EconSouth (Third Quarter 2007)
The style and substance of futures trading have come a long way from its mid-19th century beginnings. In today's brave new high-tech world, futures trading plays a major role in the global financial system, accounting for trillions of dollars in trades every day.
The United States has a long history in commodity futures trading in cities like Chicago or New York. The oldest of these exchanges still trade the lion's share of futures contracts in the United States. But the successful opening in 2000 of the Atlanta-based IntercontinentalExchange (ICE), on which half—approximately $23 billion worth—of the world's crude oil futures trade, demonstrates that there's room in the futures trading market for healthy competition. In fact, ICE is now becoming a major player in global energy and financial markets (see the sidebar.)
Nowadays futures trades are increasingly likely to occur via computer rather than on the trading floor and may involve anything from cattle to crude oil to currency. But no matter what's being traded or how the trade is transacted, the form of the futures contract is essentially the same.
The anatomy of a futures contract
In essence, a futures contract is an agreement between two parties to exchange a financial instrument or physical commodity at a future date for an agreed-upon price. A simple example is a futures contract on winter wheat contracted between a farmer and a baker.
The farmer is concerned that the price of wheat may decline before he can bring his harvest to market. The baker, who needs wheat to mill and make into bread, is concerned that wheat prices will rise and increase her cost of doing business. The baker takes the "long" position in the futures contract by agreeing to buy 100 bushels of winter wheat from the farmer six months in the future for $2 a bushel. The farmer takes the "short" position by agreeing to deliver the 100 bushels to the baker in six months and receive the $200 payment. By entering into this contract, both parties are protected against any changes in the market price of wheat.
This example illustrates the key terms of any futures contract: the quantity and quality of the commodity to be delivered (100 bushels of winter wheat), the date on which delivery will be made (six months in the future), and the futures price ($2 per bushel).
Historically, futures contracts evolved from forward contracts, which are designed around the specific needs of the contracting parties with regard to the quantity, quality, and delivery date. Parties in a forward contract interact privately and directly and are thus exposed to the risk that the other party might fail to deliver the goods or pay the agreed price. Futures contracts, in contrast, are traded on a centralized exchange and use a clearinghouse as an intermediary. The clearinghouse acts as a buyer to the seller and a seller to the buyer, thus eliminating credit risk to the buyer and seller. Because futures contracts can be easily traded by many market participants, they bring more liquidity to the market.
Originally, futures were written on agricultural products, such as wheat, corn, and soybeans, or precious metals, such as gold and silver. But futures contracts have evolved over time, often in response to financial market developments. The 1970s and '80s saw the introduction of futures contracts on financial instruments such as U.S. Treasury bills and bonds, stock indexes, and eurodollar time deposits. Energy and petroleum futures contracts were introduced on the heels of the 1970s energy crisis as the risk of oil price shocks increased. The chart to the left illustrates recent global futures and options trading volume by asset class. Financial futures (equities, interest rates, and currency) have experienced the most growth in the past five years and accounted for 90 percent of the trading volume in 2006.
Where and how are futures traded?
Futures exchanges are the centralized marketplaces in which standardized futures contracts are created and traded. The first U.S. futures exchanges, founded in the mid-to-late 19th century, began as organized market forums where buyers and sellers came together in one location to trade their goods with ease. These forums evolved into larger trading pits located either in New York or Chicago. Today the largest of these (shown on the timeline above) trade huge volumes of futures.
Until recently, futures were traded exclusively by open outcry—a process in which the customer calls a broker, the broker sends the order to the exchange floor trader, and the floor trader negotiates the price by shouting out the order to the other floor traders, who bid until a price is agreed upon. Once the two traders reach an agreement, the clearinghouse settles the trade. However, because of technological advancements and a growing global economy, this method of trading is becoming outdated.
For decades now, exchanges outside the United States have used electronic platforms to trade futures. Through a computer interface—the trading platform—traders place orders or post prices at which they are willing to buy and sell futures contracts. The host computer then sends the order through a bid-offer matching process. Once a match is found, the trade is executed and cleared by the associated clearinghouse.
In recent years, the U.S. futures exchanges have created their own versions of these platforms to compete for global trading volume and to offer electronic trading as an option for their clients.
Traders experience several benefits from an electronic market. For example, this form of trading allows for quick adaptability to market changes. Traders can watch futures prices change in real time around the world and can execute trades within milliseconds. On a single computer screen, traders can focus simultaneously on several different contracts across various markets (foreign exchange and eurodollar deposits, for example). Electronic markets also are likely to generate fewer errors in orders than open outcry trading. Last but not least, market participants can trade electronically from virtually anywhere around the world. This portability lowers traders' cost of doing business and opens up new opportunities for profitable trading.
How do futures contracts benefit the broader economy?
Futures markets are quite important to the global economy since their primary function is to distribute risk efficiently across market participants.
Some participants, like the farmer and baker in the earlier example, use futures to hedge, or reduce their exposure to, risk. These hedgers have a natural demand for futures. By entering into the futures contract, both the farmer and the baker have protected themselves against unprofitable changes in the price of wheat.
On the other end of the spectrum are speculators who use futures to take on additional risk. Speculators have no natural exposure to the risk of changing prices; instead, they buy or sell futures contracts in an attempt to make money by correctly guessing the future direction of changes in wheat prices. If a speculator thinks wheat prices will rise, he takes a long position in wheat futures, and if he is correct he will make a profit.
When speculators and hedgers trade futures contracts, they are acting on their own market analysis about supply and demand conditions in the underlying commodity (such as how a hurricane might affect oil refineries or the growth rate of India's demand for refined sugar). Their trading, in turn, affects futures prices. This process through which individuals' information and analysis become visible to the wider market through futures prices is known as "price discovery."
Every day, millions of individuals and corporations make economic decisions about how to invest their savings and which investment projects to take on. For these decisions to be efficient and investment to flow to its most highly valued use, the broader economy requires a financial market in which prices reflect all of the available information. By providing this type of price discovery, futures markets help to ensure that the overall economy functions effectively.
This article was written by Shalini Patel, a senior economic analyst, and Paula Tkac, a financial economist and associate policy adviser, both on the financial team of the Atlanta Fed's research department.