In Trading Futures, Thomas K Sneider briefly explains how futures developed. Instead of re-inventing the wheel, this is narrated below with additions and modifications of our own.
The origins of modern day futures exchanges date back to the central market places of the ancient Greek and Roman civilizations, where standardized practices of trading goods began. Methods were developed that coupled fixed times and places for trading as well as methods to store and deliver goods in the future. After the decline of the Greek and Roman civilizations, centralized trading re-emerged during the medieval times of the twelfth century.
Advances were made in the practices of self-regulation and arbitration in Medieval England, and a code known as the Law Merchant established standards of conduct acceptable to local authorities. Those that violated the standards were banned from trading and were often punished, sometimes even tortured. After Enron and endless scandals involving major brokerage houses on Wall Street, maybe the ancients had the right idea.
By the fourteenth century, the English Merchant Association was born and was recognized under common law as the arbitrator of trade disputes among members. The principles of self regulation found in English Common Law then followed settlers to the American colonies. That explains how, as early as 1752, commodity markets existed in the United States to accommodate the trade of items as diverse as textiles, metals and lumber. And so there we have 3000 years of history compressed into 3 paragraphs. No more is needed to bring us to recent times.
The history of futures trading begins in Chicago. The windy city's strategic location on Lake Michigan, easy access to the other Great Lakes and proximity to the fertile fields of the Midwest, helped contribute to its rapid rise as the nation's Grain Terminal. But not all was rosy.
An unorganized market for the abundant crops pouring in from the heartland created problems with mixing and matching supply, demand, transportation and storage. The simple model of buyer and seller getting together was not working. Often a farmer would spend as much to transport a wagon of wheat to Chicago as he did to produce the crop. Once the commodities reached the city, the farmer further encountered difficulty with distribution to outlying markets. A more organized approach to selling the crops was desperately needed.
These conditions prompted farmers and merchants to contract for forward delivery as a mechanism to offset the uncertainty of the future by establishing a price for future goods. The first recorded forward contract traded in Chicago was made on March 13, 1851. The delivery of 3,000 bushels of corn was to be delivered to Chicago in June at a price of one cent below the price on March 13th. Shortly thereafter, forward contracting began in wheat. These types of transactions eventually gave rise to the Chicago Board of Trade (CBOT), which was formed to establish a centralized meeting place for buyers and sellers of commodities. During the early days of the Board, forward contracts were the primary means of trading.
At first, forward contracts were not standardized according to quality and time of delivery. Another problem was that people are people, and therefore merchants and traders often did not meet their obligations. To circumvent these problems, a margining system was developed to help eliminate the problem of buyers and sellers not fulfilling their contracts. A margining system simply requires both the buyer and seller of the contract to deposit funds with the exchange to guarantee performance.
In 1865 the CBOT took the next step toward modern futures trading by creating a standardized agreement known as a futures contract. A futures contract is a legally binding agreement between two parties to buy or sell in the future a specific item (commodity) at a specific price. The buyer and the seller agree on a price for an item to be delivered at a specific time in the future. In futures trading today, the item traded is rarely delivered. Instead, the futures contract is closed out prior to the delivery date, either for a profit or a loss.
Futures contracts differ from forward contracts in several critical ways. First, futures contracts are traded on exchanges, while forward contracts are two-party agreements between a buyer and a seller. With futures contracts, buyers and sellers never meet, and have no knowledge of each other. Second, futures contracts rely on pre-established standards that ensure that the product being delivered will be of uniform quality. Third, a futures contract establishes a specific unit (quantity) to be traded, while the size of a forward contract is set by the buyer and the seller. Fourth, times for delivery are standardized with the futures contract. Trading months were agreed upon by grain merchants and farmers based on harvesting and transportation conditions.
As futures contracts became standardized, contracts were no longer between individuals, but part of the exchange. This had an important impact: each contract on the same commodity, and with the same delivery month, was now interchangeable. A trader could establish a futures position, and exit that position, without ever accepting delivery. In such a market, the only variable between entry and exit is price.
Standardization, a margining system and modern futures contracts all combined to allow speculators to enter into the grain trade. Speculators in turn allowed the market to become more efficient because individuals not associated with the grain trade could enter into futures trading with the hopes of securing a profit by correctly predicting prices in the future. Because speculators buy or sell contracts that may not have otherwise been traded, speculators make the market larger and more liquid and help to minimize price fluctuations.
As a direct result of standardization, futures trading exploded on the scene, and by the late nineteenth and early twentieth centuries, new exchanges were formed to trade diverse commodities such as coffee, cattle, pork bellies, orange juice, and crude oil. Eventually the futures industry expanded to include foreign currencies and contracts on government debt traded through notes and bonds. The dollar volume traded in the futures markets now exceeds that of all of the world's stock markets.
Futures markets today are continuous auctions that take place exclusively in organized exchanges such as CBOT. Commodity exchanges exist today to facilitate and regulate futures trading. The exchanges serve as virtual meeting places where buyers and sellers of a particular commodity come together to trade futures contracts of pre-determined quantity, quality, and delivery dates. The only variable is price, which is established (discovered) through the auction-like process on the trading floor of the futures exchange.
Different exchanges tend to specialize in specific commodities. For example, the Chicago Mercantile Exchange (CME) trades, among other commodities, beef, hogs, dairy, lumber, and foreign currencies, while the CBOT specializes in crops (like wheat and soybean), metals and interest rate contracts on Treasury bonds and notes. Both exchanges trade indices, but not the same ones, while some interest rate contracts (generally on foreign currencies) are traded on both. One way or another, all futures contracts are traded at a futures exchange.
A futures contract can trade hands thousands of times before the delivery date, and there is no way for Trader Joe to keep track of who is on the other side of the transaction. One of the most important functions of a futures exchange is to provide this clearinghouse operation. As a clearinghouse, the exchange acts as a third party to every futures transaction and is the guarantor of every trade. The clearinghouse insures that the markets function with integrity.
The clearinghouse is the agency of the futures exchange that is responsible for clearing trades and for the day-to-day recording of all trades at the exchange. At the end of each session, the clearinghouse must reconcile the contracts bought and sold, and settle each trader's account to the market.
Exchange clearing houses can guarantee every trade because the buyers and sellers are required to have funds in their accounts called margins, a direct descendent of the early margining systems developed with the old forward contract markets. Margins are essentially performance bonds that guarantee that the buyer and seller have sufficient funds in their accounts to execute the transaction. Margin amounts vary among different commodities, but are standardized by the individual exchanges. Margins are important, because they can largely determine the capital requirements to trade, and therefore directly affect rate of return.
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