Q&A
Futures For You
Inside The Futures World
Want to find out how the futures markets really work?
DeCarley Trading senior analyst and broker Carley Garner responds to your questions
about today’s futures markets. To submit a question, post it on the Stocks & Commodities website Message-Boards. Answers will be posted there, and selected questions will appear in future issues of S&C. Visit Garner at www.DeCarleyTrading.com. Her books, Commodity Options and A Trader’s First Book On Commodities, are available from FT Press.
Trade guarantees
How can a futures exchange afford to guarantee every trade that is executed?
Futures exchanges guarantee each transaction that they clear, but unfortunately, the guarantee isn’t that you will make money. Instead, it assures that if you do speculate, you will be compensated in the amount deserved based on entry and exit price. This seems to be a given, but it isn’t. Those speculating in forex, as opposed to futures, aren’t necessarily afforded the same luxury.
Forex traders are subject to counterparty risk. Assuming a profitable trade based on entry and exit price, forex traders rely on the party on the other side of their transaction to pay up. However, although it is a real risk, the incidence of default is rare. Just because it hasn’t been a common issue in the past doesn’t mean that it can’t or won’t in the future.
Futures exchanges stipulate and enforce margin requirements for each commodity market. Margin is a risk-based good faith deposit levied on traders with risk exposure. Simply, it is the amount of money that traders must have on deposit to buy or sell a particular futures contract or execute a short option.
Margin is a necessary evil; without ensuring that speculators have enough funds on deposit to cover potential position drawdowns, the exchanges and brokerage firms carry the risk of speculators walking away from their trading losses. This may remind you of the recent collapse in real estate.
Prior to that debacle, homeowners were able to purchase property with very little down payment, or margin; some of those who discovered they had purchased at unfavorable prices just defaulted on their mortgages. In essence, the real estate market during the latter part of the 2000 decade was operating like a giant futures market without margin requirements or, even worse, accountability. Many of those who originally bought homes on leverage without margin in the form of a down payment later walked away from their liability, leaving the banks holding the bag. The result in some markets, like my hometown of Las Vegas, was nothing short of illiquid chaos.
In the world of futures trading, the exchanges act as the bank by providing traders access to products with substantial value in return for a minimal down payment. Unlike the housing market, however, futures exchanges have established actively enforced rules in regards to proper margins. It is this aspect of the futures markets that work toward market liquidity and makes an attempt toward stability, two characteristics that a marketplace without margin, such as real estate, might not always portray.
What many don’t realize is that although the exchange guarantees each transaction, they aren’t necessarily the party facing default risk. Because the exchanges themselves are the most critical entities in the futures industry, they are also the most protected when it comes to defaulting retail clients. US futures exchanges have established tiers of liability in which they are at the top. It can be unfair at times for those of us who are below the exchanges in the line of responsibility, but we can agree that the system encourages responsible trading by holding those nearest the action to be accountable. Let’s look at the process that enables the exchange to guarantee executed trades in detail.
In order to establish a position on a US futures exchange, a futures trader must have a specific amount of margin on deposit. Should the trader’s positions move adversely enough to trigger a margin call, position adjustment, liquidation, or the deposit of funds is necessary to continue the speculative play.
If a futures trader fails to meet the requested margin requirement, the brokerage firm handling the account has the right to liquidate positions as it sees fit to bring the account in line with exchange expectations. In the case of a trading account that has lost more money than was originally on deposit (this is possible with leveraged speculation), positions are liquidated and the client is expected to bring the account whole by depositing funds.
In the meantime, the individual broker handling the account is responsible in the form of commission withholding in the amount of the cash deficit. If a futures trading account goes negative, the broker who brought the client to the firm and is paid commission accordingly would not be paid commission on any of his accounts until enough money was withheld to offset the risk to the brokerage firm should the trader fail to pay his liability. Naturally, a trader who walks away from a trading liability isn’t off the hook. Debt collection, damage credit, and possible legal action are all possibilities as the brokerage firm attempts to recoup monies owed.
If the negative balance is large enough, the broker handling the account might not make enough money to pay the deficit and might choose to quit as opposed to working without compensation for a considerable period of time. If this is the case, the brokerage firm — no longer the broker — is responsible for ensuring that the cash to cover the debit is provided to the exchange. Only in the case of a defaulting client, broker, and brokerage firm will the exchange be liable for losses in excess of funds on deposit. The accountability of risk and default creates an environment that attracts speculators and creates liquid and efficient markets for users and producers.
That said, if you are interested in entering the futures market as a broker rather than a trader, you must be willing to accept the risks as well as the potential rewards.