FUTURES & OPTIONS
Shayna Hutchins, Nermin Jasani, Regina Malta, & Kim Thrun
Agenda
What are Futures & Options?
Regina
Current Regulation
Kim
Exchanges vs. Over-The-Counter
Shayna
Clearing Houses
Shayna
SEC vs. CFTC
Nermin
Other Proposed Regulations
Nermin
F&O in BRIC Countries
Regina
The Original Futures Market



The futures/forward market began in the mid-19th
century with the establishment of central grain
markets
Farmers could sell their products either for
immediate delivery (spot market or cash market) or
for forward delivery
Trading began with floor trading of traditional
commodities such as grains, meat, and livestock
Forward and Futures Contracts




Forward contracts were private contracts between buyers and
sellers and eventually evolved into today’s futures contracts
Both forward contracts and futures contracts are legal
agreements to buy or sell an asset on a specific date
Forward contracts are negotiated directly between a buyer
and a seller and settlement terms vary from contract to
contract
A futures contract is facilitated through an exchange, and is
standardized according to quality, quantity, delivery date, and
place


The only remaining variable to be determined is price
Although some futures contracts result in the actual delivery of
the asset, others require cash settlement in lieu of delivery

Most futures contracts are liquidated before they are delivered
Today’s Futures Market



Today exchange traded futures have expanded to
include metals, energies (crude oil, gasoline heating,
natural gas and oil), currencies (U.S. and foreign),
interest rates, equity indexes (U.S. and foreign), and
treasuries
The majority of trades are now made electronically,
but are still made on the floor of the exchange
At any moment some traders are willing to buy and
other traders are willing to sell, making the futures
market very efficient
Oversight of Futures Contracts



In order to ensure the integrity of the market, all
futures contracts are reviewed by the Commodity
Futures Trading Commission (“CFTC”)
The contract must comply with the requirements of
the Commodity Exchange Act and the CFTC’s
regulations
The CFTC conducts daily market surveillance, and
can order specific action to be taken to ensure the
financial and market integrity of the exchange
Who Trades Futures?


Most of the trades made in the futures markets are
done by hedgers or speculators
Hedgers

Use the futures markets to reduce their exposure to adverse
price movements by transferring their risk to others

Their goal is long term price certainty
Include agricultural companies, mining firms, banks and
others that want to protect themselves against rising prices
of products that they need to sell
 Other hedgers are manufacturers, food processing
companies, financial firms and others that want to protect
themselves against rising prices of products that they need
to buy

Who Trades Futures?

Speculators
 Include
hedge fund managers, banks, proprietary
trading firms and individual traders
 They accept price risk in the hope that they will profit
from correctly anticipating the market’s price movement
and direction
What are Options?


The holder of the futures option gives them the right,
but not the obligation, to buy or sell a futures
contract at a specific price, called the strike price or
exercise price
The reason why someone would buy an option is
because they think that the price of the futures
contract will be higher or lower in the future
Types of Options

Call Option
Gives the holder the right to buy the futures contract at the
strike price
 If you think that the price of the futures contract will be
higher in the future then you would purchase a call option


Put Option
Gives the holder the right to sell the futures contract at the
strike price
 If you think that the price of the futures contract will be
lower in the future then you would purchase a put option

Options Pricing & Maturity


The price paid for the option is called a premium
Options have an expiration date
 If
the option is an American Option you can exercise
the option on any day up until the expiration date
 If the option is a European Option it is only exercisable
on the expiration date
FUTURES & OPTIONS:
CURRENT REGULATION
Kim Thrun
Federal Regulation

Commodity Exchange Act (CEA) (1974)
 Creates
and defines role of Commodity Futures Trading
Commission
 Authorized creation of National Futures Associations
 Significantly amended by: Commodity Futures
Modernization Act of 2000

Fundamental aim of regulation
 Help
protect market users and the public from fraud
and manipulation and to ensure fair and orderly
markets
Important Historical Regulations &
Legislation

1981


1991


CFTC requires exchanges to set speculative position limits in
all futures contracts in reaction to the attempt by William
Herbert and Nelson Hunt to corner the silver market
CFTC grants a “bona fide hedging” exemption which allows
hedgers with a legitimate business commodity to not be
constrained by positional Limits
2000
Commodity Futures Modernization Act, exempts most OTC
derivatives from regulation (this provision coined ‘the Enron
Loophole’)
 Eventually blamed for contributing to the meltdown of the
US financial markets

Federal Regulation

Commodity Futures Modernization Act of 2000 (CFMA)





Amended the CEA
Excluded trading of most OTC financial derivatives and transactions
between sophisticated counterparties (i.e. eligible contract participants
& excluded commodities)
Exclusion of hybrid instruments that are chiefly securities (Predominance
Test)
Repealed the ban on single-stock futures & implemented regulations for
the products
Created a three-tiered structure for the trading of derivatives that
distinguishes among markets based on the types of contracts traded and
the sophistication of the market participants.
Regulating Bodies

Commodity Futures Trading Commission (CFTC)

Regulates all US futures Exchanges

Exclusive jurisdiction over contracts for the sale of an asset for
future delivery and options on such contracts


Growth of the Futures Market and Financial Derivatives have tested
this exclusive jurisdiction & Futures/Securities regulation line became
muddied
1981: Shad-Johnson Accord/Futures Trading Act of 1982
Regulatory Agency with the power seek Criminal Prosecution
by the DOJ
 Senate and House Agricultural Committees oversees the
CFTC
 Executive Structure:


5 Commissioners, elected to 5 year terms by the President, with
advice and consent of the Senate, President designates one to
serve as Chairman, with confirmation from the senate
Regulating Bodies

National Futures Association (NFA)


Congressionally authorized self-regulatory organization subject to CFTC
oversight
Individuals and firms that engage in futures business with the public are
required to be members of NFA :


Responsible for registration as required by the CFTC, including exchange
floor brokers and traders



Futures Commission Merchants Introducing Brokers, Commodity Trading
Advisors, and Commodity Pool Operators
Brokers and Traders must be separately licensed to trade in commodities
Regulates – The Parties: protect investors from fraud – mediation and
arbitration for consumer complaints
The Exchange


Sets own requirements and rules, similar to the stock-exchanges
Violation of Exchange Rules can result in fines, suspension, or expulsion
Clearing Organizations

Clearing Organizations
 Entity
that clears and settles futures and derivatives
transactions
 Also, assures the proper conduct of each contract’s
delivery procedures and the adequate financing of
trading
 May be a division of a particular exchange, an
affiliate, or a freestanding entity
 Required to register with the CFTC in order to clear
transactions
 Ongoing compliance with 14 core principles
Intermediaries


In general, intermediaries must register with the CFTC
Subject to a wide range of disclosure, reporting,
recordkeeping, and ethical requirements, depending on
the nature of their activities
Futures Commission Merchants (FCM)
 Introducing Brokers
 Commodity Pool Operators
 Commodity Trading Advisers
 Floor Brokers and Floor Traders

Risk-Based Tier Structure Regulations


Multi-tiered approach to oversight based on the nature
of the underlying commodity, the participants trading,
and the manner of the trade
Market Categories
Designated Contract Markets
 Derivatives transaction execution facilities, and
 Exempt markets


Product Categories:
Excluded Commodities
 Exempt Commodities
 Agricultural Commodities

Excluded Commodities

Financial Commodities




Commodities are called excluded because they are not subject
to regulation if they are



Interest rates, currency prices, credit rating, debt instrument; any
economic or commercial index other than a narrow-based
commodity index or commodities that have no cash market
Not susceptible to price manipulation because of large scale
No cash market
(1) between Eligible Contract Participants and
(2) are not traded on an official trading facility
Because many of these products are large in scale, such as
derivatives on economic indicators or weather, they are
considered beyond the influence of interested investors
Exempt Commodities

Definition: “The term “exempt commodity” means a
commodity that is not an excluded commodity or an
agricultural commodity.”





7 U.S.C.A § 1a
Primarily metals and energy commodities
This is the provision referred to as the “Enron loophole” –
recently closed: Farm Bill HR 2419 (2007)
The transaction in the exempt commodity must be entered
into (1) between Eligible Contract Participants an not traded
on a Trading Facility or (2) between Eligible Commercial
Entities on a principal-to-principal basis through an
Electronic Trading Facility
Still subject to fraud and manipulation provisions
Agricultural Commodities

All derivatives based on farm commodities must be
traded on a CTFC-regulated exchange
 Concerns
 Readily
about price manipulation
identifiable cash market
 Limited Supply
 Significant Price Discovery function
Eligible Contract Participants


Eligible Contract Participants

Whether a transaction qualifies for an exclusion under the CFMA often depends on whether the
transaction is between “Eligible Contract Participants”

Based on regulated status or amount of assets

Financial Institutions

Insurance Companies

Investment Companies

Commodity pools with assets over $5 million

Business that (1) has assets over $10 million, (2) transactions are guaranteed by another eligible contract
participant, OR (3) if the transaction related to the business, the businesses net worth is over $1 million

Employee benefit plans with over $5 million and have investment decisions made by independent advisers

Government entities that (1) transact with other eligible contract participants (2) own and invest on a discretionary
basis over $25 million, OR (3) regularly enter into transactions with respect to the underlying commodity

Broker-Dealers

Futures Commission merchants

Individuals with total assets over $10 million – or $5 million when the transaction involves risk management

Any other person determined eligible by the CFTC

Those acting on behalf of an Eligible Contract Participant
Eligible Commercial Entity

An Eligible Contract Participant OR other entity approved by the CFTC
Designated Contract Markets (DCMs)


Highest Level of CFTC Regulatory Oversight
Characteristics:




The traditional organized futures exchanges or boards of trade –
physical or electronic
Offer the widest range of products – essentially on any type of
asset, index, or instrument
Open to all types of market participants: institutional & retail
Regulations:

Exchanges must apply for the DCM designation.


Qualifications: the ability to prevent market manipulation, rules to
ensure fair and equitable trading, rules for operation of the trade
execution facility, financial integrity of transactions, public access to
rules and contract specifications, and the ability to obtain the
information necessary to perform required functions.
Must demonstrate ongoing compliance with the 18 established
principles
Exempt Commercial Markets/Electronic
Trading Facilities


Least Regulated by the CFMA – exempt from most
requirements of the CEA (except still subject to antifraud and
manipulation provisions)
Highest Restrictions on the types of commodities that may be
traded and who may participate – Exempt Commodities on a
Principal-to-Principal Basis between Eligible Commercial
Entities




Metals & Energy
Must notify the CFTC of the intention to operate within the
exemption
No clearing requirement, but many choose to have/provide a
clearing function
Generally – these are the platforms for the trading of OTC
derivatives
Regulation of Electronic Trading
Facilities/Exempt Commercial Markets

This is the market where the “Enron loophole” allowed
energy companies to trade without positional limits –
recently limited: Farm Bill HR 2419 (2007)

Amended CEA, providing for the CFTC regulation of Electronic
Trading Facilities that offer “significant price discovery contracts”
in commodities




Price Discovery: The process of determining the price level for a
commodity based on supply and demand conditions. Price discovery
may occur in a futures market or cash market.
Essentially, if the supply and demand functions serve to determine
the price of the underlying commodity or contract, or effect other
market prices
Can happen when the ECM’s prices are routinely disseminated or
quoted
If the contract meets any of the criteria, the electronic trading
facility becomes subject to exchange-like regulation, meaning the
facility will have to comply with exchange-like regulation
Price Discovery, Hedging, & Speculation


Price Discovery is an important function of the Futures Market – by
influencing demand and supply for futures contracts the price is determined
– transparency is important in this respect
Economically, Futures Trading is a zero-sum game for participants –
someone wins and someone looses

Fundamentally, hedgers may be “happy” to lose because this loss is the cost of
the insurance function



Default is less likely when futures are used in an insurance function
Also – in this respect, futures provide stability in a volatile market
Speculation also plays an important role in the market


While hedgers come to the market to alleviate risk, speculators come to the
market to take on that risk
Often compared to gambling because phenomenal fortunes have been made
and lost


CFMA has provisions that preempt state laws that would classify futures as gambling
Speculation , while often evoking a negative connotation, actually adds liquidity
to the market
Speculation

Competition among speculators provides an efficient
market – moves closer to the prefect competition model:
liquidity in the market drives down spreads


Allows hedging to occur at a lower price and alleviates
much of the counterparty search problems
Information is incorporated swiftly and leads to efficient
price discovery
Reason why stock-index futures are attractive, they move in
tandem with the underlying stocks and are cheaper to buy
and have a lower tax structure in some cases
 Extreme efficiency is demonstrated – stock-index prices
often change before the underlying stock prices do

Speculation – Negative Aspects



Speculation can cause prices to deviate from the intrinsic
value if speculators are trading on misinformation
Speculation can lead to the Creation Positive Feedback
Loop – (Creation of an Economic Bubble): price rises due to
speculation can cause further speculative purchasing
Too many speculators demanding push the price of the
underlying commodity upwards




Blamed for recent (2007-2008) increases in food and oil prices
Change in traditional producer-consumer hedging transaction to
current producer/consumer/speculator-speculator is blamed for
causing unnatural multiples in the market (market much larger
than necessary to successfully hedge) *
Fueled by non-delivery settlement – not required to deliver the
underlying commodity
Convergence-demand effects
Importance of Closing the Loophole


Fundamental Fairness
Ability of Regulators and the Market to
Stop/Regulate Bubbles
Regulations

Margin Regulations

Futures Contract






Standardized Contracts



Initial usually around 5% to 15% based on volatility
Maintenance usually 75% of the Initial
Mark to Market rule does not apply to Hedging Transactions
Margin rules differ across the various option exchanges:
For the Chicago Board of Trade and the Chicago Mercantile Exchange, the
Futures margin is determined by the SPAN margining system, which takes into
account all positions in a customer’s portfolio
Type, Quality, Quantity
Non-delivery settlement
Until 2000, futures transaction were required to occur on registered
or regulated exchanges – off-exchange trading of futures were
banned

NOW: Risk-based tiered approach to regulation
New Regulations

Greater transparency in Exempt Markets

Including Intercontinental Exchange (an ECM) contracts in the Commitments of
Traders Reports


Regulation of off-shore contracts based on US products


“The Commitments of Traders (COT) reports provide a breakdown of each Tuesday’s
open interest for market reports in which 20 or more traders hold positions equal to or
above the reporting levels established by the CFTC.” http://www.cftc.gov/marketreports/commitmentsoftraders/index.htm
CFTC & UK Financial Services Authority reach a deal to tighten oversight of
energy markets
Raised Capital standards for commodity brokers & requiring firms to
incorporate OTC derivatives positions into their risk-based capital
calculations (CFTC rules finalized Dec 31)
Consequences for Failure to Follow
Regulations

Violation of the NFA rules of professional ethics and
conduct, failure to comply with financial and
recordkeeping requirements – Can result in a
permanent bar from engaging in any futuresrelated business
FUTURES & OPTIONS:
EXCHANGES VS. OVER-THE-COUNTER
CLEARING HOUSES
Shayna Hutchins
Exchanges

Futures Contracts
 Standardized
 Underlying
asset
 Contract size/units
 Place
 Maturity
 Counterparty
 Contracts
between intermediaries, separate buyer and
seller
 Deliver to the exchange, not to a specific party
 Used for short term hedging
Exchanges
Party 1
Corn Farmer
 CME
Exchange
CBOT
Group
 CME
– Chicago Mercantile Exchange
 CBOT – Chicago Board of Trade
 NYMEX – New York Mercantile Exchange
 CBOE
– Chicago Board Options Exchange
Party 2
Ethanol
Producer
Over-The-Counter Markets

Forward Contracts
 Individually
tailored to a particular risk
 Direct contract between buyer and seller
 Prices derived from exchanges
 Price
discovery on exchanges keep OTC markets and
forward contracts in line with futures prices
 Good
 Ex)
for hedging against long-term investments
Stream of foreign currency
Over-The-Counter Markets
Party 2
Ethanol
Producer
Party 1
Corn Farmer
Broker
Exchanges vs. Over-The-Counter

Exchanges
 High
liquidity
 High transparency
 Low risk

OTC
 More
flexible
 Low liquidity
 Low transparency*
 Higher counterparty risk*
 High risk
Problems with OTC Markets

Transparency
 Availability
 Price,
of information
volume, contracting parties
 Evaluating
and managing risk
 Counterparty
 Systemic
credit risk  default risk
risk
 Interconnections
 The
and contracts between firms
Domino Effect
The Domino Effect
Corn
Farmer
Corn
Farmer
Ethanol
Producer
Corn
Farmer
Orville
Speculator
Kellog’s
Speculator
Problems with OTC Markets

Counterparty risk
 OTCs
deal with counterparty risk by setting privately
negotiated collateral requirements
 Not
standardized
 Doesn’t take credit risk or exposure into account
 Because no transparency/availability of information
 Difficult to evaluate
 Actual
risk depends on actual deals being done
 Possibility of certain firms cornering the market
 Market
Concentration
 Creates systemic risk
Market Concentration (OTC)
Kellog’s
Corn
Farmer
(seller)
Ethanol
Producer
Orville
Redenbacher
Livestock
Farmer
Market Concentration (Exchange)
Kellog’s
Corn
Farmer
(seller)
Livestock
Farmer
Hedger
Ethanol
Producer
Orville
Redenbacher
Speculator
Proposed Solution: Centralized Clearing


When OTC markets become large enough to
significantly impact the overall financial system,
they need to have centralized clearing in order to
aggregate the information on outstanding deals
and risk exposures for the benefit of regulatory
authorities and other market participants
3 different types of central clearing
 offer
different levels of market integration and
transparency
Types of Centralized Clearing

1. Deals Registry
 Most
basic arrangement
 Registry of deals in which counterparties report trades
 Public disclosure of trading information
 Leads to more accurate pricing and safer collateral
requirements
 Creates incentive for sellers to limit risk exposure
 Investors, regulators, and financial institutions can better
analyze and hedge “true” risk
 Reduce systemic risk
Types of Centralized Clearing

2. Clearing House as Central Counterparty
 Stronger
form of clearing
 Takes on the role of counterparty and guarantor of all
contracts
 Similar
 Deals
to clearing house for a formal exchange
are still individually negotiated, but are then split
into 2 separate contracts and required to be registered
with the clearing house in the middle of the transaction
 Clearing house sets standardized margin requirements
for all contracts
 Still offers access to multiple trading platforms
Types of Centralized Clearing

3. Formal Exchange
Strongest and most centralized form of market organization
 High transparency


Offers highly visible prices and volumes
Allows broad market participation
 Minimizes counterparty risk through standardized margins
and contract guarantees supported by the capital of both
the clearing house and independent market makers
 Creates problem of standardizing complex instruments

Not a one-size-fits-all solution
 Compromises flexibility of the contracts


High cost of setting up and running an exchange

Not suitable for thinly traded instruments
Policy Recommendations

Trade disclosure to promote transparency
 Balance

information with confidential trading strategies
Centralized organization
 Assume
role of counterparty and guarantee trades
 Reduces risk and increases transparency


Importance of non-standardized instruments
Compromise: Clearing House as Central
Counterparty is the favored solution
Clearing Houses

Acts as an intermediary between buyer and seller
 Guarantees
both buyers and sellers will receive what
they’ve contracted for
 Seller doesn’t have to worry about financial stability of
buyer
 Buyer doesn’t have to worry about product of seller
Party 1
Corn
Farmer
Firm 1
Local Agri.
Bank
Clearing
House
Firm 2
JP Morgan
Party 2
Ethanol
Producer
Clearing Houses: Risk Minimization

Margin requirements




Amount due varies based on market fluctuations
Clearing house tallies up daily trades/contracts
Mark to market daily
Parties holding contracts that have fallen during the day are
required to pay the clearing house a sort of security deposit




“Margin calls”
Investors must be able to fulfill immediately
When the contracts are closed out at maturity, the clearing house
pays the parties who contracts have gained in value
Futures trading is a zero-sum game: for every winner, someone
loses an equal amount


Ensures that risk associated with highest possible cost of closing out a
contract the next exchange day is completely covered
Assumes most unfavorable change in the market of the positions held
Clearing Houses: Risk Minimization

Additional security measures
 Instead
of standing between 2 traders, the clearing
house stands between 2 member firms
 Each firm monitors its own customers and makes margin
calls when necessary
 If
a customer can’t fulfill the margin call, the firm closes the
account, sells off the positions, and may take a loss
 Firms
pay attention to the credit of their customers
 Clearing house pays attention to the credit of the firms
 Clearing house will only have to make good on a trade
if the losses are so great that the firm itself fails
Public vs. Private Clearing Houses

Public Option
 Government
run
 May be more highly monitored
 Possibility of a government run monopoly

Private Option
 Used
in Europe as a profit making business
 Many
 Each
institutional banks operate their own clearing houses
exchange in the U.S. has its own clearing house
 Possibility of high fees injected into the OTC market
 Risky because they need to turn a profit
The Future of F&O Markets



Academic debate
No current proposed regulation to set up a
mandatory clearing house for futures and options
Current action on clearing houses for derivatives
 Played
a larger role in the financial crisis
 Viewed as riskier instruments

Wait-and-see approach
A Caveat: Where does the risk go?



Transfer of risk from banks to clearing houses
Either option will have to be backed by the
government and has the possibility of becoming a
“too-big-to-fail” institution if it is the sole clearing
house
Option of creating multiple clearing houses that are
in competition with one another
 Competition
can fuel risky behavior
Final Thoughts


Is this idea an example of the herding effect?
Does it create another moral hazard by passing off
risk?
Party 1
Corn
Farmer
Firm 1
Local Agri.
Bank
Clearing
House
Firm 2
JP Morgan
Party 2
Ethanol
Producer
FUTURES & OPTIONS:
THE SEC AND THE CFTC
OTHER PROPOSED REGULATIONS
Nermin Jasani
Merging the SEC and CFTC

Why merge the SEC and the CFTC?
 Mainly
because there is overlap between both
organizations with respect to products like OTC
derivatives and their function in regulating the futures
market and the stock market
What are the benefits of a merger?






Allow both the CFTC and the SEC to share information
and prevent a future financial breakdown
Stronger oversight
Eliminating turf wars
Reducing delays in launching derivatives
Eliminates the overlap
Save on government expenditure with the SEC and
CFTC – proposed CFTC budget for 2010 is $177.7
million, and the proposed SEC budget for 2010 is
$1.13 billion
Why shouldn’t they merge?



Merging them would be inefficient – SEC’s function
to level the playing field, and CFTC’s function of
hedging risk
Time consuming for Congress to re-write both the
SEC and CFTC regulation
If there was a merger, SEC’s policies would prevail
over the CFTC’s, which would be unsuccessful in
regulating the futures market
Will the SEC and CFTC actually merge,
or is this simply coffee talk?




Not anytime soon, they may merge some of their
activities, but a complete merger is unlikely anytime
soon
September 2009 – Geithner stated that he does
not plan on merging these regulators, and it is not a
priority
The House Bill and Senate Bill mention nothing
about merging these regulators
Politics - Senate Agricultural Committee is unlikely to
relinquish its power
Regulations proposed by CFTC to
regulate F&O
POSITION LIMITS

What are position limits?


Position limits are created for the purpose of maintaining
stable and fair markets. Contracts held by one individual
investor with different brokers may be combined in order to
gauge accurately the level of control held by one party
Purpose of position limits?
Reducing volatility in the markets
 Reduce speculation
 Increasing transparency with respect to actual demand
 Limiting the number of futures/options contracts that one
party can hold – preventing corner’s in the market

Limits on energy futures and options

What includes “energy”?


Why have energy as the first position limit imposed by the
CFTC?
Increased energy prices in summer 2008 led Congress to believe
that energy traders were driving up the cost of energy
 This position limit is intended to reveal what actual demand for
energy is, which will provide a more accurate price for energy
 CFTC estimated that if the limit were adopted today a trader
could hold no more than 98,200 contracts of crude oil
Will there be any exemptions for energy position limits?
 Airlines and other companies who are hedging for business
purposes will receive an exemption for this requirement


Natural gas, heating oil, crude oil and gasoline
Will there be additional position limits?

CFTC is having a meeting on metals in March to
begin discussing positional limits
H.R. 4173

What does the House bill have with respect to
futures and options?
 Taxing

Purpose of the tax?
 Fund

futures and options transactions
the CFTC
Flaws of this proposed tax?
 Drive
trading to less regulated and less transparent
markets (overseas), severely curtail market-making
activity, and drive up the costs of hedging price risks
H.R. 4173



Requires the CFTC to establish hard limits on
commodity trading both on and off exchanges
Already seeing it in the form of position limits
Forcing the SEC and CFTC to work together in
creating rule-making authority. If they do not meet
statutory deadlines, the Treasury will prescribe the
rules. This threat is intended to force these agencies
to work together, for once.
H.R. 4173

Futures Held in a Portfolio Margin Securities Account
Protection:
 The
bill attempts to extend SIPC insurance to futures
positions held in a customer portfolio margining account
under a program approved by the SEC.
Regulating the foreign exchange market

Forex limits:
 Leverage
in retail forex customer accounts would be
subject to a 10-to-1 limitation, which means 10:1
leverage would be the maximum amount allowed for
forex traders in the U.S.
 This means that before you can purchase a lot of say
100k yen, you have to have a higher margin – i.e. pay
10k instead of 1k as a margin requirement.
 Disadvantages – traders are not fond of increasing the
margin requirements, which will reduce their yield;
already discussing moving to off shore sources.
Flash orders in the options world

Reducing flash orders in the options world:
While most attention has focused on flash trading on stock
exchanges, such practices appear to be more prevalent on
options exchanges, according to industry participants. On
options exchanges, flash orders commonly go by different
names, such as "step-up" orders.
 High-frequency traders have increasingly been moving into
the slower options-trading universe, traders say.
 Hybrid Agency Liaison mechanism. Trades that go to the
CBOE, which accounts for about one-third of all optiontrading volume, can be frozen for about one-tenth of a
second. That brief moment gives other traders on the
exchange the opportunity to match the order at the national
best bid offer, or NBBO, before it routes to another venue.

Other possible regulation


Treat futures like stocks and increase their
transparency as the SEC requires
Heavier fines
Activity in F&O Markets

Total options trading volume for 2009 was
3,612,637,118 contracts.




This surpasses 2008’s record year by 0.84 percent which
saw 3,582,572,581 total options contracts change hands
Options Premium: $1.22 trillion, down from $1.9 trillion
in 2008 as prices to buy options came down from the
peaks seen at the height of the financial crisis
2009: total futures 587,977,047
2008: total futures 825,544,634
FUTURES & OPTIONS:
EMERGING MARKETS
(BRIC COUNTRIES)
Regina Malta
Futures in Emerging Markets

BRAZIL
 Exchanges:
 Brazilian

Mercantile and Futures Exchange
(BMF)
RUSSIA
 Exchanges:
 Moscow
Interbank Currency Exchange (MICEX)
 Futures and Options RTS (Russian Trading System) (FORTS)
Futures in Emerging Markets

INDIA
 Exchanges
 National
Stock Exchange of India (NSE)
 Bombay Stock Exchange (BSE)
 Multi Commodity Exchange of India (MCX)
 National Multi Commodity Exchange of India (NMCE)
 National Commodity and Derivatives Exchange (NCDEX)
Futures in Emerging Markets

CHINA
 Exchanges:
 Dalian
Commodity Exchange (DCE)
 Shanghai Futures Exchange (SHFE)
 Zhengzhou Commodity Exchange (ZCE)
 China Financial Futures Exchange (CFFEX)
Brazil: F&O Markets

Derivatives trading in Brazil began in 1917 on an
exchange




Most of the trades were in coffee and cotton
In 1997the three main derivatives exchanges merged to
form a single exchange called the Brazilian Mercantile
Futures Exchange (BMF)
Today, Brazil offers futures trading through both
organized exchanges and over-the-counter (OTC)
markets
The most actively traded futures contract in Brazil is the
Interbank Deposits (DI) futures
Brazil: F&O Markets

The two main exchanges in Brazil are the BMF the
Bovespa (Brazil’s stock and options exchange)




The BMF derivatives exchange, located in Sao Paulo, is
the 5th largest futures exchange in the world
The BMF decided to go public in 2007 and conducted
an IPO
The Bovespa exchange, also located in Sao Paulo, is the
7th largest futures and options exchange in the world


The BMF is a self regulatory organization
The Bovespa mostly trades options on single stocks and
options on stock indexes
Both the BMF and the Bovespa offer electronic trading
Brazil: Clearing Houses






Clearing houses are used to clear exchanged traded futures contracts and also OTC
traded derivatives (voluntary). The clearing house becomes the counterparty to
every contract traded, and therefore fully assumes the credit risk of the contract.
The clearing house has AAA ratings because they are highly capitalized. Investors
post collateral directly with the clearing house.
The clearing house has five-levels of capitalization which assures greater credit
protection.
1. Customer margin
2. The firm which brokered the trade.
3. Clearing member to whom the broker is tied.
4. Special Fund of Clearing Members.
5. The BMF itself.
Margin requirements provide the greatest defense against contract default.
Currently there are no collateral requirements in the OTC market, so most
transactions end up operating with no collateral at all, unless the parties chose to
use the BMF clearing house.
The BMF clearing house has its own bank in order to facilitate the settlement and
overall payment of the transaction conducted.
Brazil: OTC Markets





OTC markets are usually not very transparent due to lack of
regulation on reporting and disclosure requirements. Brazil has
established some reporting requirements for OTC markets trading. In
order to be considered legally enforceable, every transaction must
be reported to one of two central registration and confirmation
organizations- the BMF or CETIP.
Because of the reporting requirements in the OTC market, Brazil has
the most transparent OTC market in the world.
There are about 15-20 dealers in Brazil’s OTC derivatives market.
Unlike most markets, inter-dealer market transactions are conducted
through the BMF instead of through OTC transactions. They then
provide derivative instruments to their buys in OTC market. The result
being that the markets are more interconnected and reduced credit
exposure.
Brazil’s futures market allows for the price discovery for the realdollar exchange rate and the interest rate.
Brazil: Hedging

One of the most important features of the market is
that it allows for hedging the fluctuations in
domestic market interest rates
 This
is so important because Brazil has a past history
with very high inflation and high nominal interest rates

Hedging is also used to comply with environmental
climate change requirements, by trading carbon
futures contracts
Russia: F&O Markets


FORTS (Futures and Options on RTS) is the leading derivative market
in Russia
Open Join Stock Company “Russian Trading System” Stock Exchange
organizes trading on the FORTS exchange in Russia




The clearing function for the derivative market is performed by the
Closed Joint Stock Company “RTS Clearing Center”
FORTS is mostly run by the leading Russian brokerages and
investment banks
Participants in the FORTS market are highly capitalized investment
companies and banks
The range of futures contracts traded on FORTS is narrow


Futures contracts traded on the FORTS consists of the shares and bonds
issued by major Russian companies, RTS Index, foreign currency, the
average MosIBOR overnight rate, and MosPrime 3month rate
The commodities traded include Urals oil, gas oil, gold, silver, and sugar.
Russia: To Develop or Not to Develop?


The main reason for the underdevelopment of the Russian derivative
market can be traced to the legal risk associated with the lack of
regulation in the market
In the beginning Russian courts refused to recognize net payouts as a
legal contract, and therefore they were unenforceable



In 2007 these contracts were made enforceable provided that at least
one of the parties involved in the transaction is a Russian bank or a
recognized participant of the market
Although this solved part of the problem, a huge reason why the Russian
market is still having trouble expanding is that they are unfamiliar with
the concept of close-out, or liquidation netting.
In 2009 after much debate, Russia finally a set of standard
derivative contracts. The posting of collateral was also introduced.
Although this was a big step forward in growing the Russian
derivatives market, it is unclear how the participants will react to the
new system.
India: F&O Markets




Futures Markets evolved in India in 1875 with the
opening of the Bombay Cotton Trade Association
Ltd.
The earliest futures contracts traded were
groundnut, castor seed, and cotton
Futures trading in oilseeds soon followed
In 1945 the East India Jute and Hessian Ltd. was
formed to conduct organized trading in both raw
Jute and Jute goods
India: F&O Markets

In December 1952 Forwards Contract Regulation Act was enacted,
which provided for a 3-tier regulatory system:




An association recognized by the government to provide
recommendations to the Forwards Market Commission
Forwards Markets Commission.
Central Government
The Forward Contract Regulation Rules were established by the
Central Government in 1954. The rules divided commodities into 3
categories based on the extent of regulation:



Commodities under which futures trading can be organized under a
recognized association
Commodities in which futures trading is prohibited
“Free Commodities” which do not fall under the first two categories. The
association trading these commodities must obtain a Certificate of
Registration from the Forward Markets Commission
India: Futures Market Re-Emerges




Trading was pretty much halted altogether in the 1970s
Futures trading was slowly reintroduced in the 1980s
In 1991 the Government of India liberalized industries
in both the domestic and external sectors. Soon after
another Committee was introduced to help expand the
futures market
The Committee recommended futures trading in:

Basmati Rice, Cotton and Kapas, Raw Jute and Jute Goods,
Groundnut, Rapeseed/mustard seed, cotton seed, sesame
seed, sunflower seed, safflower seed, copra and soybean,
and oils, Rice bran oil, Castor oil, Linseed, Silver, and Onions
India: Futures Market Re-Emerges

Today, there are no restrictions on futures trading in
any commodity
 However,

Futures contracts are available in 1month, 2month,
and 3month terms, and are settled on the last
Thursday of every month
 Contracts

options trading in commodities are prohibited
are traded in lot sizes.
The Securities and Exchange Board of India also
overlooks the activities of the Futures market, as
well as the stock market
China: F&O Markets




Futures trading was first introduced in 1990
Futures trading in China is governed by the Administrative Regulations on
Futures Trading
The China Securities Regulatory Commission, part of the State Counsel
Securities Commission, is the main policy implementation body
The China Futures Association (CFA) was established in 2000 to promote
market development



The CFA is a non-profit self regulatory organization. The CFA is supervised by
the China Securities Regulatory Commission.
The authority of the CFA lies in its collective members which include:
brokerage firms, futures exchange special members and licensed individual
futures traders
The CFA acts as a bridge between the futures market participants and the
Government of China

It implements laws, regulations and policies for the futures market, while also
maintaining the transparency and fairness of the market
China: Futures Exchanges





A futures exchange can be organized as either a membership organization
or a corporation
China currently offers futures contracts in 19 commodities, with various new
contracts being proposed
There is no futures option trading
Chinese futures exchanges are required by law to enforce futures margins
requirements, price limits, position limits, large account position reporting
requirement, risk reserve requirement, etc.
There are 165 futures brokerage companies in China.


Companies that participate in the futures market must have their clients sign a
risk disclosure document with a client agreement and must also deposit futures
margin requirement before starting to trade. These companies are also
responsible for completing delivery procedures on behalf of their clients.
In 2009 the China Futures Association reported a futures trading volume of
130.51 trillion yuan, up 81.5% from the past year

The largest trades were in copper, natural rubber and soybean oil.
QUESTIONS?
FUTURES &
OPTIONS
Shayna Hutchins, Nermin Jasani, Regina Malta, & Kim Thrun