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For every buyer, there is a seller and for every seller, there is a buyer. Matching these two together so that a trade can be consummated requires the participation of a host of individuals and organizations, each having specific roles, which in the aggregate make the futures market the efficient mechanism that it is today.
Throughout this section, reference is made solely to the futures market only for convenience and simplicity of presentation. The market for options on futures is structured in very much the same manner.
A futures exchange is a meeting place where futures contracts are bought and sold. Trading occurs against a background of regulatory surveliance and guidelines from the exchange itself and from the Commodity Futures Trading Commission CFTC. Each exchange has its own list of products that it trades, and each product is traded in a designated futures trading pit. A trading pit is an area of floor, usually round with concentric steps leading down into the center.
The trading pits are each divided into a number of sections designated for trading in particular contract months. No trading may occur outside a contract's assigned pit, nor is trading permitted at any time other than during those hours which have been designated by the exchange.
Some exchanges also use automated trading facilities or computer networks which serve as trading pits. In addition to providing the market place for trading futures and regulating trading within its pits, futures exchanges also design and specify their futures contracts. Futures contracts are very specific in terms of the quality and quantity of goods underlying the contract.
You may have wondered who determines these specifications. The answer is the futures exchange. Working with participants in the industry such as traders, fund managers and natural hedgers, a futures exchange designs a contract to meet the greatest need.
If the exchange succeeds, it will have designed a futures product that many players can use or trade, and volume in the futures will grow. Contract specifications can sometimes be changed by the exchange, and is usually done to keep the contract viable. To stand in a trading pit, a trader needs to buy an exchange membership, pay annual dues, and register with various regulatory agencies.
Naturally, few people would trade futures if it required that they stand in the trading pit. To solve this problem, in steps the futures broker. A futures broker acts as a communication link between the trading pit and the trader, taking orders from the customer, and executing them in the futures pit. By law, futures brokers do not have the authority to take customer funds and hold them in deposit.
Only an FCM can do this. For this reason, a futures broker needs to team up with an FCM in order to provide order execution services to its customers. In a literal sense, it stands as a buyer to every seller and a seller to every buyer. That means that a futures trader does not have to worry about any default of a futures counterparty. What happens if that person cannot pay? Does A sacrifice her profit? The answer is "NO". The clearing corporation guarantees the transaction.
The clearing corporation's elimination of such counterparty credit risk provides a great benefit to the futures and options markets. One may wonder how the clearing corporation does this.
The answer lies in the margin deposit that every other futures trader must make before trading any contract. This margin is available to the clearing corporation and, together with other reserve cash and various protection funds, are used to cover any customer default. A clearing corporation is composed of clearing members, most of which are large FCM's.
It is a mark of distinction for an FCM to be a clearing member. The primary purpose of the NFA is to ensure, through self-regulation, high standards of professional conduct and financial responsibility on the part of the individuals and organizations that are its members: In connection with its regulatory responsibilities, the NFA conducts periodic audits of its members' financial and other records, monitors sales practices and provides a mechanism for the arbitration of futures related disputes between NFA members and the investing public.