Commodity futures trading - Industry Overview

US Industrial Outlook, Annual, 1993 by Donald H. Heitman

Since the early 1970's, U S. commodity futures trading has grown in volume every year, often quite dramatically, with the single exception of a moderate downturn in 1991. Despite continuing competitive pressure from foreign futures markets, volume recovered in 1992 and that pattern of steady growth is expected to continue in 1993.

In addition to a return to the pattern of steady volume growth, 1992 saw innovative efforts by the U.S. futures I industry designed to respond to an increasingly globalized, electronically sophisticated and competitive marketplace. U.S. futures exchanges explored various technological enhancements aimed at improving the efficiency of the trading process, including a revolutionary hand-held "electronic trading card." U.S. exchanges launched the first international, multi-exchange screen-based electronic trading system.

U.S. exchanges also continued to seek out new areas which may lend themselves to futures and options trading. Over the past decade, an average of more than 20 new futures and option contracts has been approved for trading each year. Innovative contracts approved in 1992 included futures on health insurance, homeowners insurance, chemical fertilizers, jet fuel, scrap steel, barge freight rates, and Clean Air Act emission allowances.

The futures industry, for purposes of this chapter, includes individuals and firms engaged in the offer, purchase or sale of commodity futures or option contracts for their own account or for the account of others, exchanges, exchange clearinghouses and other services involved with futures or option trading under the following Standard Industrial Classification (SIC) categories: Commodity Contracts Brokers and Dealers (6221), Security and Commodity Exchanges (6231), Investment Advice (6282) and, Services Allied with the Exchange of Securities or Commodities, Not Elsewhere Classified (6289).

For answers to questions regarding data collection procedures, factors affecting international data, the use of constant dollars, sources and references, and the SIC system, see "How to Get the Most Out of This Book" on page 1. For other topics related to this chapter, see chapters 1 (Metals and Industrial Mineral Mining), 3 (Crude Petroleum and Natural Gas), 4 (Petroleum Refining), 13 (Metals), 45 (Commercial Banking), 48 (Mutual Funds), and 49 (Securities Firms).

The roots of U.S. futures trading go back almost 200 years to regional cash markets in agricultural commodities that arose in the late 1700's. Supply/demand imbalances in these cash markets gave rise to the practice of forward contracting--the purchase or sale of a specific quality and quantity of a commodity for delivery at a specified future date. Between 1850 and 1900, the need for greater control of financial risks gave rise to futures trading on organized exchanges. A futures contract can be seen as a specialized type of forward contract in which quality, quantity and delivery terms are generally standardized, leaving only price to be determined. A primary benefit of trading on a futures exchange is that the exchange clearinghouse stands behind each contract, acting as the buyer to each seller and the seller to each buyer, effectively removing concerns about counterparty credit risk.

The basic risk management principles of futures trading have very broad applicability and today U.S. futures exchanges have evolved to offer both futures contracts and options on a wide variety of commodities. (An option is a contract in which the buyer pays a premium for the right, but not the obligation, to make a future purchase or sale at a specified price.) The range of products offered on 11 actively trading U.S. futures exchanges includes contracts on agricultural commodities (both domestic and foreign-grown), metals, energy products, currencies, and a wide array of U.S. and foreign financial instruments and indices.

Futures and options markets perform two vital economic functions, hedging and price discovery. In hedging, a commercial enterprise seeks to manage or control its exposure to price change risk by assuming a futures or option position which offsets the risk of its cash market operations. The ability to hedge allows firms to lock in prices, facilitates long-term planning and promotes business and financial stability.

The price discovery function of futures trading simply means that the continuous, open outcry auction of a futures exchange trading pit is an excellent method for accurately determining the appropriate price level of a commodity, based upon supply and demand factors. The price information generated on futures exchanges is widely disseminated and used as a pricing gauge by many individuals and firms that do not participate in futures markets.

Futures trading encompasses both hedgers, seeking to manage risk, and speculators, who voluntarily assume risk in hopes of making a profit on price changes. Some of the participants in futures markets include: commercial hedgers; individual speculative customers; brokerage firms ("futures commission merchants" or FCMs) that execute customer orders and may also conduct proprietary trading for their own accounts; institutional money managers trading for their own accounts or on behalf of clients, such as pension funds; commodity pools (the futures equivalent of a mutual fund); and exchange members who trade on the exchange floors, executing customer orders or engaging in speculative trading for their own accounts, thereby providing vital market liquidity.