874, renamed in 1898 the Chicago Mercantile Exchange (CME). 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.
Later in the 1970s saw the development of the financial futures contracts, which allowed trading in the future value of interest rates. 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.
This article is licensed under the GNU Free Documentation License. It uses material from the Wikipedia article "Futures_exchange".