CHAPTER 2

Futures Markets Refinements

In this chapter, we explore the structure of futures markets

and consider some current issues facing the futures
markets. This chapter is organized into the following
sections:

1. Margin Systems and Spreads

2. Exchange Competition

3. Contract Innovation and Contract Success

4. The Internationalization of Futures Markets

5. Future Market Players

6. Current Futures Industry Issues

7. Market Manipulation

Chapter 2 1
 Spreads

Spread

A spread occurs when a trader holds a combination of

related futures positions. In this section, we explore two
types of spreads:

1. Intra-market Spread

A spread position with both futures positions on the same

commodity. This reduces the risk of a spread relative to a
single contract. Exchanges impose lower margin
requirements on such spreads.

2. Inter-market Spread

A spread in two distinct, but related, commodities.

Exchanges determine which commodity pairs qualify for
inter-market spread. Margin requirement are lower in
qualifying inter-market spreads.

Chapter 2 2
 Margin Systems on Spreads

Inter-Market Cross-Margining

A margining systems that recognizes a spread between

two distinct, but related commodities.

This system establishes a trader's margin requirement by

considering the trader's entire portfolio, even if parts of the
portfolio are held in different exchanges.

Standard Portfolio Analysis of Risk (SPAN)

A partial cross-margining system that offers cross-

margining between futures and options on futures by
considering the entire portfolio in setting margin
requirements.

Chapter 2 3
 Margin Systems & Spreads

Table 2.1
Examples of Intermarket Spreads
Qualifying for Spread Margin Treatment
Exchange Commodity Pair
Chicago Board of Trade Treasury bonds vs. Treasury notes
Any pair of wheat, corn, or oats
Any pair of soybeans, soyoil, or soymeal
Gold vs. silver
Chicago Mercantile Exchange Eurodollars vs. Treasury bills
Any pair of foreign currencies (British pound,
European Union Euro, Swiss franc, Japanese
yen, Canadian dollar, Australian dollar)
Any pair of cattle, feeder cattle, or hogs
Pork bellies vs. hogs

Chapter 2 4
 Margin Systems & Spreads

Intra-Market Spread

Commodity B
Long Position
Month 1
Trade A Exchange C
Commodity B
Short Position
Month 3

Inter-Market Cross-Margin
Commodity C
T Exchange E
Long Position
R
A
D Broker B
E
R Commodity D
Exchange F
Short Position
A
Chapter 2 5
 Margin Systems and Spreads

Benefits of the Cross-Margining System:

1. Lower initial margin.

2. Central clearinghouse to serve various markets.

3. Increase trading due to lower margins.

4. Helps US exchanges compete with foreign financial

markets.

5. Reduces forced sell-offs by some traders during

periods of dramatic price changes.

Risks Associated with Cross-Margining:

1. Potential for an increase in the overall risk of system-

wide default.

2. Offsetting positions my diverge from their normal

relationship.

Chapter 2 6
 Margin Systems & Risk Measurement

Value-at Risk (VAR)

Offers a statistical measure of risk exposure. Simulations

such as Monte Carlo or historical simulation are used to
estimated VAR.

Risk Metrics

Risk Metrics is another analytical technique to measure

risk exposure. Works well with “linear instruments.”

Chapter 2 7
 Exchange Competition

Futures exchanges are businesses that create markets.

Therefore, exchanges compete through:
1. The technology employed

2. The innovation in the design of the contracts

3. The fees charged

4. International competition

5. The business models adopted

6. The quality of trading information provided

Chapter 2 8
 Technology Employed

Exchanges compete on two levels:

1. Floor trading versus electronic trading

Trading costs, increase trading volume and overall

trading efficiency are key elements in this level of
competition.
2. Competition between exchanges to become the
market host

Exchanges rarely offer similar contracts. Trading

volume tends to migrate to one exchange and stay
there. However, subsequent migration can occur (e.g.,
the Eurex & the Bunk Contracts).

Chapter 2 9
 Technology Employed

Ele c tro nic Tra ding v s . P it Tra ding (19 9 8 -2 0 0 3 )

600, 000, 000

500, 000, 000

400, 000, 000

Contr ac ts
300, 000, 000
T r ade d
E l e c t r onic T r a ding

200, 000, 000 P i t T r a ding

100, 000, 000

-
2003 2002 2001 2000 1999 1998

Year

Chapter 2 10
 Technology Employed
Floor Trading Versus Electronic Trading

1. Electronic trading is gradually displacing open outcry

trading in the US.

2. U.S electronic trading has impacted the way

exchanges are structured, as more exchanges move
from non-profit to for-profit organizations.

3. Electronic trading dominates in foreign exchange.

4. Electronic trading has made 24-hour trading possible in

some futures contracts.

5. Electronic trading technology has become a important

asset to the exchange.

6. Electronic trading helps reduce out-trades (a price or

quantity discrepancy between the trade data
transmitted by the seller and the buyer’s brokers).

7. In electronic trading, there are other types of errors

including: “fat finger” (adding an extra zero to an order
before sending it electronically).

Chapter 2 11
 Innovation in Contract Design

Exchanges compete by:

1. Trading contracts in a group of related, complementary

contracts.
Example: CBOT soybean complex contracts.

2. Creating product differentiation

Example: CBOT and Minneapolis Grain Exchange
wheat contracts specify different deliverable
grades.

3. Calling for product delivery at different locations

Example: CBOT and Minneapolis Grain Exchange call
for delivery of wheat at different places.

4. Competing with other markets

Example: SWAPS as substitute for exchange-traded
futures contracts.

Chapter 2 12
 Innovation in Contract Design

Table 2.3 shows ten factors that increase the chance of a

contract’s success.

Table 2.3
Commodity Characteristics Desirable for Futures Trading
1. Large cash market 6. Good contract design
2. Substantial price volatility 7. Strong support from exchange
3. Good information on cash prices members
4. Lack of close substitutes 8. Large deliverable supply
5. Availability of related contracts for 9. Absence of regulatory barriers
spread trading 10. Homogeneous cash commodity

Chapter 2 13
 Exchange Fees

CME 2002 Income Statement Excerpt

Revenues

Clearing and transaction fees $356,396,000

Quotation Data fees $ 48,717,000

GLOBEX access fees $ 12,945,000

Communication fees $ 9,733,000

Investment income $ 7,740,000

Securities lending interest $ 18,169,000

Other $ 15,379,000

Chapter 2 14
 International Competition

Insert figure 2.1 here

Chapter 2 15
 International Competition

Growing Foreign Exchange

In 1988, US futures market’s volume was 69.11% of the

world’s total. Today, 5 of the top 10 most successful
contracts are traded on foreign exchanges.

Today, many exchanges are truly global enterprises that

cannot be easily classified by geography.
Table 2.5
Top Ten Futures Contracts Worldwide
2003
Volume
Contract Exchange (millions)
Euro Bund Eurex 224.4

3-month Eurodollar Chicago Mercantile Exchange 208.8

TIIE 28 Day Mexican Derivatives Exchange 162.1

E-Mini S&P 500 Chicago Mercantile Exchange 161.2

3-month Euribor Eurex 150.1

U.S. 10-year T-Note Chicago Board of Trade 146.8

3-month Euribor Euronext 137.7

DJ Euro Stoxx 50 Eurex 116.0

U.S. 5-year T-Note Chicago Board of Trade 73.8

E-mini Nasdaq Chicago Mercantile Exchange 67.9

Source: Futures Industry Association for calendar year 2003.

Chapter 2 16
 International Competition

U.S. Trading of Foreign Products

U.S. laws and regulations do not restrict the offer and sale
of foreign exchange-traded futures products in the United
States.

Exception

U.S. law requires that the CFTC approves foreign stock

index futures products before they can be offered for sale
in the United States.

International Competition and Trading Costs

US exchanges are still able to compete on trading fees.

This advantage reflects the economies of scale in
operating a futures exchange.

Chapter 2 17
 Futures Market Players

Futures Exchanges have multiple players. In this section,

the following players will be discussed:
1. Floor Broker

2. Futures Commission Merchant

3. Introducing Broker

4. Associated Person

5. Commodity Trading Advisor

6. Commodity Pool Operator

Chapter 2 18
 Futures Market Players

Floor Broker (FB)

An individual located in the exchange floor who executes

an order for the purchase or sale of a futures contract for
another person . Electronic trading has created an “e-local”
who performs the same function as the floor trader.

Futures Commission Merchant (FCM)

A brokerage firm that accepts orders to trade futures on

behalf of public customers and who accepts money to
support such an order. FCMs must be registered at NFA
and public customers must use a FCM to trade at an
organized exchange.

Introducing Broker (IB)

An individual or firm that accepts orders to trade futures,

but who does not accept the funds from customers.

Chapter 2 19
 Futures Market Players

Associated Person (AP)

Account executives and sales people who deal directly with

customers on behalf of an FCM or IB.

Commodity Trading Advisor (CTA)

A individual who directly or indirectly advises others

regarding their futures trading.

Commodity Pool Operator (CPO)

An individual or firm that pools together the funds of many

investors into a single account for the purpose of trading
futures and futures options. This is done much in the same
way as a mutual fund.

Chapter 2 20
 Futures Industry Registrants

Table 2.4
Futures Industry Registrants
Brokers, Advisors, and Fund Managers

Number
Category (September
30, 2003)
Associated Persons (AP) 48, 062

Commodity Pool 2,059

Operators (CPOs)

Commodity Trading 2,812

Advisor (CTA

Floor Broker (FB) 8,756

Floor Traders (FT) 1,458

Futures Commission 205

Merchant (FCM)

Introducing Broker (IB) 1,646

Total 64,998
Source: CFTC 2003 Annual Report.

Chapter 2 21
 Current Futures Market Issues

Exchange Governance

How exchanges deal with conflicts of interest between its

member and public customers.

Clearinghouse Governance

Should clearinghouse functions be separated entirely from

the trade execution function?

Clearing of OTC Derivatives at Futures Clearinghouses

Should futures and OTC be mingled for clearing purposes?

Some argue that this practice may increase systematic
risk.

Chapter 2 22
 Current Futures Market Issues

Churning

A form of fraud in which a broker executes excessive

trading in a client's account seeking to maximize his/her
commissions regardless of the client's best interests.

Bunched Orders and Post-Trade Allocations

A bunched order is a collective trade on behalf of several

accounts. Federal regulations prohibit brokers, advisor and
others market professionals from allocating orders among
accounts after trades have been executed. This regulation
aims to prevent allocating trades in unfavorable fashions.

Chapter 2 23
 Current Futures Market Issues

Block Trading

A large trade negotiated away from the exchange, but

pursuant to exchange rules, and then submitted to the
exchange for clearing and settlement. Traders engage in
block trading to avoid the risk of having their trade broken
up and filled at multiple, and uncertain prices.
– Some argue that exchanges should adopt rules setting
strict price parameters on block trades to avoid
fragmenting and undermining of the price discovery
function of the market.

– Others fear that strict limits on pricing would only drive

block traders away from the futures markets toward the
over-the-counter market, further fragmenting the market.

Chapter 2 24
 Current Futures Industry Issues

Dual Trading
In dual trading, a single individual fulfills the function of a
floor trader and a floor broker simultaneously.
– Critics argue that dual trading can facilitate front running
and other questionable trading practices.
– Defenders maintain that dual trading promotes liquidity in
the market and that dual trading keeps trading costs low.

Table 2.6
Major Findings of CFTC Study of Dual Trading
1. Dual traders tend to specialize in acting as floor brokers or floor traders.

2. Dual trading is not more prevalent in low volume markets or more distant
trading months.

3. Dual traders do not achieve better execution than nonBdual brokers.

4. Dual traders do not perform better than nonBdual brokers in providing

market liquidity.
Source: Commodity Futures Trading Commission, AEconomic Analysis of Dual
Trading on Commodity Exchanges,@ November 1989.

Chapter 2 25
 Current Futures Market Issues

Payment for Order Flow

Practice of some exchanges that pay brokers to direct

orders to them.
Proponents argue that this practice ultimately benefits the
investors by receiving lower trading costs.

Critics of this practice argue that this practice will distort open
competitive and efficient trading by making practices such as
“wash trading” attractive to brokers.

Event Markets

Event market allows participants to profit from occurrence

of a specific event.
Policy Analysis Market (PAM) and Iowa Electronic Markets
(IEM) are examples of event markets.

Chapter 2 26
 Market Manipulation

Market manipulation undermines the price discovery

functions of futures markets.

Federal courts use a four pronged test to determine if

manipulation has occurred:
1. That the accused had the ability to influence market
prices.

2. That the accused specifically intended to do so.

3. That an artificial price occurred.

4. That the accused caused an artificial price.

Chapter 2 27
 Market Manipulation

Market Power Manipulation

Occurs when a trader has control of a commodity

and a large futures position allowing him/her to corner or
squeeze the market.
Corners

Trader influences the price of a futures contract by

gaining control over trading in the futures and the
deliverable supply of the underlying good.

Squeezes

Trader achieves effective control over the price of a

futures contract due to disruptions in the supply of the cash
commodity.

The Hunt Silver Manipulation

The Alleged Soybean Manipulation of 1989

Chapter 2 28
 Market Manipulation

False Report Manipulation

Knowingly making false communications or misleading or

inaccurate reports concerning crop or market information
or conditions that affect the price of any commodity.

Micro-manipulation

Momentary rigging of a futures contract’s settlement price.

It involves the intent to trade in a way that creates an
artificial price that last only an instant.

Chapter 2 29