Futures Exchange: Overview of How it Works, History

What Is a Futures Exchange?

A futures exchange is a marketplace where all types of futures and options on futures contracts are bought and sold. Those allowed access to the exchange are brokers and commercial traders who are members of the exchange. Members need to be registered with the National Futures Association and the Commodity Futures Trading Commission. Individuals who want to trade futures contracts must have an account with a registered broker. Futures exchanges also provide clearing and settlement functions.

How a Futures Exchange Works

Futures exchanges provide a market where these and other derivatives can be traded. The financial incentives for those who run the exchange are based on the volume and dollar value of what is traded—the more, the better. That means they work to increase futures trading while regulators and stakeholders in the industry should ensure that the market is fair and without too much volatility. This has led to new kinds of derivatives in recent years, driving increased participation through electronic networks.

According to the Futures Industry Association, futures trading worldwide more than doubled from 12.1 billion contracts in 2013 to 29.2 billion in 2023. Investors trade futures linked to commodities, currencies and cryptocurrencies, electricity, financial securities, freight weights for shipping, indexes, interest, network bandwidth, rates, and weather events like temperature, rainfall, and hurricanes. In recent years, the Chicago Mercantile Exchange (CME) has begun offering event-based futures where you essentially bet yes or no for questions on the value of currencies, indexes, and other assets, with terms ending daily, quarterly, or yearly.

While futures used to be traded through open outcry in the trading pits of the CME or the New York Mercantile Exchange (NYMEX), most are bought or sold through the electronic networks of the exchanges. Trading is much more decentralized worldwide and done almost 24 hours a day during the week.

Most futures trading by volume is done by companies seeking to hedge the risks they see ahead. For example, an airline might worry that the price of oil is set to go up. They might buy futures contracts that set their future fuel prices lower than where they think the price might go. Alternatively, an oil company might sell futures in their product if they worry it could go too low, giving them too little to pay overhead later in the year. Thus, they buy futures that set a floor on how much they'll get for their oil in several months. Others trade futures to speculate on changes in prices over time.

Here are two main reasons to trade in futures:

1. Risk management: Futures exchanges enable hedgers such as farmers, manufacturers, and others to manage the risk of price changes in the commodities or financial instruments they deal with. By locking in prices for future dates, they can protect themselves against market prices that would impact their bottom line.
2. Speculation: In addition to hedging, futures exchanges offer prospects for speculators to profit from changes in the prices of the underlying assets. Speculators assume market risk hoping to profit but also add liquidity to the market through their trades.

To encourage as much participation and liquidity as possible, contracts on an exchange have standard sizes, expiration dates, and, for options, strike prices. This differs from forwards, which are traded over the counter (OTC) and can have different terms for each contract.

Exchanges provide the following for those trading in futures:

• Clearing and settlement: Futures exchanges typically have a clearing house, which acts as the counterparty to all trades. Clearing services ensure that participants don't have to worry about the risk of the other party to the contract failing to deliver on their obligations, as can happen with OTC transactions. The clearinghouse also handles the settlement of trades and the daily marking to market of positions, ensuring that gains and losses are reflected in participants' accounts.
• Price publishing: By aggregating buy and sell orders from participants wherever they're trading, futures exchanges provide a mechanism for price discovery, reflecting the market's view of the future value of an asset. This is valuable information for producers, consumers, and investors.
• Standardization: Futures exchanges provide uniform contracts to be traded on their platforms, specifying the quantity, quality, and delivery time of the underlying assets. This helps produce liquidity since no one has to negotiate the specifics of each contract.
• Transparency and regulation: Futures exchanges are under regulatory oversight to ensure fair trading practices and transparency. This includes publishing real-time data on prices and volumes.

A Short History of Futures Exchanges in the US

The roots of futures trading in the U.S. began in the mid-19th century, even before the concept was fully formed as uniform contracts bought and sold. Farmers had long used forward contracts, private agreements to sell their crops at a future date, to lock in prices and manage risk. The Chicago Board of Trade, founded in 1848, initially focused on trading in grains like corn and wheat, and forward contracts were traded on the prices of these goods. Over the next few decades, the railroads and telegraph networks expanded, allowing those in agricultural hubs in the Midwest to communicate more swiftly with the financial centers in Chicago and the East. Soon, futures markets quickly moved beyond just grains. The New York Cotton Exchange (1870) and the Kansas City Board of Trade (1876) emerged, followed by exchanges for livestock and, later, metals. The largest futures exchange in the U.S., the CME, was formed in 1898. As futures expanded, speculation increased, drawing in traders without a direct connection to the underlying commodity.

Bond and currency futures emerged in major foreign exchange markets in the 1970s. Today's futures exchanges are significantly larger as the volume of trading in derivatives has increased. Financial exchanges have also merged, including the CME and the Chicago Board of Trade in 2007. Rebranded as the CME Group, it then acquired NYMEX Holdings Inc., the parent company of NYMEX, and the Commodity Exchange Inc. in 2008. Growing again in 2012, it added the Kansas City Board of Trade, the major exchange for hard red winter wheat.

Another major exchange for futures in the U.S. is the Intercontinental Exchange (ICE). Started as an electronic exchange in 2000, ICE acquired the International Petroleum Exchange in 2001. In 2007, it folded in the New York Board of Trade and the Winnipeg Commodity Exchange. Finally, it expanded into equities by acquiring NYSE Euronext in 2013.

The Bottom Line

Futures exchanges streamline trading by connecting traders and ensuring secure transactions. The exchanges offer clearing services, further increasing confidence in trading. However, access is exclusive to member firms and individuals, meaning independent traders can invest in futures only through a member brokerage firm.