Futures Trading Roles: Commodity Exchanges, Regulators, and Brokers
by
Darrell Jobman
The following
is an excerpt from Darrell Jobman's Profitable Trading the Turtle Way
The Role of the Exchange
Much has been made of the troubles in collateralized debt obligations, mortgage-backed securities and other creative financial instruments whose collapse led to the credit crisis and threatened the integrity of the global financial system in 2008. These over-the-counter derivative products did not trade on exchanges, and no one had any idea of how many of them there were or how creditworthy they were. There were no regulations and no transparency, and little concern about the amount of risk they posed for global markets.
In futures trading, the exchange is the centerpiece of the trading activity, primarily conducted today electronically on computers. In recent years exchanges have been challenged to keep up with advances in technology, with changes in ownership from member-only entities to publicly traded companies, with the development and expansion of competitive new exchanges operating in a global environment, and with a number of mergers and consolidations in the ever-changing exchange world.
Here are some of the roles that futures exchanges fill in the trading process:
Centralized Marketplace – Whether trading occurs in a pit, or more likely, a computer, the exchange provides one centralized location where buyers and sellers gather to match orders. This pool of traders expedites the price-discovery and risk-transfer processes. Details about the results of this trading activity provide the price structure for many of today’s markets.
Product Offerings – Every viable business has to offer products or services. In the trading world it is the exchanges that create, develop and market the products that are traded, frequently doing the research to support the contract and producing the materials to promote their markets to traders. Exchanges do not own the product or carry an inventory; they just turn concepts into tradable contracts and post them for the world to see and trade.
Trading Rules – Exchanges have developed a set of detailed trading rules over the years that govern how trading is conducted in a central location. These rules protect traders, dictate how various orders should be handled and place restrictions on price manipulation, front-running or insider trading. Maintaining the integrity of the trading process is vital to building trust and confidence in the marketplace, which is what allows exchanges to function in the first place.
Futures exchanges also set performance bond requirements for all of its contracts, a role that the Federal Reserve has for the equities markets.
Trade Matching – For every buyer, there must be a seller, and for every seller there must be a buyer. The exchange provides the facilities and the rules to match buyer and seller and makes trading a more orderly process than the chaotic scene sometimes depicted in the media.
A clearing organization, sometimes operated by the exchange and sometimes a separate entity, works with clearing members of the exchange to make sure that all positions balance out, assuring that the appropriate amounts of margin money are deposited, and resolving any discrepancies. In futures, the clearing organization actually acts as the buyer to every seller and the seller to every buyer to protect against the risk that a counter-party will not hold up its side of a transaction.
The Role of the Regulators
Government regulators act as watchdogs, overseeing trading activity. The check-and-balance tension among regulators, exchanges and brokers helps to guard the public interest and maintain a level trading field for all investors and traders. Nearly everyone can agree that a balance of regulation is a good thing because its existence gives the public comfort and confidence that an outside source is guarding their interests, although that has been called to question in some highly publicized cases such as that of Bernard Madoff.
In addition to providing or approving market regulations, the regulators also provide traders and consumers with valuable details about the status of brokers and firms, warning about investment scams, and reduce the negative aspects of the industry helping to keep it as “clean” as possible.
Regulators for the futures industry include the Commodity Futures Trading Commission (CFTC) and the National Futures Association (NFA). Generally, persons who handle your money must be registered with a regulatory agency.
The Role of the Broker
Although futures trading occurs on an exchange, you can’t get there without going through a broker, your entrée to the trading world. In fact, your only contact with trading may well be your broker as you may not know or care which exchange is executing your order.
Commodity Exchanges, Regulators, and Brokers
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