- What is Futures markets?
- How the Futures contracts works?
- What risks involved to Futures trading?
- What you must know before trading Futures Market
- Know the risks before investing
- What are the financial guarantees and financial control in futures trading?
- A security deposit (margin)
- Segregation (separation) of customers’ funds
- Financial supervision
- Market regulation
- Checking the risk management procedures
- Defaulting on account of brokerage firm
- Default on the client’s account
- Additional Resources
- Measures of customer protection in case of bankruptcy of a broker
What is Futures markets?
Futures markets are on-going auction markets and clearing houses, where there is the most recent information on supply and demand.
They are a place where buyers and sellers of an ever-expanding list of products meet.
Nowadays this list includes: agricultural products, metals, oil products, financial instruments, foreign currencies and stock indices.
Also trading of options on futures contracts is performed, which gives an opportunity to the option buyers to participate in futures markets with limited (previously known) risk.
Despite the rapid growth and diversification of futures markets, their main objective remains the same as it has been for nearly one and a half century – to provide an effective mechanism of management of price risks.
How the Futures contracts works?
Futures contracts are the contracts in which the price level is set now for the product that will be delivered in the future.
Buying or selling futures, individuals and businesses insure themselves against sudden price changes.
This is called hedging.
Other participants of futures markets are investors-speculators, who take risks from which hedges protect themselves.
Most speculators are not going to make or take delivery of the goods, and try to profit from price changes.
This means that they buy, when they expect increase of prices, and sell when they expect price reduction.
The interaction of hedgers and speculators helps to create active, highly liquid and competitive markets.
Participation in futures trading for speculation has become particularly attractive due to availability of alternative methods of participation.
What risks involved to Futures trading?
At the same time, many futures traders prefer to make their own decisions in trade (what and when buy and sell), while others use the services of professional trading consultants or shift to others the necessity to engage in trading each day, setting up accounts with trust management, or participating in “commodity pool” on the principle of mutual fund.
For individuals who fully understand the risks involved and can take those, placing a part of their capital in futures trading opens the possibility of greater diversification and a potentially higher overall profitability of their investments.
There are also many ways to combine futures with stocks, bonds and other investments.
Yet it is obvious that speculation in futures contracts is not for everyone.
While it is possible to obtain significant gains in a short period of time, it is also quite possible to incur substantial losses in a short time.
The possibility of big profits or losses versus initial capital investment lies primarily in the fact that futures trading is a form of speculation with a lot of leverage.
Only a relatively small amount of money is required to manage assets with a much higher cost.
What you must know before trading Futures Market
With respect to any investment that you are considering, in order to collect the necessary information you need to find answers to the following questions:
- Information about the investment itself and the associated risks.
- How fast it is possible to liquidate your investments or (trade) position if necessary / desired.
- What other participants there are in the market.
- Alternative methods of participation (in the market).
- How the pricing comes out.
- Overhead costs of trading.
- How the calculation of profits and losses is made.
- What the different forms of regulatory control and protection are.
- Experience, “purity” (honesty, reputation, “transparency”) and “track record” (achievements) of your broker or advisor.
- The financial stability of the company you are working with.
Answers to these questions will help you to become an aware investor.
Know the risks before investing
The risk of loss in futures trading can be very high.
You have to decide based on your financial capacity, whether such trading is acceptable to you.
Before undertaking an independent trade or authorize someone to trade on your account, you need to familiarize yourself with the following:
- If you buy an option, you may lose total bonus and commission paid in respect of a transaction.
- Selling uncovered options involves a great and theoretically unlimited risk (in the case of options Call). Due to the strong price movements, the option premium may increase significantly, and the broker can increase the size of margin calls in excess of what SPAN requires, a procedure that determines the minimum level of security funds.
- If you buy / sell a futures contract or sell an option, you can completely lose the value of the original security, and all additional funds that your broker will require to maintain the position. In an unfavourable market movement is possible that your broker will urgently request from you additional funds to maintain your positions. If you find yourself unable to find and transfer the appropriate amount in the time prescribed, your position may be liquidated and you will be financially responsible for any deficiency, which is thus formed.
- Under certain conditions, the elimination of your positions may be difficult or impossible (for example, in the case of Limit-Move or Open Gap).
- Statement of orders such as Stop-loss or Stop-limit does not guarantee the limit of your losses by calculated value, because market conditions may make accurate execution of the warrants impossible.
- Spreading position may be not less risky than the usual ‘long’ or ‘short’ position.
- The presence of “leverage” in futures trading can equally lead to big losses as well as to big profits.
- Investing in Managed Futures involve risk of partial or complete loss of invested funds. You are strongly advised to carefully read the principles of program trading, the major provisions of the applicable risk management procedures, structure and size of payment manager of the manager, before making a decision on practicability of investment in the futures and options market instruments or adding Managed Futures program to your investment portfolio.
It is expressly prohibited by regulatory bodies of the industry to guarantee any future profitability or size of potential losses.
However, involvement of a professional manager can significantly reduce the risk of unplanned losses and make investment activity more predictable.
Bear in mind, however, that no historical results (real or simulated) guarantee their reproduction in the future.
What are the financial guarantees and financial control in futures trading?
In this document we refer to the example of the Chicago Mercantile Exchange (CME), but almost all of the methods of insurance and removal of financial risks also apply to other U.S. exchanges.
The purpose of the whole system of financial control is to avoid default (non-fulfillment of financial liabilities) by any of the participants throughout the payment chain.
The role of the clearing and settlement firms (FCM) As known, the stock trading counterparty of each buyer or seller of futures contracts is the clearing house.
It consists of clearing and settlement brokerage firms (FCM), i.e. namely those firms that enter into brokerage services agreement with clients, accumulate their funds and are accredited as full members of the exchange.
The clearing house requires that each transaction is guaranteed by the relevant FCM.
Only FCMs are representatives of clearing house in the current trade.
The clearing house will never examine or monitor the sufficiency of funds of the non-clearing broker (not entitled to keep the funds of a client) or client.
FCM will in any case be responsible and will pay for all transactions of its customers.
FCM is not entitled to combine the customer funds with their own funds.
In addition, the Commodity Futures Trading Commission (CFTC) and exchanges themselves require FCM to have a certain minimum of owned net capital, namely in the amount of 4% of all client funds deposited in segregated accounts (as below).
The minimum amount is $ 2 million. Moreover, if the net capital is close to 6% of segregated funds, the FCM becomes subject to litigation, so usually FCMs keep the level of their own net capital much higher.
In addition, accounts receivable are not included into assets in calculation of this capital, which considerably enhances the value of net capital.
Financial guarantees The insurance risk system is aimed at: – preventing accumulation of losses and defaults, – providing sufficient resources to cover all futures (future) commitments, – timely identification of financial and operational weaknesses, – ensuring rapid elimination of financial problems and protection of the clearing system.
Debt elimination between the parties of exchange trade as they arise plays a huge role in the financial stability of exchanges.
It is achieved by establishing of official stock quotes for all traded instruments at the end of the trading day, and by bringing all accounts with open positions to that price.
For example, if you bought gold at $ 370/XAU (XAU – troy ounce), and the trading closed at $ 380, then the amount of $ 1,000 will be credited to your account immediately after the trade ends (the amount of the contract is 100XAU).
From that account, which sold gold at $ 370, on the contrary, the same amount will be debited.
Until closing of the position, this reduction of accounts to the market price will happen every day.
This happens without participation or permission of the client which is envisaged by the client’s contract.
If the amount on any account falls below a certain value (maintenance margin), the client will be required to deposit additional funds, or its position will be forcibly closed.
Thus, the participant is deprived of the opportunity to delay payments “until later”, accumulate debts and create the risk of non-payment.
Each day, by the opening of trading the clearing house, on the basis of bringing of all the accounts to the market, the clearing house pays or withdraws money from FCM.
In addition, at 11.30 there is another session for intraday price calculation among FCM (but not on customer accounts), and if the market is very active and there are significant price fluctuations (“volatile” market), there may be another additional session of calculations.
Only on CME the total from $ 2 to 7 billion pass through these payments daily.
This system differs from other markets, including the interbank forex market, stock market, and others.
Their participants regularly take on credit risk against other participants.
At that, the insolvency of one can cause a chain of defaults.
2. A security deposit (margin)
CME sets the minimum initial and maintenance margin level of guarantee for all traded instruments.
The basis for calculation of value of such securities is a historical volatility of prices, the current and expected market conditions, and other relevant information.
From time to time the margin changes to meet the changing conditions.
Margin in futures trading is a deposit guaranteeing fulfilment of commitments.
At disappearance of liabilities (closing of the position) the margin will be unlocked and can be withdrawn from an account, or used for other open positions.
Maintenance Margin is a minimum of funds that should be on the client’s account in order to maintain an open position for the instrument.
For a variety of instruments the margin is different in absolute value, sometimes considerably, but it is always 5-15% of the nominal value of the specific futures contract.
FCM may, at their discretion, increase (or decrease, but only within the day) margin requirements for their customers.
The value of the margin is set by means of mathematical modelling so as to cover the maximum daily fluctuation of prices for the contract (we will omit the details of such fluctuations here).
Often, the value of margin is set with reserve, especially for those markets that react nervously to political news (e.g. crude oil).
Pledges for options reflect price movements of corresponding futures underlying the options, volatility, time to expiration, and other risk factors.
In addition, the premium on long positions is paid by the buyer in full all at once, and on short positions of sellers strict standards of securing are set.
3. Segregation (separation) of customers’ funds
U.S. legislation on futures and options requires that client funds and positions are held separately from the assets and positions of the clearing brokerage firm.
This protects the customer from insolvency or financial instability of the broker.
This applies also to the clearing house – on the basis of specific written instructions from the brokerage firm it keeps the positions and funds of clients separately from the funds of the firm.
Integrity and efficiency of this system depends on timely delivery of instructions by the broker.
Audit Department of CME (as well as other stock exchanges) regularly checks the timing of such orders.
Violations of these rules are considered serious and lead to the serious sanctions.
4. Financial supervision
Reporting: All FCMs submit the full balance to the exchange on the monthly basis, and once a year – the balance, certified by an independent auditor.
Checks: All FCMs are subject to unexpected financial inspections at least once a year.
Inspections focus on the specific risks of futures and options trading.
Exchange of information: Almost all the futures markets are now members of the network on exchange of information in relation to their brokerage firms.
As a rule, the same brokers work on many platforms, so this system allows you to quickly find out about the problems of FCM, before they affect all categories of customers.
Intraday monitoring: During the day, the risk management department several times checks the balance of FCM for the purpose of reduction to the market (see above) of their aggregate positions.
Large loss-making positions are immediately taken under control.
Experts of exchange can even visit the office of the relevant FCM and check whether these positions are secured by deposits, and how this loss will affect the state of the firm.
For this purpose there are numerous mathematical modelling techniques of “stressful” situations and their impact on the balance of the brokerage firm.
As a result of these inspections additional margin may be required or some positions may be closed.
5. Market regulation
Risk Management Department has access (on a confidential basis) to information on all client and broker accounts.
It constantly monitors the accumulation of loss-making positions, particularly in terms of their belonging to related, affiliated customers or brokers.
In addition, experts trace the state of affairs on other markets as well, including the position of participants under suspicion.
This allows taking timely measures aimed at elimination of the risk for the clearing system and its individual members.
6. Checking the risk management procedures
The exchange regularly checks how the work on the identification of risks is organised in the brokerage firms accredited to this exchange.
Defaulting of clearing brokerage firm (FCM) Although exchanges (in this case, CME) supervise their brokers very closely in terms of financial risk, there are special programs in case FCM fails to fulfil its obligations.
7. Defaulting on account of brokerage firm
If FCM fails to fulfil its obligations to the clearing house not in connection with the trading activity of customers, the clearinghouse can immediately do the following: – transfer all the segregated funds and positions of clients to another clearing firm, – transfer management to itself, or even eliminate own positions of FCM, – use a pledge of the firm and its additional insurance premiums to satisfy default obligations – use all the other assets of this FCM (e.g. shares) – use the guarantee issued by the founders of FCM.
The customers’ funds and their positions cannot be used to cover default obligations which arose as a result of the brokerage firm activity itself.
8. Default on the client’s account
If FCM is unable to fulfil its obligations to the clearing house due to a default arising on the account of a client, the clearing house can immediately do the following: – transfer the positions and funds of other clients to another broker, – take control or liquidate positions on the client’s account as well as the broker’s own positions, – use the pledge of this brokerage firm and its additional insurance premiums to satisfy the default obligations – use all other assets of this FCM (e.g. shares).
Despite the fact that clearing house separates (segregates) customer funds from brokerage firms, the client funds of one brokerage firm are kept together on the same account.
Therefore, in case of default of one client other customers of this brokerage firm can potentially suffer.
The positions of other clients at the same time can also be forced to close.
9. Additional Resources
To cover the risk of default for customers and clearing firms not involved in default, CME has a constant credit line of 500 million dollars, the access to which is provided in full on the day of appeal.
The line is provided by a consortium of U.S. and foreign banks.
The next source of financial security – excess funds of the exchange itself – is about $ 100 million.
After this, exchange may resort to the use of the security deposit, made up of contributions from all accredited FCMs.
If that is not enough, the exchange will appeal directly to FCM and request from them to make an emergency deposit to 10% of the total amount of all margin deposited with the clearing house, each in proportion to its share of the security deposit.
10. Measures of customer protection in case of bankruptcy of a broker
In the case of bankruptcy of FCM, U.S. law provides for the satisfaction of firm clients’ claims (with the exception of its affiliates) in the first place.
Clients’ security deposits, as well as the variation margin on open positions that are in the clearing house of the exchange shall not be included in the bankruptcy estate and are returned to customers directly.
Customers working with other brokers (not with those who themselves or whose client got into a situation of default) are fully protected, since their funds in the clearing house under no circumstances can be used to fulfill the contractual obligations of default accounts.
Clients’ protection As mentioned above, the customers bear the risk of loss in a single case if there was a default on the client’s account, which is served in the same brokerage company, and the brokerage company’s financial condition is in such a state, that it cannot make up for these losses.
Protection from such default in the first place consists in monitoring of the level of financial control in FCM.
Exchange, above all, controls the fact that all have made deposits according to their positions, constantly monitors the financial condition of FCM, and if necessary, takes the necessary measures to prevent the crisis.
However, in exchange, there is usually a “second level of client protection,” and namely, the reserve fund.
It is used to compensate customers’ losses if the financial condition of the broker does not allow it to do it on its own, on condition that the losses of the client were caused by this default.
Physical closing of exchange in case of disaster At the stock exchange (e.g. CME) there is a comprehensive and constantly checked backup system of all transactions and financial information for protection from long-term failure / termination of the clearing system work in case of some catastrophic phenomena.
The reserve system fully ensures uninterrupted operation of the exchange.
It includes: – the main backup server located at a different physical address.
Clearing system of exchange may at any time be switched to this backup server, – the system of price quotation runs on a twin Tandem Computers server, besides, there is also a physically remote backup server, – all entries of clearing and trading operations are duplicated, and copies are stored in a physically remote location, – back-up systems of telecommunications, telephone, – backup uninterruptible power supply – for cases of failure in the urban scale, as well as back-up in case of urban local substations for cases of local failure.