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The former can be regarded as a club, whose members are the futures brokers. This club has entry and procedural rules, and provides a forum for trading, be it physical (a trading pit), or electronic (screen-based).
The futures exchange is therefore something like an independent football stadium, which allows the players use of its facilities, as long as they behave themselves, but is in principle unconcerned with the operation of any particular football league.
The clearing entity itself may be an integral part of the exchange (such as the OSE), a subsidiary of the exchange (as is the case for the CBOT), or it may be a completely separate institution (for example, the London Clearing Corporation which clears trades for LIFFE).
There are two main inter-related mechanisms designed to ensure the performance of futures and options traded on an officially recognised exchange, these being -
With this action, one new contract will come into existence.
These contracts are continually being created and closed as trades are transacted on the exchange, such that the total number of contracts in existence is always changing. This is not the case with equities or bonds, which are assets - not contracts - and of which there are, day-to-day, a fixed number.
At the time of the trade, the situation can be represented diagrammatically
At the end of each day, all trades are passed through the clearing house.
With this process, the direct link between the two brokers is broken and the clearing house steps in between the brokers, taking the other side of the contract to each broker. Such that, in the above case, one contract is created between Broker A and the clearing house (Broker A being short and the exchange long), and another contract is created between the clearing house and Broker B ( the exchange being short and the broker long).
The futures trade now looks like this
The clearing house now takes upon itself the role of guaranteeing performance of the contracts to each of the respective brokers. Hence it becomes the counter-party to all open contracts.
Overall, the clearing house will have no net exposure to price movements, as it will always have a matched position (reflecting the fact that futures markets are a zero sum game).
To help strengthen this guarantee mechanism, the clearing house will usually have a guarantee fund to call upon in the event of a default by a member broker.
The other mechanism used to ensure performance of the contracts is the margin procedure.
The level of margin called is set by the clearing house and is usually a function of the volatility of the underlying cash market. It is calculated to cover the maximum expected move in the cash market in one day (i.e. the highest probable loss incurred on a contract between daily margin calls).
The brokers positions will be marked to market each day, and further margin calls made when the market moves against a position.
By this method, come expiry of a contract, it should never arise that the clearing house suddenly learns that a broker can not honour a contract. This is because, whatever losses the broker has incurred on the position should already have been paid, in the form of margin calls to the clearing house over the period that the position had been held open. Example.
The robustness of a futures market therefore derives from the existence of a guarantee fund and the procedure of margin calls.
One definition of an exchange-traded futures (or options) contract is that it is a standardised forward contract, and many investors may prefer exchange traded contracts to OTC contracts because of this perceived standardisation. However, while standardisation may exist between brokers and the exchange, contracts between brokers and clients may vary. Here, the contracts are usually governed by the client agreement signed when setting up the account.
The advantage of a central guarantee mechanism is obviously that brokers do not have to check the credit worthiness of potential counter parties on the exchange - the counter party is always the clearing house.
However, this tidy arrangement does not necessarily extend to the end clients. The guarantee mechanism is to ensure performance of the contracts between brokers and brokers (not brokers and clients).
An exchange has strict membership rules and monitors its members closely. It does not want to have to check the financial standing of any number of potential investors. Hence, this is left up to the brokers themselves.
Therefore, in the event of a massive default on a futures exchange, investors would have to look to the credit-worthiness of their broker alone.
Sometimes an exchange will have a compensation fund for the benefit of clients, but this will usually be far smaller than the guarantee fund.
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