Here is a “gradual” description of how a Futures trade takes place with all intermediaries involved:

A BUYER AND A SELLER

In its most basic form a transaction involves 2 parties: a buyer and a seller.

A buyer transacts directly with a seller

THE EXCHANGE: A CENTRAL “MEETING” PLACE

However buyers need to find sellers and vice-versa. This is where exchanges come into play. They are a central place where trading takes place.

For example, the Chicago Board of Trade (CBOT) is the central place where wheat trading takes place. All sellers and buyers meet and agree on transaction prices there. Exchanges also enforce rules such as standardised terms (e.g. wheat futures contract provides for delivery of 5,000 bushels of any of several varieties of wheat during March, May, July, September, or December).

All buyers and sellers come to the exchange to transact

COUNTERPARTY RISK

Futures contracts are an agreement between two parties for future delivery of an underlying (e.g. wheat) in exchange for a Cash amount (settlement) dictated by the agreed price. Up until settlement, there is risk that one of the parties will not be able to fulfil its obligation and result in a financial loss to the other party. This is called Counterparty Risk.

To avoid this situation, an intermediary, part of the exchange, will guarantee the trade. This is the Central CounterParty. All trades are actually given up to the Central CounterParty – which means that technically you buy from the CCP and your counterparty (the other side of the trade) sells to the CCP.

The CCP enforces each party to maintain adequate levels of initial and variation margin to cover any potential losses. All of the CCP trades are cleared through its clearing house.

The exchange provides a Central CounterParty and Clearing House to act as a guarantee between buyer and seller.

BROKER INTERMEDIATION

Now, there are millions of buyers and sellers that want to trade on the exchange. The exchange is not going to deal with all buyers and sellers. Instead, an exchange is a B2B-only platform where broker-dealer firms place their trades between each other.

For a buyer to trade, she needs to go through a broker to place her order/trade on the exchange. However broker-dealers (also called Futures Commission Merchant – FCM) are large independent firms, or part of large investment/commercial banks. As such they will not deal with most clients (retail and small institutional). Those clients would go through Introducing Brokers (IB), which will act as an extra intermediary between the client (you) and the exchange in a B2C fashion – delegating the trade execution, back-office operations, etc. to the FCM.

There is a further distinction between FCM:

• Clearing FCM, which is a clearing member of an exchange
• Non-clearing FCM, which must clear its trade through a clearing FCM

The picture gets fuller with broker intermediaries: Introducing Brokers, clearing and non-clearing FCM.

HOW TRADING TAKES PLACE AT THE EXCHANGE

In the old days, most trading took place in open outcry, on the trading floor of the exchange, between the local representatives of the broker-dealer firms (traders, brokers, market-makers/specialists). Floor traders stand in a trading pit to call out orders, prices, and quantities of a particular commodity by making “crazy hand gestures” (think of the last scene of Trading Places). Note that open outcry is pre-dated by blackboard trading.

Electronic trading has emerged in the last decades and gradually replaced open outcry. The electronic platform of an exchange (e.g. e-cbot for CBOT) is essentially a matching engine which all broker-dealers connect to and submit their orders.

The full picture.

With the advent of electronic trading a new class of brokers has appeared: Direct Access Trading (DAT) brokers. They offer their clients (including retail) an electronic platform that allows for a direct access to the exchange (as opposed to more traditional online retail brokers, which are just an electronic IB). DAT brokers usually offer to retail investors low transaction costs and high execution speed.

I hope I have not forgotten anything. If so, please let me know in the comments. In a next post I will investigate how the various automated trading platforms fit into that model.