21 April 2020
I’ve recently been learning about cryptocurrency futures trading, and am finally grasping some of the core concepts. In this article, I’m going to explain how futures markets work, and in particular the logic of why contracts are settled daily, by building on a simple farmer and baker example I read about at Investopedia.
Imagine it’s January, and a wheat farmer and a baker both need some predictability about the price of wheat on May 1. The baker needs 5,000 bushels of wheat, which is what the farmer needs to sell. They can come to an agreement today to exchange that wheat in May at today’s price of $4 per bushel, and the formalization of that agreement would be called a futures contract.
The baker would be said to be on the long side of the agreement (he has the obligation to buy the wheat) and the farmer would be said to be on the short side of the agreement (she has the obligation to sell the wheat.) The contract price would be $4, and the settlement date would be May 1.
Now lets imagine that on May 1 the market price—usually referred to as the spot price—of wheat is $5 per bushel. Rather than physically delivering 5,000 bushels of wheat, the farmer and baker simply agree to settle the contract in cash. The baker owes the farmer the $20,000 agreed in January (i.e. $4 per bushel for 5,000 bushels), and the farmer owes the baker $25,000 so that he can purchase 5,000 bushels of wheat in the current market (since it now costs $5 per bushel). As a net result, the farmer gives the baker the difference of $5,000.
By doing a cash settlement, instead of physical delivery, both parties retain the outcome of the original contract.
Now, rather than arranging this contract directly, let’s imagine there’s a business that runs a futures marketplace—called an exchange—where the May 1 wheat contract is bought and sold by farmers and bakers (or others who need wheat) who don’t know each other. And to avoid dealing with the contractual physical delivery of commodities, let’s imagine the exchange implements cash settlement.
How could this work?
For starters, the exchange needs to address the risk that the buyers and sellers don’t default on their agreements, regardless of what happens to the price of the commodity over time. The exchange operator could do this by requiring that buyers and sellers deposit some cash that the exchange holds as collateral. Let’s imagine that in the case of our particular farmer and baker, who want to enter into a contract that today is worth $20,000, the exchange requires each to deposit $10,000. In modern futures exchanges, this collateral is called margin.
We’ve seen in the previous example that the price of wheat in May was $5, which resulted in the farmer transferring $5,000 to the baker to cash settle their contract. In this case, the farmer’s $10,000 of margin in her exchange account would have been sufficient for the exchange to settle this contract.
But what would happen if the May 1 market price of wheat was $7, in which case the farmer owed the baker $15,000? The exchange could ask the farmer to deposit an additional $5,000, but what if she didn’t?
How can the exchange address this kind of risk? Through the mechanism of daily settlement.
Rather than wait until May 1 to settle the contract, what if the exchange did a settlement of the contract every day, until May 1? Let’s see how the farmer’s account would look over a contract of, say, five days (just to make the following table shorter), and settled daily:
For a futures contract of 5,000 bushels at today’s price of $5, that settles daily, we see the same net effect for the farmer—i.e. a total transfer of $5,000—as if the contract settled at the end.
With daily settlement, if the price goes against the farmer for a while, such that her margin (collateral) drops to a dangerous level, the exchange can request that she add additional margin to her account. This is known as a margin call. If she doesn’t, and her margin reaches zero, the exchange can simply close out her position, an event called liquidation, and let another farmer in the marketplace pickup and carry on with the contract.
Since this market model for the trading of commodities doesn’t actually involve the physical delivery of commodities, financial investors began participating simply for the opportunity to speculate on the future price change of the underlying commodity. And naturally, today we have platforms like Bitmex and Deribit that let crypto currency investors speculate on the future prices of currencies like Bitcoin.
This article has explained the fundamentals of futures markets. Here’s some additional comments and issues I’ll address in future articles: