What is a futures exchange?
A futures exchange is a marketplace where all types of futures and options on futures contracts are bought and sold. Brokers and commercial traders who are members of the exchange have access to the exchange. Members must be registered with the National Futures Association and the Commodity Futures Trading Commission. Individuals wishing to trade futures contracts must have an account with a registered broker. Futures exchanges also offer clearing and settlement functions.
The central theses
- Futures exchanges offer people who want to trade commodities the opportunity to find each other quickly and trade safely.
- Access to the exchange is only available to members.
- Individuals wishing to trade must do so through a brokerage firm that is a member of the exchange.
- Exchanges also offer clearing services.
How a futures exchange works
Futures exchanges provide a market on which these and other derivatives can be traded. The financial incentives for those running the exchange are based on the volume and dollar value of goods traded – the more the better. This means that they are working to increase futures trading, while regulators and industry stakeholders should ensure that the market is fair and without too much volatility. This has given rise to new types of derivatives in recent years and increased participation via electronic networks.
According to the Futures Industry Association, global futures trading more than doubled from 12.1 billion contracts in 2013 to 29.2 billion in 2023. Investors trade futures related to commodities, currencies and cryptocurrencies, electricity, financials, shipping freight weights, indices, interest rates, network bandwidth, tariffs and weather events such as temperature, precipitation and hurricanes. In recent years, the Chicago Mercantile Exchange (CME) has begun offering event-based futures, where you essentially bet “yes” or “no” on questions about the value of currencies, indices, and other assets. The terms end daily, quarterly or annually.
While futures were once traded by open outcry in the trading pits of the CME or the New York Mercantile Exchange (NYMEX), most are bought or sold through the exchanges' electronic networks. Trading worldwide is significantly more decentralized and takes place almost 24 hours a day during the week.
The majority of volume futures trading is conducted by companies looking to hedge against the risks they see in the future. For example, an airline might fear that the price of oil will rise. They could buy futures contracts that set their future fuel prices lower than they think the price might rise. Alternatively, an oil company might sell futures contracts for its product if it fears the price might be too low, leaving it with too little for overhead costs later in the year. So they buy futures, which put a floor on how much they will receive for their oil in several months. Others trade futures to speculate on price changes over time.
Here are two main reasons to trade futures:
- Risk management: Futures exchanges allow hedgers such as farmers, manufacturers and others to manage the risk of price changes in the commodities or financial instruments they trade. By setting prices for future dates, they can protect themselves from market prices that would impact their bottom line.
- speculation: In addition to hedging, futures exchanges offer speculators the opportunity to profit from changes in the price of the underlying assets. Speculators assume market risk in the hope of making profits, but also bring liquidity into the market through their trades.
To promote maximum participation and liquidity, contracts on an exchange have standard sizes, expiration dates and, in the case of options, exercise prices. This is different from forwards, which are traded over-the-counter (OTC) and can have different terms and conditions for each contract.
For futures trading, exchanges offer the following:
- Clearing and settlement: Futures exchanges usually have a clearing house that acts as a counterparty for all trades. Clearing services ensure that participants do not have to worry about the risk that the other party to the contract will default on its obligations, as can be the case with OTC transactions. The clearinghouse also handles trade settlement and daily market valuation of positions, ensuring that profits and losses are reflected in participants' accounts.
- Price publication: By aggregating buy and sell orders from participants regardless of where they trade, futures exchanges provide a price discovery mechanism that reflects the market's assessment of an asset's future value. This is valuable information for producers, consumers and investors.
- standardization: Futures exchanges offer uniform contracts for trading on their platforms that specify the quantity, quality and delivery time of the underlying assets. This helps create liquidity because no one has to negotiate the details of each individual contract.
- Transparency and regulation: Futures exchanges are under regulatory supervision to ensure fair trading practices and transparency. This includes publishing real-time data on prices and quantities.
Average daily futures contracts
The average daily contract volume traded on the Cboe Futures Exchange over the past 30 days was 218,467 (as of February 14, 2024).
A Brief History of Futures Exchanges in the USA
The roots of futures trading in the United States date back to the mid-19th century, before the concept of uniform buying and selling of uniform contracts was fully developed. Farmers have long used forward contracts, private agreements to sell their crops at a later date, to set prices and manage risks. The Chicago Board of Trade, founded in 1848, initially focused on trading grains such as corn and wheat, and futures contracts were traded on the prices of these commodities. Over the next few decades, the railroad and telegraph networks expanded, allowing people in agricultural centers in the Midwest to communicate more quickly with financial centers in Chicago and the East. Soon futures markets quickly expanded beyond just grains. The New York Cotton Exchange (1870) and the Kansas City Board of Trade (1876) emerged, followed by livestock and later metal exchanges. The largest futures exchange in the USA, the CME, was founded in 1898. As futures expanded, speculation increased, attracting traders who had no direct connection to the underlying commodity.
In the 1970s, bond and currency futures emerged on major foreign exchange markets. Today's futures exchanges are significantly larger as the trading volume of derivatives has increased. Financial exchanges have also merged, including the CME and the Chicago Board of Trade in 2007. The company was renamed CME Group and acquired NYMEX Holdings Inc., NYMEX's parent company, and Commodity Exchange Inc. in 2008. In 2012, it grew again and the Kansas City Board of Trade, the main exchange for hard red winter wheat, was added.
Another important exchange for futures in the USA is the Intercontinental Exchange (ICE). ICE was founded in 2000 as an electronic exchange and acquired the International Petroleum Exchange in 2001. In 2007, it merged with the New York Board of Trade and the Winnipeg Commodity Exchange. Finally, the company expanded into equities through its acquisition of NYSE Euronext in 2013.
When was the first futures exchange founded?
The first futures exchange, the Chicago Board of Trade, was founded in the United States in 1848 (then as a spot market), primarily for commodities such as corn and wheat.
Can private investors trade directly on futures exchanges?
Investors must do this through brokers who are members of the exchange and have direct access to the trading floor or electronic trading system. This ensures that only qualified participants participate in trading and market integrity is maintained.
How do futures exchanges differ from stock exchanges?
Both are places for trading financial instruments, but they cover different types of products and purposes. Futures exchanges specialize in futures contracts and other derivatives and focus on hedging and speculating on the future price of assets. Stock exchanges, on the other hand, deal with the buying and selling of shares of companies as well as securities tied to exchange-traded funds and other financial instruments. The permitted trading, the applicable regulations and the type of participants also differ between the types of exchanges.
What is margin in futures trading?
Margin is the amount of money that must be deposited by both the buying and selling sides of futures contracts in order for the trade to occur. These are not costs or fees, but rather a part of the equity that is deposited as security.
The conclusion
Futures exchanges streamline trading by connecting traders and ensuring secure transactions. The exchanges offer clearing services, which further increases confidence in trading. However, access is restricted to member firms and individuals only, meaning independent traders can only invest in futures through a member brokerage firm.
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