Posted By: Ilan Levy-Mayer Vice President, Cannon Trading Futures Blog
Futures contracts are one of the most important financial innovations in history, but they are often misunderstood. These contracts are used to transfer risk between different parties. Futures markets originated as a way for producers to stabilize their income and/or raw material supply amid market fluctuations, but it soon grew into a way for speculators to bet on the direction of a given commodity. These two market forces interact to create the futures markets that we know today and each plays a critical role in the market’s dynamics.
Forward contracts vs. Futures contracts
Before the North American futures market originated some 150 years ago, farmers would grow their crops and then bring them to market in the hope of selling their inventory. But without any indication of demand, supply often exceeded what was needed and unpurchased crops were left to rot in the streets! Conversely, when a given commodity – wheat, for instance – was out of season, the goods made from it became very expensive because the crop was no longer available.
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In the mid-nineteenth century, central grain markets were established and a central marketplace was created for farmers to bring their commodities and sell them either for immediate delivery (spot trading) or for forward delivery. The latter contracts – forward contracts – were the forerunners to today’s futures contracts. In fact, this concept saved many a farmer the loss of crops and profits and helped stabilize supply and prices in the off-season.
On March 27, 1863, the Chicago Board of Trade adopted its first rules and procedures for trade in forwards on the exchange (Hieronymus 1977, 76). The rules addressed contract settlement, which was (and still is) the fundamental challenge associated with a forward contract – finding a trader who was willing to take a position in a forward contract was relatively easy to do; finding that trader at the time of contract settlement was not.
The CBT began to transform actively traded and reasonably homogeneous forward contracts into futures contracts in May, 1865. At this time, the CBT: restricted trade in time contracts to exchange members; standardized contract specifications; required traders to deposit margins; and specified formally contract settlement, including payments and deliveries, and grievance procedures (Hieronymus 1977, 76).
The inception of organized futures trading is difficult to date. This is due, in part, to semantic ambiguities – e.g., was a “to arrive” contract a forward contract or a futures contract or neither? However, most grain trade historians agree that storage (grain elevators), shipment (railroad), and communication (telegraph) technologies, a system of staple grades and standards, and the impetus to speculation provided by the Crimean and U.S. Civil Wars enabled futures trading to ripen by about 1874, at which time the CBT was the U.S.’s premier organized commodities (grain and provisions) futures exchange. 1
Today’s futures market is a global marketplace for not only agricultural goods, but also for currencies and financial instruments such as Treasury Bonds and securities (securities futures). It’s a diverse meeting place of farmers, exporters, importers, manufacturers and speculators. Thanks to modern technology, commodities prices are seen throughout the world, so a Kansas farmer can match a bid from a buyer in Europe.
Futures markets are available based upon stock indexes (such as the Nasdaq or FTSE 100), currencies (such as the Euro to US Dollar exchange rate), commodities (such as Gold and Silver), agricultural products (such as Corn and Wheat), and even weather (you can actually trade Snow futures).
Futures Markets originated as a way for producers to stabilize their income and/or raw material supply amid market fluctuations, but it soon grew into a way for speculators to bet on the direction of a given commodity. These two market forces interact to create the futures markets that we know today and each plays a critical role in the market’s dynamics.
The Commodity Futures Trading Commission (CFTC)–the government body responsible for regulating the futures market-classifies market participants as “commercial traders” or “non-commercial traders” (otherwise referred to as speculators).
These two parties are defined by the CFTC as follows:
- Commercial traders are those that use futures in a given commodity in order for hedging purposes, as defined in CFTC regulations.
- Non-commercial traders are those that do not own the underlying assets or its financial equivalent and only hold positions in futures contracts.
- Commercial hedgers and speculators play very different roles in the futures marketplace, but both are necessary in order to keep things running smoothly. Generally, commercial hedgers have large, long-term needs that are filled by liquidity that’s generated from shorter-term speculators that are more in-tune with future supply and demand conditions.
- Despite the apparent benefits, speculators have been the source of controversy in the futures market. The presence of purely financial speculators that began entering the market en masse in 2003 has led to concern that they are pushing up the price of crude oil as much as 40%, according to testimony from Exxon Mobil’s Rex Tillerson in 2011.
- The anecdotal evidence may be high, but there is little statistical evidence backing this assertion, according to several academic papers. For instance, a 2009 Federal Reserve report entitled, “Does Speculation Affect Spot Price Levels?”, found no evidence that speculative activity in the futures markets for industrial metals caused higher spot prices in recent years.
- A separate 2012 study, entitled “The Role of Speculation in the Oil Markets: What Have We Learned So Far,” found strong evidence that the co-movement between spot and futures prices reflects common economic fundamentals rather than the financialization of the oil markets – that is, speculators provide liquidity without significantly impacting spot prices. (2)
The Futures markets are here to stay and a credible and important role in risk management for a variety of participants in economically viable capitalistic societies.
- Joseph Santos, South Dakota State University 2-5-2010
- Commodity Futures Trading Commission C.F.T.C.
SPECIAL NOTE: Trading Futures, Options on Futures, and retail off-exchange foreign currency transactions involves substantial risk of loss and is not suitable for all investors. You should carefully consider whether trading is suitable for you in light of your circumstances, knowledge, and financial resources. You may lose all or more of your initial investment. Opinions, market data, and recommendations are subject to change at any time.