Futures Exchange: Overview of How it Works, History

What Is a Futures Exchange?

A futures exchange is a marketplace where a diverse range of commodities futures, index futures, and options on futures contracts are bought and sold. Those who are 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 (NFA) and the Commodity Futures Trading Commission (CFTC). Individuals who want to trade futures contracts must do so by establishing an account with a registered broker. Futures exchanges also provide clearing and settlement functions.

How a Futures Exchange Works

The function of a futures exchange is to standardize and promote futures trading for as many participants as possible. The incentive mechanisms for those who run the exchange are roughly based on the volume and dollar value of what is traded—the more the better. That means they work to bring in as many participants making as many trades as is possible. This has led to many innovations in recent years, driving increased participation through electronic networks.

Where a futures exchange used to have an important physical presence, such as the trading floors in the Chicago Mercantile Exchange (CME) or the New York Mercantile Exchange (NYMEX), it is no longer true that these locations hold as much meaning as they once did. Since trading can happen from the computer of anyone connected through the internet to an exchange-member broker, trading is decentralized around the world and happens nearly 24 hours a day during the week.

Futures traded on a futures exchange allow the sellers of the underlying commodities the certainty of the price they will receive for their products at the market. At the same time, the exchange will enable consumers or buyers of those underlying commodities the certainty of the price they will pay, at a defined time in the future.

To encourage as much participation and liquidity as possible, contracts trading on an exchange have standardized sizes, expiration dates, and, for options, strike prices. This standardization contrasts with over-the-counter (OTC) contracts where buyers and sellers agree to bespoke terms.

Exchanges also provide pricing information, disseminated by information vendor firms. Information sharing allows for transparency in activities and fairness to all. Pricing information, including price, bids, and offers, is available to all interested institutions and individuals equally, no matter their size.

Another very important aspect of the exchange is that it provides clearing services. While various firms provide the clearing, the exchange standardizes the charges and the performance of that service. Clearing services ensure that participants don't have to worry about the risk of their trade counterparty failing to deliver on their contractual obligations. That makes trading a very simple proposition for short-term speculators and keeps them interested in participating in the futures market.

A Short History of Futures Exchanges in the U.S.

The largest futures exchange in the U.S., the Chicago Mercantile Exchange, was formed in the late 1890s when the only futures contracts offered were for agricultural products. The emergence of interest rate, or bond futures, and currency futures in major foreign exchange markets came in the 1970s. Today's futures exchanges are significantly larger, with hedging of financial instruments via futures. These futures hedging contracts comprise the majority of the futures market activity. Futures exchanges play an important role in the operation of the global financial system.

Financial exchanges saw many mergers, with the most significant being between the Chicago Mercantile Exchange and the Chicago Board of Trade (CBOT) in 2007. Rebranded as the CME Group, it then acquired NYMEX Holdings, Inc., the parent of the New York Mercantile Exchange (NYMEX) and Commodity Exchange, Inc (COMEX) in 2008. Growing again in 2012, it added the Kansas City Board of Trade, who is the dominant player in hard red winter wheat.

Another major player in the U.S. is the Intercontinental Exchange (ICE). Born as an electronic exchange in 2000, ICE acquired the International Petroleum Exchange (IPE) in 2001. In 2007, it obtained both the New York Board of Trade (NYBOT) and the Winnipeg Commodity Exchange (WCE). Finally, it expanded into equities with the acquisition of NYSE Euronext in 2013.