The futures exchange provides a method in which the buyers can meet the sellers. Before the futures exchange it was still possible to have a forward contract between two parties but the credit risk of the counter party was a major issue. The future exchange developed a clearing house which records every transaction, facilitate and regulate the delivery of goods and settle all trading transactions. It plays a third party role in every transaction which takes place. It assumes a role in a way that the seller has sold the contract to the clearing house and the buyer is purchasing the contract from the clearing house. The net effect is that the number of contract bought and sold are same.
In case of very liquid commodities like crude oil the buyer will find a seller and other way round within seconds where the clearing house is playing the intermediary role. However for certain other commodities it might take much longer to find a counter party which will complete the transaction. The futures exchange works on a highly leveraged model. A trader trading contracts worth $100,000 would be required to put a margin payment of less than $5,000. This highly leveraged method of functioning would wipe out the entire account with a few percentage points movement in the price of the asset. In order to make sure that all the parties are meeting their dues the clearing house steps in. This process in which the clearing house is stepping in between two parties to guarantee that the terms of the contract will be met is called “novation”.
Clearing house model
Here Trader 1 and Broker 1 do not know Trader 2 and Broker 2. They complete the transaction with the clearing house and are liable to make payments to the clearing house in case of loss.
This model can be seen in comparison to the OTC model.
Here trader 1 instructs broker 1 to find a counter party for a given contract he is willing to sell. Broker 1 finds Broker 2 who on behalf of Trader 2 is looking to buy the contract. Now Broker 1 and Broker 2 deal directly instead of having a counter party between them which can guarantee the successful completion of the contract and make sure the obligations are fulfilled by all parties. FX market and spot market are a prime example of the OTC model. During the financial crisis of 2007-08 different parties including the government started to build pressure on traders that they complete their trades through a clearing house instead of the OTC model.
The clearing house is able to ensure that both the parties meet their dues through the use of margin payments. The traders make initial margin payment to the clearing house. This varies according to each commodity and it is not a percentage of the contract. This does not give the right to ownership to any party but is simply a security deposit given in good faith which indicates that you will honor the obligations of the contract. You can keep a higher amount than the initial margin but not lower in your account. Similarly brokers can ask their clients to pay a higher margin payment but not less than the minimum amount set by the clearing house. The second type of margin is called maintenance margin. This balance is required in the account so that a margin call is not made on your account. Once the funds in the account fall below the maintenance margin they have to be brought back to initial margin levels to continue trading.
A simple example: Let’s assume that the initial margin payment for a wheat futures contract is $1,500. The maintenance margin is $1,200. If the price of wheat goes down by 8 cents per bushel it would effectively cause a price fall of $400 (A wheat contract has a standardized quantity of 5000 bushels. Hence loss=5000*0.08) per contract. After deducting $400 from the traders account the current balance is $1,100 which is lower than the maintenance margin. Hence a margin call will be generated on that account and the trader will have to bring his balance back to the initial margin or 1,500 in his account. If on the other hand there is an uptick in the price of wheat the profit will be deposited in your account. When trading with multiple contracts the maintenance margin for the whole account is viewed as a whole. Let’s assume that there are 10 open positions where the initial margin requirement are $10,000 and the maintenance margin requirement are $6,000. If the value of the entire account drops by $6,000 the balance in the account will be $4,000 which is lower than the maintenance margin requirement. Hence a margin call will be generated on the account and the account will have to be brought back to $10,000 level.
This process of marking open positions to market every day helps in balancing risk both for the individual traders and for the entire system as a whole. This way large loss is not accumulated by any party in a way that they would not be able to meet their obligations. Each day all the clients are given information regarding the balance in their account and the amount they have in excess to the maintenance margin. If a margin call is generated on an account it is given a time of 24 hours to bring the account back to initial margin level or to close some open positions which would help them in meeting the maintenance margin requirement.
Introduction to the Futures Market Tutorial
1) Introduction to the Futures Market
2) History of the Futures Market
3) How the Futures Market Works
4) Difference between a Forward and Futures Contract
5) Participants in the Futures Market
6) Main factors that impact Futures Prices
7) What is a Futures Clearing House?
8) Risks in the Futures Market