The Role of Futures Markets

A futures contract is an agreement to buy or sell a commodity at a fixed future point in time at a price agreed upon today.

Futures markets and their clearing houses exist to provide firms with efficient tools to manage their price and counterparty risks.  Futures markets evolve when it becomes cheaper and more efficient to trade in a central marketplace than via a non transparent OTC market. Costs of trading include search and transaction costs, the spread between the bid and offer price, credit costs and administration (including delivery) costs.

The Value Propositions of a Futures Market

Feature Benefit
Price discovery and transparency  All bids, offers and trades are published in real-time – providing robust forward prices to underpin informed investment, sales/purchasing and related risk management decisions.
Credit risk protection  A clearing house reduces counterparty risk.
Novation As the central counterparty to every transaction, a clearing house ‘nets’ existing and any new futures contracts agreed between counterparties.
Anonymity  Orders are matched without disclosing client’s identity to the market.
Flexible trading mechanisms/market access arrangements Futures markets can be accessed directly electronically (including the internet). Trades negotiated off-market can also be registered for clearing.
Standardised agreements and reporting  Only one agreement with a clearing participant is needed to trade with a limitless number of counterparties. Market users receive standardised daily reports and a single net cash payment/ invoice from their clearing participant.
New participants and liquidity pools  Financial institutions, hedge funds, market-making firms, proprietary traders and speculators, many of whom have a preference to trade through the ‘safety’ of a clearing house, represent an enormous liquidity pool available to help market participants manage their price and counterparty risks.

The following table summarises the primary differences between futures and forward (or swap) contracts.

Forward and Swap Agreements Futures Contracts
Trading
Agreements		 Trades are underpinned by trading agreements, eg ISDA, SCOTA etc. Agreements are needed with all trading counterparties. Clearing agreements bind clients to their Clearing Participants and in turn the Clearing House. Given that all trades are ‘novated’ to the Clearing House, one clearing agreement enables a client to initiate trades with a limitless number of counterparties.
Counter-Party Credit  Counterparty credit exposures need to be carefully monitored and managed with all counterparties. The Clearing House becomes the central counterparty to all trades and effectively guarantees contract performance. The Clearing House manages its risk through calling Initial Margins, Variation Margins and Delivery Margins1.

Futures markets provide a useful mechanism for market participants to lay-off risk from trading that might have originated in OTC trades and/ or EFP transactions to accommodate the delivery of the underlying product or a variant of its specification at the same or a different location.

1 Letters of Credit (LCs) can be lodged as collateral for Initial Margins and Delivery Margins.