Economic Purposes of Futures Trading

Economic Purposes of Futures Trading

Other Economic Benefits

The opportunity to hedge theoretically makes it possible for hedgers throughout the marketing and processing chain to operate on narrower profit margins which may be caused by market competition.

For example, if the wheat miller has protected his inventory with a hedge, he can add on his milling margin and offer a firm price to the baker. Because the hedge lessens his chance of significant loss from an adverse price change, he can theoretically sell to the baker at a lower price. The baker who also hedges can reduce his risk and thus has more flexibility in matching any reduction in price which the market dictates.

Narrower at risk margins permit lower prices, resulting in considerable savings for consumers. Conversely, narrower at risk margin also may enable producers to increase their profits.

Another benefit of hedging involves financing. While some bankers refuse to consider hedges as a factor in commodity loans, others make it a regular policy to do so. Bankers, particularly those who lend to commercial borrowers, say that hedgers can borrow a greater percentage of the value of their commodity, usually at lower interest rates, than can non-hedgers. The lower cost financing thus permits higher profit margins for the hedger and possibly lower prices for the end-user.

What Futures Do Not Do

Futures trading is not intended as a way to transfer ownership of the actual commodity, so few traders deliver on futures contracts. Cash markets normally provide the most efficient way to exchange ownership of a commodity; futures markets are a way to forward price the commodity and to lessen the risk of ownership.

Several academic as well as trade studies have concluded that the futures markets do not "cause" cash market prices to rise or fall. Both the cash and futures markets respond to the same basic supply and demand factors. Because futures trading has low transaction costs, participants are able to actively and immediately express their views on their estimate of projected likely prices. New information is continuously injected into the market via last sale prices for various futures contracts. This results in expectations about price movements being first noticed in the organized exchange traded futures markets. On the other hand, the cash market tends to respond to situations in its local geographic area while the futures market tend to additionally consider broader national, as well as international implications to events. But the regulatory force of arbitrage--which is the simultaneous purchase and sale of identical goods in two markets at different prices to capture a riskless profit--keeps all markets in rough balance. Either price may move first or furthest.

Futures markets do not promise that commodities will trade at some specific price at a future date. Suppose that, on June 15, December silver trades at $5.00 an ounce. The quotation does not say that a trader can enter the cash market in December and buy or sell silver for that price. It does imply that, on June 15, a binding contract guaranteed by the clearing corporation for that specific exchange was entered into by a seller of the contract to deliver a standardized grade and quantity of silver in December (if the expiration date was the December contract) at an approved warehouse and receive $5.00 an ounce. As we mentioned earlier, only a small percentage of exchange traded futures contracts result in the actual delivery of the underlying assets. Most are offset prior to expiration. In this case, offset means that the obligation to perform under this contract can be extinguished by buying back the contract on the open market at a price higher or lower than it was originally entered into by the selling party.

The Role of Speculators

Price has a rationing effect. In other words, when supplies of a commodity appear greater than present demand or need, prices tend to decline. If supplies appear to fall short of fulfilling demand, prices trend upward. Estimating market supply and demand conditions are the challenges faced by market participants.

Market analysts such as economists who study commodity markets have concluded that speculators play an essential role in futures trading. Speculators are a source of immediate liquidity for the markets, which is a characteristic of a continuously active market. However, the mere presence of speculators is but one component of a healthy market. Another active group of participants are hedgers. These are individuals, firms or institutions which have or use the underlying commodity in their business and use the futures markets as a means of transferring price risk associated with their inventory.

Take grain, for example. The cost of storing grain until it is needed is built into futures prices. Speculative activity, gauging the size of the crop and the need for storage, along with other factors such as interest rates helps to determine the cost for storing a commodity--which helps to determine the size of the built-in carrying charge.

Much trading is "at the market," the price then current in the trading pits. A trading pit is the area at an exchange where members congregate to trade specific commodity futures contracts. At trading pits on the floor of an exchange, orders are exposed to competing bids and offers. In busy, high-volume markets, there are many "resting" orders--orders held by a broker in behalf of a customer to buy or sell at prices higher or lower than the current market price. The interplay among market participants, and the activation of resting orders causes prices to move up and down, and along with market determined interest rates will affect the cost of holding the underlying commodity in inventory. Merchandisers and processors watch price changes carefully, looking for favorable hedging opportunities. The result of this action is a viable, liquid market.

A speculator is an additional buyer of commodities whenever it seems that market prices are lower than they should be. Consumers consider this to be against their best interest. Conversely, when it appears that prices are too high, a speculator becomes an active seller, arousing the ire of producers.

One fact that often is not considered is that few speculators agree on what is too low--or too high. Some may want to sell at a particular price, others may want to buy at that price, and some may not be interested at all. Therefore, there usually are willing buyers and sellers in the market at all times.

Individual speculators tend to trade smaller number of contracts than hedgers and to hold market positions for a shorter time, so several may be needed to offset one large hedge order. The maximum number of contracts which can be held by any one speculator is limited by exchange rules and the CFTC.

Regulation of Futures Trading

In the legislation establishing the CFTC, Congress recognized that futures markets serve a national interest. Congress sought to assure that there will be orderly futures markets, operating fairly, and that prices determined at these markets will be free of distortion.

The CFTC oversees exchange rule enforcement and conducts its own surveillance of trading in futures and related cash markets as part of its mission to prevent market abuse and to enhance the operations of the market. The Commission approves the regulations and rules of the futures exchanges and requires exchanges to enforce them. Each futures contract is reviewed by CFTC economists and trading experts to confirm that its terms are consistent with cash market practices, it may serve an economic purpose, and it is not contrary to the public interest.

The National Futures Association (NFA), a "registered futures association" under the Commodity Exchange Act, has been authorized by the Commission to register all categories of persons and firms dealing with customers. Before registering a new person or firm, the NFA conducts a thorough background check of the applicant to determine whether they should be precluded from conducting commodity business.

Firms that handle the money of customers who trade futures or options are required to keep customers' equity accounts separate from the firm's accounts, mark customer accounts to the present market value at the close of each day, and place any funds due a customer in an account separate from the firm's own fund or account. This segregation of funds protects clients' funds in case of a firm's separate financial difficulty. The industry has an outstanding record for protecting customers' funds, due in part to these rules.

The CFTC offers a reparations procedure for persons who have reason to believe that they have suffered a loss due to a violation of the Commodity Exchange Act or CFTC regulations in their dealings with introducing brokers (IBs), commodity trading advisors (CTAs), commodity pool operators (CPOs), futures commission merchants (FCMs), or associated persons (APs) affiliated with these registrants. The reparations program is an alternative to the industry arbitration procedure and to normal civil court remedies. Decisions may be appealed to the Commission itself and to a U.S. Court of Appeals.

The responsibility of the CFTC might best be summarized by saying that its purpose is to ensure fair practice and honest dealing in futures trading, in order to permit accurate price discovery and opportunity for efficient hedging through competitive, manipulation-free markets.

While futures trading can be very beneficial to hedgers and very profitable to some speculators, it is definitely not for everyone. In fact, the majority of people who speculate in commodity futures or options lose money. If you are considering speculating in commodity futures or options, be sure that you have speculative capital that you can afford to lose, thoroughly check on the firm and individual with whom you are considering doing business, review the disclosure information which must be provided before you open an account and educate yourself on how the market works. If you need additional information, please call the CFTC's Office of Public Affairs at (202) 418-5080 or the National Futures Association at (800) 676-4632.

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