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History of Futures
The history of futures trading is, in a sense, two histories, both focused on how people have tried to improve the effectiveness of the commercial marketplace. The early story is a tale of how people in an agrarian society used forward contracts (agreements to buy now, but pay and deliver later) as a means of getting farm commodities efficiently from producers to consumers, at established prices and delivery terms, and how those forward contracts evolved into futures contracts. The present day story explains how the futures industry reinvented itself in the latter part of the twentieth century, essentially by redefining the meaning of “commodity,” so that it could accommodate the needs of complex financial markets in a society whose economy was no longer based primarily on agriculture.
The Early Story on commodities
Commodity markets have existed for centuries around the world because producers and buyers of foodstuffs and other items have always needed a common place to trade. Cash transactions were most common, but sometimes “forward” agreements were also made – deals to deliver and pay for something in the future at a price agreed upon in the present. There are records, for example, of “forward” agreements related to the rice markets in seventeenth century Japan; most scholars agree that forward arrangements actually date back much farther in time.
The immediate predecessors of futures contracts were “to arrive” contracts. These were simple agreements to purchase designated goods when they arrived by ship, and they were used for centuries when shipping was the primary mode of international trade.
The first organized grain futures trading in the U.S. began in places such as New York City and Buffalo, but the development of “modern” futures, which are a unique type of forward agreement, began in Chicago in the 1840s. With the construction of the railroads, Chicago began to emerge as a center for transportation between midwestern producers and east coast population centers. The city was a natural hub for trade, but the trading that took place there was inefficient and unorganized until a group of Chicago-based business men formed the Board of Trade of the City of Chicago in 1848. The Board was a member-owned organization that offered a centralized location for cash trading of a variety of goods as well as trading of forward contracts. Members served as brokers who facilitated trading in return for commissions.
As trading of forward contracts increased, the Board decided that standardizing those contracts would streamline the trading and delivery processes. Instead of individualized contracts, which took a great deal of time to negotiate and fulfill, people interested in the forward trading of corn at the Board, for example, were asked to trade contracts that were identical in terms of quantity, quality, delivery month and terms, all as established by the exchange. The only thing left for traders to negotiate was price and the number of contracts.
These standardized forwards were essentially the first modern futures contracts. They were unlike other forwards in that they could only be traded at the exchange that created them, and only at certain designated times. They were also different from other forwards in that the bids, offers and negotiated prices of the trades were made public by the exchange. This practice established futures exchanges as venues for “price discovery” in U.S. markets.
In contrast to customized contracts, standardized futures contracts were easy to trade, since all trades were simply re-negotiations of price, and they usually changed hands many times before expiration. People who wanted to make a profit based on a fortuitous price change, or alternatively, who wished to cut mounting losses as quickly as possible, could “offset” a futures contract before expiration by engaging in an opposite trade: buying a contract which they had previously sold (or “gone short”), or selling a contract which they had previously bought (or “gone long”).
The usefulness of futures trading became apparent, and a number of other futures exchanges were established throughout the country in the decades that followed. The Chicago Butter and Egg Board was founded in 1898 and evolved into Chicago Mercantile Exchange (CME) in 1919. Futures exchanges also opened in Milwaukee, New York, St. Louis, Kansas City, Minneapolis, San Francisco, Memphis, New Orleans and elsewhere. Chicago, however, became the most influential and predominant location for futures trading in the U.S.
The Era of Financial Futures
Throughout the first seven decades of the twentieth century, the futures industry remained essentially as it had been – focused on the trading of futures on agricultural products. But a remarkable change occurred in the industry in 1971, with the introduction of futures based on financial products.
A New Concept: Futures on Foreign Currencies
Until 1971, world currencies had been pegged to an international gold standard, but that year the gold standard was abolished and currency values were allowed to “float.” Leaders of CME recognized that a currency whose value was determined by market forces had become a commodity like any other, and therefore futures could be traded on it. There was (and still is) an enormous forward market for currency trading, but until then there were no exchange-traded, standardized futures on currencies. As with futures on agricultural commodities, currency futures offered an opportunity to hedge against risks in price changes, as well as to profit from changes in values. That year, CME formed the International Monetary Market (IMM), initially a separate exchange closely linked to CME, and hosted its first futures trades on foreign currencies.
The notion of trading futures on currencies was highly controversial. But the concept garnered credibility from the support of economist Milton Friedman, who pronounced that the IMM would “enable the world to operate more smoothly and effectively.” Friedman proved correct, and now currency futures have become an integral part of international finance.
Interest Rate Futures
For many people it is one thing to understand the agricultural futures markets and even currency futures, but quite another to begin to imagine futures on interest rates. Like agricultural products and currencies, however, interest rates – the price of money – vary according to market pressures, and in this sense, they can also be viewed as a type of commodity. Since many businesses are subject to risk as rates change, the futures industry reasoned that interest rate futures could offer opportunities for hedging against rising or falling rates or capitalizing on rate changes, as did futures on other commodities. CME launched its first interest rate product in 1976 – a 90-day U.S. Treasury bill futures contract – and over the next six years it became CME’s most actively traded product.
CME then proposed trading futures on interest rates paid for U.S. dollars on deposit overseas – dubbed “Eurodollars” – and again broke new industry ground by making Eurodollar futures the first futures contract which did not feature an actual or physical delivery but rather used cash settlement. Cash settlement eliminated the difficulty of physically delivering interest obligations, such as Treasury bills or notes, and thereby expanded the range of products upon which futures could feasibly be traded.
Stock Index Futures
Like currencies, interest rates, and crop prices, stock index values also vary according to numerous market pressures. Changes in index values can positively or negatively affect businesses that depend on them, such as mutual fund companies and pension funds. Stock indexes, then, also fit into the expanded definition of “commodity.” In the early 1980s, stock index values had become the barometers of overall health of the stock markets, and stock index futures drew an immediate audience because they enabled people to trade the values of “the market” without having to own any individual shares.
CME launched its first stock index futures contract, the S&P 500® contract, in 1982. Stock index traders quickly learned that they could use the futures markets to hedge against falling prices and take advantage of rising prices. When a market move took place, traders could use index futures to either protect their investments or increase their position in the market without having to actually buy or sell stocks. Stock index futures are also appealing in that they are typically less costly and easier to buy and sell than buying and selling shares of hundreds or even thousands of stocks.
Quite clearly, trading futures on stock index levels was a far cry from trading on live cattle or corn. The futures industry, however, led by the innovative thinking at CME, had learned how to expand its markets and to meet the risk management needs of our complex, post-agrarian society.
What are futures?
Futures are contractual agreements made between two parties through a regulated futures exchange. The parties agree to buy or sell an asset - livestock, a foreign currency, or some other item - at a certain time in the future at a mutually agreed upon price. Each futures contract specifies the quantity and quality of the item, expiration month, the time of delivery and virtually all the details of the transaction except price, which the two parties negotiate based on current market conditions. Some futures contracts call for the actual, physical delivery of the underlying commodity or financial instrument at contract termination. Others simply call for a cash settlement at contract termination. Generally, however, market participants do not hold their futures contracts until termination but rather offset futures contracts they have bought ("gone long") by a subsequent sale; or, offset futures contracts they have sold ("gone short") by a subsequent purchase.
Futures contracts are also called derivatives, because their value is derived from the market value of the underlying commodity or financial instrument on which the contracts are based. Futures traded on exchanges regulated by governmental agencies may be distinguished from derivatives traded over-the-counter.
In broadest terms, futures are about anticipated future prices of basic commodities and financial instruments, based on current information. Futures are concerned with such questions as what will the price of cattle be next December? What will interest rates be in six months? How much will a euro be worth in May?
Because commodity prices are constantly changing, virtually all businesses face ongoing price risk. Meat processors face risk from fluctuating cattle prices, lenders from changing interest rates, and international businesses from varying currency rates. All these businesses can use futures to help manage their exposure to price risk.
Futures contracts – price agreements – are bought and sold in what is basically a marketplace of opportunity for two symbiotic groups: hedgers, who seek to offset price risk, and speculators, who try to make a profit from favorable price fluctuations. Hedgers are typically businesses and financial institutions who buy and sell futures contracts seeking to “lock in” future prices for commodities that are essential to their business operations. Speculators are a diverse group that includes day traders, financial institutions such as banks and hedge funds, and arbitragers. These groups are brought together at a futures exchange, which provides a venue where their orders may interact on a trading floor or a computer network, and where price agreements can be negotiated.
Traders’ decisions generally aren’t random, but are based on a synthesis of a great deal of data and a variety of different strategies. Some people make trading decisions based on fundamental analysis of the forces of supply and demand in a commodity market (“fundamental analysis”); others trade based on an analysis of market trends and price chart patterns (“technical analysis”).
Because futures prices represent the aggregate of all available information that may affect the market, they are viewed as reflecting a process of “price discovery.” Prices change constantly in response to numerous factors, ranging from weather and wars to political decisions and popular trends. The futures markets assimilate that information and provide a means of determining the price above which buyers will not buy and below which sellers will not sell – the “equilibrium” price – where the supply to be sold and the demand to buy are in balance. The price of futures and the underlying cash markets on which futures are based tend to come together or “converge” by contract expiration. The price of a futures contract at expiration and the cash (“spot”) price of the underlying asset must be the same, because both refer to the same asset are basically equivalent, because both prices refer to the same asset.
What is a futures exchange?
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A futures exchange, legally known in the U.S. as a “designated contract market,” is, at its core, an auction market – highly regulated, technical and complex – but an auction market nonetheless.
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A futures exchange is the only place where futures and options on futures (which offer the right, but not the obligation, to buy or sell an underlying futures contract at a particular price) can be traded. Trading may take place either on the exchange’s trading floor or via an electronic trading platform. An exchange itself does not trade futures. Instead, it:
- Provides and maintains the facilities where buyers and sellers meet, ranging from traditional “trading pits” to global electronic trading networks
- Researches, develops and offers futures contracts to be traded
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Oversees the trading of its products and enforces trading-related rules and regulations
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Monitors and enforces financial and ethical standards
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Provides daily and historical data on the contracts traded under its auspices
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Futures exchanges in the U.S. are subject to a great deal of regulation. They are monitored by the Commodity Futures Trading Commission (CFTC) and the National Futures Association (NFA). In addition, most futures exchanges practice intense self-regulation, monitoring their employees and the trading practices that occur in their facilities.
These agencies look after the public interest, ensure fair practice and monitor the process of price discovery that occurs in futures trading. Other governmental bodies, including the Securities and Exchange Commission, the Federal Reserve Board, and the U.S. Treasury Board also monitor some futures exchange functions. Violations of exchange rules can result in substantial fines, as well as suspension or revocation of trading privileges.
Futures Exchanges in the U.S. and Abroad
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There are currently 13 futures exchanges registered in the U.S. but not all are hosting active trading. CME is the largest futures exchange in the U.S. by volume, and the first U.S. futures exchange to become a for-profit corporation, after revising its original private membership structure and a becoming publicly traded company in 2002. Most U.S. exchanges remain not-for-profit, private membership organizations, but a number of them are actively weighing the advantages of changing to stock corporations.
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There are more than 50 futures exchanges worldwide, and they are structured in a number of different ways. Some futures exchanges are owned by groups of banks or by a stock exchange holding company. Other exchanges, or their holding companies, are publicly listed on a stock exchange, similar to CME.
How Futures Exchanges Earn Income
Since futures exchanges do not themselves engage in trading, people sometimes wonder how they earn money.
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Futures exchanges earn income primarily by:
- Receiving a fee for every trade made through the exchange.
- Selling price data – current, streaming price data in real time as well as historical price data on trades made through the exchange. At CME, data subscription services include CME E-quotes™ and CME E-history.
- Charging for clearing services, if the futures exchanges own their own clearing house, as is the case with CME. Some exchanges outsource the clearing function. The Chicago Board of Trade, for example, has its contracts cleared through the CME Clearing House.
Types of Futures Traders
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Hedgers
Hedgers are looking for some measure of price certainty. Commodity hedgers – people who trade agricultural products, energy products or metals, for example – typically are involved in commercial interests that either produce, process or utilize the commodity they are trading. Hedgers of financial futures are typically in businesses that depend upon interest rates, foreign exchange rates, or stock index levels, such as banking or pension fund management.
Cattle ranchers, for example, may fear that cattle prices will decline before they bring their animals to market. To protect themselves, they decide to sell futures on live cattle that will expire at approximately the same time they expect to deliver their cattle to the market, and at the price they are hoping to get in the cash market. If cattle prices do go down, the ranchers can still make money on their futures positions, that will hopefully offset the reduced price they receive for their cattle.
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Speculators
Speculators trade futures with the objective of making a profit by being on the right side of a price move. Since the prices of commodities and financial instruments tend to change frequently, at least in certain markets, trading opportunities can be numerous.
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Speculators can be categorized into several broad groups: scalpers, day traders, position traders, arbitragers, and people seeking exposure to certain markets.
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Scalpers
Scalpers typically trade for a small profit on any single trade and therefore often trade continuously, seeking to make as many small gains as possible. In so doing, they create liquidity – the presence of enough people in the market so that market participants, notably hedgers, can buy and sell quickly and in large volume without substantially impacting prices. Scalpers’ frequent trades increase the trading possibilities available to others, and help provide the liquidity that is essential to the existence of futures markets.
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Other speculators include day traders, who typically make one or two trades per day, and position traders, who tend to hold contracts for days, weeks or months, depending on market factors.
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And finally, arbitragers are speculators who watch the relative value of multiple markets closely and step in to trade whenever momentary price discrepancies appear. By keeping prices in line for the same product trading on different exchanges, arbitragers lend stability to the price negotiation process.
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