Tuesday, November 6, 2007

Nature of contracts

Exchange traded contracts are not issued like securities, but they are "created" when one party buys

(goes long) a contract from another party (who goes short). In the beginning there are no contracts, so

the number of long contracts must equal the number of short contracts. This always goes through the

exchange, which means that the exchange is the counter party for all trades. However, the exchange does

not take any net positions. In this way clients do not know with whom they have ultimately traded.

Compare this with securities, in which an issuer issues the security. After that, it is a legal entity

that is traded independently of the issuer. Even if the issuer buys back some securities, they still

exist. Only if they are legally canceled can they disappear.

Standardization

The contracts traded on futures exchanges are always standardized. In principle, the parameters to

define a contract are endless (see for instance in futures contract). To make sure liquidity is high,

there is only a limited number of standardized contracts.

Derivatives Clearing

There is usually a division of responsibility between provision of trading facility and settlement of

those trades. While derivative exchanges like the CBOE and LIFFE take responsibility for providing

efficient, transparent and orderly trading environments, settlement of the resulting trades are usually

handled by Clearing Corporations, also known as Clearing Houses, that serve as central counterparties to

trades done in the respective exchanges. For instance, the Options Clearing Corporation and the London

Clearing House respectively are the clearing corporations for CBOE and LIFFE. A well known exception to

this is the case of Chicago Mercantile Exchange, which clears trades by itself.

Central Counterparty

Derivative contracts are leveraged positions whose value is volatile. They are usually more volatile

than their underlying asset. This can lead to situations where one party to a trade loses a big sum of

money and is unable to honor its settlement obligation. In a safe trading environment, the parties to a

trade need to be assured that their counterparty will honor the trade, no matter how the market has

moved. This requirement can lead to messy arrangements like credit assessment, setting of trading limits

and so on for each counterparty, and take away most of the advantages of a centralised trading facility.

To prevent this, Clearing corporations interpose themselves as counterparties to every trade and extend

guarantee that the trade will be settled as originally intended. This action is called Novation. As a

result, trading firms take no risk on the actual counterparty to the trade, but on the clearing

corporation. The clearing corporation is able to take on this risk by adopting an efficient margining

process.

Margin and Mark-to-Market

Clearing houses charge two types of margins: the Initial Margin and the Mark-To-Market margin (also

referred to as Variation Margin).

The Initial Margin is the sum of money (or collateral) to be deposited by a firm to the clearing

corporation to cover possible future loss in the positions (the set of positions held is also called the

portfolio) held by a firm. In the simplest case, this is the dollar figure that answers a question of

this nature: What is the likely loss that this firm may incur on its portfolio with a 99% confidence and

over a period of 2 days? The clause 'with a 99% confidence' and 'over a period 2 days' is to be

interpreted as that number such that the actual portfolio loss over 2 days is expected to exceed the

number only 1% of the time, although how they know this is unknown. Several popular methods are used to

compute initial margins. They include the CME-owned SPAN (a grid simulation method used by the CME and

about 70 other exchanges), STANS (a Monte Carlo simulation based methodology used by the OCC), TIMS

(earlier used by the OCC, and still being used by a few other exchanges like the Bursa Malaysia.

The Mark-to-Market Margin (MTM margin) on the other hand is the margin collected to offset losses (if

any) that has already been incurred on the positions held by a firm. This is computed as the difference

between the cost of the position held and the current market value of that position. If the resulting

amount is a loss, the amount is collected from the firm; else, the amount may be returned to the firm

(the case with most clearing houses) or kept in reserve depending on local practice. In either case, the

positions are 'marked-to-market' by setting their new cost to the market value used in computing this

difference. The positions held by the clients of the exchange are marked-to-market daily and the MTM

difference computation for the next day would use the new cost figure in its calculation.

Clients hold a margin account with the exchange, and every day the swings in the value of their

positions is added to or deducted from their margin account. If the margin account gets too low, they

have to replenish it. In this way it is highly unlikely that the client will not be able to fulfill his

obligations arising from the contracts. As the clearing house is the counterparty to all their trades,

they only have to have one margin account. This is in contrast with OTC derivatives, where issues such

as margin accounts have to be negotiated with all counterparties.

Regulators

Each exchange is normally regulated by a national governmental (or semi-governmental) regulatory agency:

* In Australia, this role is performed by the Australian Securities and Investments Commission
* In the Chinese mainland, by the China Securities Regulatory Commission
* In Hong Kong, by the Securities and Futures Commission
* In India, by the Securities and Exchange Board of India.
* In Singapore by the Monetary Authority of Singapore
* In the UK, futures exchanges are regulated by the Financial Services Authority.
* In the USA, by the Commodity Futures Trading Commission.

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