Futures Market

The issue of how best to regulate futures markets has recently come to the fore of public policy debates about financial governance. However, futures markets themselves are not new. They were first instituted in Japan in the eighteenth century for trading rice and silk at a set price, and in the 1850s, they were introduced in the United States for markets in cotton, corn, and wheat. Their rationale remains much the same now as then. A futures market is a continuous auction market in which participants buy and sell commodities contracts for delivery on a specified date. The price of the futures contract is a derivative of the price in the spot market for the related commodity. The only real difference between early [Page 332]and later futures markets is the nature of the commodity against which the contract is drawn. Although the original futures markets traded in agricultural products, today they trade primarily in financial instruments. Contemporary futures contracts relate overwhelmingly to a predetermined exchange of financial products at a price that may or may not diverge significantly from the price of that product in the spot market. If a trader has accepted a contract to buy a product at a particular time for a particular price, this contract is legally binding. That trader is obliged to execute the exchange, irrespective of whether a loss is incurred by doing so.

The likely existence of price differentials between the spot market and the futures market suggests that there are two reasons for operating on the futures market. The first is a form of insurance against financial risk. Traders may attempt to offset the risk from forward price volatility in any financial product—such as foreign exchange, company shares, or the stock market index—by entering the relevant futures markets as a buyer. In this way, traders lock in the price they will pay for a product at a specified date. This hedges the risk of adverse price changes in the interim, and it makes the process of financial planning more predictable.

However, price differentials between the spot market and the futures market also provide traders with incentives to buy futures contracts as speculative assets. Profits can be made either by holding the futures contract until maturity and being on the right side of the market, or by selling the contract to another party at a higher price before it matures. Only a small proportion of futures contracts are held until maturity by the person purchasing the original contract. This suggests that the overwhelming motive for operating on the futures market is to speculate. Moreover, futures markets tend to be highly liquid, encouraging more and more speculators to use them. Trading volumes in futures markets now comfortably exceed trading volumes in related spot markets, and they dwarf levels of activity within the productive economy.