Futures are safe

Contributor: Mike Wilkins

“Futures are safe”, that’s not an expression you hear very often. Let’s face it, in a world where most people’s exposure to futures markets is limited to watching “Trading Places” and hearing nightly news reports about surging commodity prices, the perception is that futures markets are fraught with danger and are just one step above the blackjack table in Vegas. But there was Donald Wilson, founder of DRW Trading and one of the leading minds in the exchange traded derivative spaces reminding an audience at last week’s Aite Group “Trading 2011: Trading In The Fast Lane” conference that in spite of all the sensationalism, futures markets provide an efficient system for price discovery and risk management.

Wilson’s thesis revolved around five points:

Transparency. The current market price for any contract is always displayed to all participants. Trades are reported the moment a match is made, and historical trade activity is readily shown and easily accessed. There’s no secondary marketplaces, no off-tape transactions that get published after the fact.

Trade certainty. Futures exchange matching algorithms are pretty simple—whether they’re pro-rata or first in first out. In either case, if you’re in the market and your price is traded through, you know your order is matched. There’s no chance of a smaller market participant getting “lost in the shuffle” when a trade takes place between two large dealers.

Heterogeneous liquidity. Contracts are flexible in duration, delivery and expiration terms, but standardized in terms of how they are priced and settled. Every contract traded is listed along with its specifications on an exchange website for all to see. From these standardized contracts, hundreds of thousands of different exotic combinations can be created but still centrally listed and subject to a standard set of rules.

Independent Settlement. Price settlement is determined by the exchange based on the price at the end of the trading session, not by a consortium of dealers trying to lobby in favor of their positions.

No accumulation of losses. Every futures position is held at a clearinghouse and marked to market at the end of every session. Central clearing eliminates the possibility of off-books trickery.

When catastrophes have crippled the markets, futures have always been there to provide a venue for risk management. When the stock market crashed in 1989 and trading on the NYSE came to a halt, all eyes focused on the Major Market Index pit at the Chicago Board of Trade as it remained open. As the swaps market blew up in the wake of AIG’s collapse, the CME Group’s Eurodollar contract boomed.

With advantages such as this, it’s no wonder that so much of the proposed financial reforms revolve around a futures-type business model for execution and clearing. Reviewing the five points above, the futures marketplace sounds pretty safe to me.

Do you think futures markets have been unfairly demonized over the years?

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