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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: Margin Systems and Spreads Exchange Competition

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CHAPTER 2 Futures Markets Refinements


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chapter 2 futures markets refinements
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:
  • Margin Systems and Spreads
  • Exchange Competition
  • Contract Innovation and Contract Success
  • The Internationalization of Futures Markets
  • Future Market Players
  • Current Futures Industry Issues
  • Market Manipulation

Chapter 2

spreads
Spreads
  • Spread
  • A spread occurs when a trader holds a combination of related futures positions. In this section, we explore two types of spreads:
  • Intra-market SpreadA 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.
  • Inter-market SpreadA 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

margin systems on spreads
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

margin systems spreads5
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

Long Position

Exchange E

T

RA

D

E

R

A

Broker B

Commodity D

Short Position

Exchange F

Chapter 2

margin systems and spreads
Margin Systems and Spreads
  • Benefits of the Cross-Margining System:
  • Lower initial margin.
  • Central clearinghouse to serve various markets.
  • Increase trading due to lower margins.
  • Helps US exchanges compete with foreign financial markets.
  • Reduces forced sell-offs by some traders during periods of dramatic price changes.
  • Risks Associated with Cross-Margining:
  • Potential for an increase in the overall risk of system-wide default.
  • Offsetting positions my diverge from their normal relationship.

Chapter 2

margin systems risk measurement
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

exchange competition
Exchange Competition
  • Futures exchanges are businesses that create markets.Therefore, exchanges compete through:
    • The technology employed
    • The innovation in the design of the contracts
    • The fees charged
    • International competition
    • The business models adopted
    • The quality of trading information provided

Chapter 2

technology employed
Technology Employed
  • Exchanges compete on two levels:
  • Floor trading versus electronic tradingTrading costs, increase trading volume and overall trading efficiency are key elements in this level of competition.
  • Competition between exchanges to become the market hostExchanges 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

technology employed floor trading versus electronic trading
Technology Employed Floor Trading Versus Electronic Trading
  • Electronic trading is gradually displacing open outcry trading in the US.
  • U.S electronic trading has impacted the way exchanges are structured, as more exchanges move from non-profit to for-profit organizations.
  • Electronic trading dominates in foreign exchange.
  • Electronic trading has made 24-hour trading possible in some futures contracts.
  • Electronic trading technology has become a important asset to the exchange.
  • Electronic trading helps reduce out-trades (a price or quantity discrepancy between the trade data transmitted by the seller and the buyer’s brokers).
  • 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

innovation in contract design
Innovation in Contract Design
  • Exchanges compete by:
  • Trading contracts in a group of related, complementary contracts.

Example: CBOT soybean complex contracts.

  • Creating product differentiation

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

  • Calling for product delivery at different locations

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

  • Competing with other markets

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

Chapter 2

innovation in contract design13
Innovation in Contract Design
  • Table 2.3 shows ten factors that increase the chance of a contract’s success.

Chapter 2

exchange fees
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

international competition
International Competition
  • Insert figure 2.1 here

Chapter 2

international competition16
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.

Chapter 2

international competition17
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

futures market players
Futures Market Players
  • Futures Exchanges have multiple players. In this section, the following players will be discussed:
    • Floor Broker
    • Futures Commission Merchant
    • Introducing Broker
    • Associated Person
    • Commodity Trading Advisor
    • Commodity Pool Operator

Chapter 2

futures market players19
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

futures market players20
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

current futures market issues
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

current futures market issues23
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

current futures market issues24
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

current futures industry issues
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.

Chapter 2

current futures market issues26
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

market manipulation
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:
    • That the accused had the ability to influence market prices.
    • That the accused specifically intended to do so.
    • That an artificial price occurred.
    • That the accused caused an artificial price.

Chapter 2

market manipulation28
Market Manipulation
  • Market Power Manipulation
  • Occurs when a trader has control of a commodityand a large futures position allowing him/her to corner or squeeze the market.

Corners

Trader influences the price of a futures contract bygaining control over trading in the futures and thedeliverable supply of the underlying good.

Squeezes

Trader achieves effective control over the price of afutures contract due to disruptions in the supply of the cash commodity.

The Hunt Silver Manipulation

The Alleged Soybean Manipulation of 1989

Chapter 2

market manipulation29
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