Stuart Bell, Michael Rieke3/2/2009

First futures contract – Japan 1710: Dojima Rice Exchance• Samurai needed stable conversion of rice to currency.

1852: First formal futures contract written in the US at Chicago Mercantile Exchange (CME).

Almost all trading is on grain, specifically wheat.

Until 1922 no formal governing body existed for futures trading – done through bills in Congress

Debate existed as to legitimacy of futures, some saw them as “unnatural” or even evil.

1868 -1880: Futures traders dispense completely with handling physical underlying.• 1885-1889: 8.5 Billion bushels of wheat traded in New

York, only 16.5 million enter city. This practice of “conceptual trades,” trading

goods without actually possessing them, is a new one.

Hearings began in congress to determine if these “fictitious dealings” would be permitted.

Compromise is reached: Futures pits will be allowed, “bucket rooms” banned.

Rule created is that of “contemplating delivery”• Traders must “contemplate corporeal goods” while

trading in futures. – Supposed to maintain responsibility, what do you think?

1922: Congress realizes that a formal agency is needed to oversee the futures markets• Creates Grain Futures Administration (GFA), a division

of the USDA. By 1936 futures are being written on other

commodities such as cotton and butter.• The GFA is seen as inadequate, another bill is passed.• Creates Commodity Exchange Authority (CEA)

1974: Federal Government realizes futures are expanding in scope beyond that of the CEA. Decides a new, much more powerful agency is needed.• Creates the Commodity Futures Trading Commission

(CFTC)

1971: Nixon closes the gold window and exchange rates float worldwide.

1972: International Monetary Market (IMM) founded• Facilitates futures trading on foreign currency allowing

entities to hedge against the new movements in exchange rates.

• Represents the first non-commodity future.• Sets the stage for future innovation.

1975: High inflation and fluctuating interest rates prompt the IMM to propose futures contracts based on interest rates.• Based on US Treasury securities (bonds and notes) Fed and

Treasury are concerned.• Newly created and powerful CFTC sees potential benefits,

decides to approve their creation.• Represents first futures contracts based upon a financial

security, creating financial futures.

1982: CFTC Approves trading of stock index futures.• S&P 500, NYSE composite, Value Line Average• First futures based on an equity index.

1982: CFTC approves creation of National Futures Association (NFA)• Non-government agency funded by

membership dues paid by all futures market members.

• Handles specific exchange regulation while CFTC performs broad oversight.

Throughout 80’s & 90’s further applications for futures are approved.

US Regulatory Authorities consist of the CFTC and NFA.

Exchanges still maintain significant autonomy and ability to self-regulate.

ExchangeExchange

NFA

CFTC

Traders

Traders

Exchanges are merging, globalizing, and moving to electronic trades.• 80% of CME trading now down

electronically.• 2006 NYSE merged with

Euronext, huge electronic European exchange.

• Many see open outcry pits as eventually disappearing completely.

As a result of the markets becoming globalized and further interconnected, regulatory bodies are having to adapt .• 2006: CTFC & UK Financial Services

Authority forge agreement for co-operation.• 2008: CTFC and SEC agree to co-operate

officially on reviewing and monitoring new derivatives.

Now to how futures trading actually works:

There are 3 main types of orders• Market Order• Limit Order• Stop Order

Is a buy or sell order to be executed by the broker immediately at current market prices

Simplest of the order types In fast-moving markets, the price

paid or received may be quite different from the last price quoted before the order was entered

Is an order to buy at no more (or sell at no less) than a specific price

Gives the customer some control over the price at which the trade is executed

May prevent the order from being executed

Is an order to buy (or sell) a security once the price of the security has climbed above (or dropped below) a specified stop price

When the specified stop price is reached, the stop order is entered as a market order.

Customer does not have to actively monitor how the contract is performing

Because the order is placed as a market order once the limit is hit the price can be different than the stop price

Limits are made with the aim of protecting the investors

They are meant to prevent unreasonable price movements on the market in one trading day.

The limits are to cause breaks in the action when trading becomes especially volatile

These limits are determined by the futures exchange (with CFTC approval)

If the price reaches the upper or lower limit trading can be halted this could be for a few minutes or it could be for the rest of the day

This “cooling off period” is to prevent panic in the market.

After this period the limits could be expanded by the board of the exchange and trading can resume.

When the limit is hit trading is not always halted sometimes trading can continue at a price that does not break the upper or lower limit.

This decision is up to the board of the exchange

Trading on the exchange floor is restricted to Members of that exchange.

Seats on an exchange can be bought or leased and vary in price depending on which exchange it is and the supply and demand for that seat. (Chicago, Kansas City, New York, London)

There are locals on the exchange floor (people trading for their own accounts) and floor brokers (people trading for others).

Floor brokers are also allowed to trade own their own behalf but,

only if it does not affect their clients.

Open Outcry• This system works by “buyers” yelling out their

best offer price, while “sellers” yell out their best sell price when they yell out the same a contract is made.

• Requires that traders cannot bid below the highest bid, nor can sellers offer higher than the best offer.

• This makes since that a seller could not sell a contract for $9.50 if someone next to him/her was trying to sell it for $9.00

• The open outcry system allows for a trader to see what all the other traders are doing.

• They can also pick up on the emotion of the market to know how volatile it is.

When the market gets too loud they can use a series of hand signals.

These hand signals let the floor brokers take orders from many traders at once

The signals communicate: • Quantity• Price • Month • Type of order (buy, sell, cover, short)• Status of the order

This makes the market run quickly and efficiently

Despite this, open-outcry pits are very chaotic places! Pit Video (1:20)

Buy Sell1-5 Vertical

6-10 Horizontal

Buy/Sell Signals Price Signals

Quantity Signals

x1 Touch Chin x10 Forehead

Expiration Signals

January –Hand to Throat

July –Point to eye

August-Rub Forehead

Images: OxfordFutures.com

“Trading ahead is a violation of a specialist's negative obligation to New York Stock Exchange customers. By trading from his or her own account rather than letting public orders match one another, the specialist is robbing the public of its opportunity to transact the security.” – Investopedia.• IE – Traders are “Trading Ahead” of customers orders with their

own accounts. Trading ahead in particular is considered a serious

violation of regulations. Pit traders have been known to make $1,000,

$10,000, or even $1M in a day trading their own money.• Therefore incentive to cheat is strong.

As stated before exchanges are moving heavily into electronic trading.

This is taking the form of both automated transactions done of the floor, and electronic tablets carried by traders (like NYSE).

Open outcry is likely to soon disappear completely.• Floored the movie, coming 2009• Clip

“In the wheat pit at the CME Group Inc.’s trading floors, Mike Ryan stands next to his father wearing a flat screen, like half a laptop, on a sturdy black band around his neck. While his father trades wheat futures face-to-face in the open-outcry pit, Ryan uses the screen to trade the same contracts all over the world on the CME Globex electronic trading platform.” – Medill Reports

1. What was the very first commodity future written on?

2. In what decade was the CFTC formed and financial futures pioneered?

3. What is the independent regulatory authority between exchanges and the CFTC?

4. What is a stop order?5. What is trading ahead?6. What is a price limit?

Any questions?

Thank you!