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Chapter 1 1 CHAPTER 1 Futures Markets Introduction In this chapter, we introduce futures markets and their key players. This chapter is organized into the following sections: 1. Forward Contracts Versus Futures Contracts 2. Institutions Facilitating Futures Trading 3. Structure of Futures Exchanges 4. Clearinghouses’ Role in Futures Markets 5. Types of Futures Contracts 6. The Social Function of Futures Markets 7. Futures Markets’ Regulatory Framework and Taxation
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Page 1: chapter1

Chapter 1 1

CHAPTER 1Futures Markets Introduction

In this chapter, we introduce futures markets and their key players. This chapter is organized into the following sections:

1. Forward Contracts Versus Futures Contracts

2. Institutions Facilitating Futures Trading

3. Structure of Futures Exchanges

4. Clearinghouses’ Role in Futures Markets

5. Types of Futures Contracts

6. The Social Function of Futures Markets

7. Futures Markets’ Regulatory Framework and Taxation

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Chapter 1 2

Forward Contracts

A forward contract is an agreement between two parties (counterparties) for the delivery of a physical asset (e.g., oil or gold) at a certain time in the future for a certain price that is fixed at the inception of the contract.

Forward contracts can be customized to accommodate any commodity, in any quantity, for delivery at any point in the future, at any place.

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Chapter 1 3

EXAMPLE: St. Bernard Puppy

Counterparties: Buyers and Seller

Asset/Commodity: St. Bernard Pup

Delivery/Payment Time: 6 weeks

Priced Fixed: $400

Buyer: Dog Fancier has a long position

Seller: Breeder has a short position

Trading Volume: Occurs when one trader buys & another sells

Open Interest: Number of open contracts obligated for delivery

If the dog owner had completed similar contracts for six different dogs, the open interest would be 6.

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Chapter 1 4

Future Contracts

Futures contracts are highly uniform and well-specified commitments for a carefully described good (quantity and quality of the good) to be delivered at a certain time and place (acceptable delivery date) and in a certain manner (method for closing the contract) and the permissible price fluctuations are specified (minimum and maximum daily price changes).

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Chapter 1 5

Forward Versus Futures

COMPARISON FORWARD FUTURES

Trade on organized exchanges No Yes

Use standardized contract terms No Yes

Use associate clearinghouses to guarantee contract fulfillment No Yes

Require margin payments and daily settlements No Yes

Close easily No Yes

Regulated by identifiable agencies No Yes

Any quantity Yes No

Any product Yes No

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Chapter 1 6

Futures Contract Standardized Terms

1. Quantity

2. Quality

3. Expiration months

4. Delivery terms

5. Delivery differentials

6. Delivery dates

7. Minimum price fluctuation

8. Daily price limits

9. Trading days and hours

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Chapter 1 7

CBOT Wheat Futures Contract

Quantity: 5,000 bushels per contract.

Quality: No. 2 Soft Red, No. 2 Hard Red Winter No. 2 Dark Northern Spring, or No. 1 Northern Spring.

Expiration: July, September, December, March, & May.

Delivery Terms: Wheat must be delivered at a “regular” or approved warehouse (e.g., warehouses located Chicago Switching District).

Delivery: Any business days in the delivery month.

Payment: Seller received payment and delivers a warehouse receipt to the buyer.

Price Fluctuation: 1/4 cent per bushel.

Daily Price Limit: Trading price on a given day cannot differ from the preceding day's closing

price by more than 30 cents/bushel ($1,500/contract).

Trading Days: Wheat trades from 9:30 a.m. to 1:15 p.m. Chicago time.

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Chapter 1 8

Institutions Facilitating Futures Contract Trading

There are two types of organizations that facilitate futures trading:

Exchange

Exchanges are non-profit or for-profit organizations that offer standardized futures contracts for physical commodities, foreign currency and financial products.

Clearinghouse

A clearinghouse is agency associated with an exchange, which settles trades and regulates delivery. Clearinghouses guarantee the fulfillment of futures contract obligations by all parties involved.

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Chapter 1 9

The Organized Exchange

Not-for-Profit Organization Structure

Members hold exchange memberships or seats that allow them to:

1. Trade on the exchange

2. Have a voice in the exchange’s operation

For-Profit Organization Structure

Members receive shares or stocks.

Demutualize

Conversion of an exchange from not-for-profit to for-profit.

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Chapter 1 10

Organized Exchange: Trading Systems

Futures contracts trade by two systems:

Open Outcry

Open outcry is a trading room where traders literally “cry out” their bids to locate another trader who is willing to trade with them.

Electronic Trading Platforms

Contracts are traded through electronic computer networks. Electronic trading represents over 50% of futures contracts trading.

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Chapter 1 11

Organized Exchange: Trading Players

Speculator

A trader who enters the futures market in pursuit of profit, accepting risk in the endeavor.

Hedger

A Trader who enters the futures market to reduce some pre-existing risk exposure.

Broker

An Individual or firm acting as an intermediary by conveying customers’ trade instructions. Account executives or floor brokers are examples of brokers.

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Chapter 1 12

Major Futures Exchange

Table 1.6

Major Futures Exchanges in the World for 2003 EXCHANGE

2003 Volume (Futures Only)

Top 20 % Volume

Eurex (Germany) Chicago Mercantile Exchange (USA)

668,650,028 530,989,007

24.55 19.49

Chicago Board of Trade (USA) Euronext-Liffe (Netherlands) Mexican Derivatives Exchange (Mexico)

373,,669,290 273,121,004 173,820,944

13.72 10.03 6.38

Bolsa de Mercadorias e Futuros (Brazil) New York Mercantile Exchange (USA)

113,895,061 111,789,658

4.18 4.10

Tokyo Commodity Exchange (Japan)

87,252,219

3.20 London Metals Exchange (UK).

68,570,154

2.52

Korea Stock Exchange (South Korea)

62,204,783

2.28 Sydney Futures Exchange (Australia)

41,831,862

1.54

National Stock Exchange of India (India)

36,141,561

1.33 SIMEX (Singapore)

35,356,776

1.30

International Petroleum Exchange (UK) OM Stockholm (Sweden) Tokyo Grain Exchange (Japan) New York Board of Trade (USA) Bourse de Montreal (Canada) MEFF Renta Variable (Spain) Tokyo Stock Exchange (Japan)

33,258,385 22,667,198 21,084,727 18,822,048 17,682,999 17,109,363 15,965,175

1.22

.83

.77

.69

.65

.63

.59

Total Top 20 2003 Futures Volume

2,723,882,242

100% Source: Futures Industry Association.

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Chapter 1 13

Clearinghouses

1. Guarantee that the traders will honor their obligations (solves issues of trust).

2. Each trader has obligations only to the clearinghouse, not to other traders.

3. Each exchange uses a futures clearinghouse.

4. Clearinghouses may be part of a futures exchange (division), or a separate entity.

5. Due to 2000 CFMA, clearing arrangements vary across industries.

6. Clearinghouses are “perfectly hedged” by maintaining no futures market position of their own.

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Chapter 1 14

The Function of Clearinghouses in Futures Markets

Obligations without a clearinghouse

Buyer

SellerBuyer

Seller

Clearing-house

Obligations with a clearinghouse

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Chapter 1 15

Major Futures Clearing Organizations

Table 1.7

Major Futures Clearing Organizations Clearinghouse

Affiliated Exchanges

The Clearing Corporation (CCorp)

US Futures Exchange and the Merchants Exchange of St. Louis

Chicago Mercantile Exchange Clearinghouse

Chicago Mercantile exchange With clearing link to CBOT

Kansas City Board of Trade Clearing Corporation

Kansas City Board of Trade

Energy Clear Corporation

Exempt Commercial Markets

MGE Clearinghouse

Minneapolis Grain Exchange

NYMEX Clearinghouse

New York Mercantile Exchange

New York Clearing Corporation The Options Clearing Corporation The London Clearinghouse

New York Board of Trade OneChicago, NQLX, & option exchanges Exempt Commercial Markets and OTC markets

Sources: The CFTC web site, www.cftc.gov.

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Chapter 1 16

Margin and Daily Settlement

Margin A good-faith deposit (or performance bond) made by a prospective trader with a broker. Margin can be posted in cash, bank letter of credit or short-term U.S. Treasury instruments.

Daily Settlement

Process by which traders are required to realize any losses in cash immediately (marked-to-the-market). The losses are usually deducted from the margin deposit.

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Chapter 1 17

TYPES OF MARGIN

There are 3 types of margin:

1. Initial Margin

Deposit that a trader must make before trading any futures.

2. Maintenance Margin

When margin reaches a minimum maintenance level, the trader is required to bring the margin back to its initial level. The maintenance margin is generally about 75% of the initial margin.

3. Variation Margin

Additional margin required to bring an account up to the required level.

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Chapter 1 18

Futures Market Obligations

Table 1.2

Futures Market Obligations The oat contract is traded by the Chicago Board of Trade. Each contract is for 5,000 bushels, and prices are quoted in cents per bushel. (a) Party 1

Party 2

Buys 1 SEP contract for oats at 171 cents per bushel

Sells 1 SEP contract for oats at 171 cents per bushel

(b) Party 1 Clearinghouse

Buys 1 SEP contract for oats at 171 cents per bushel

Agrees to delivery to Party 1 a SEP contract for oats at a price of 171 cents per bushel

(c) Party 2 Clearinghouse

Sells 1 SEP contract for oats at 171 cents per bushel

Agrees to receive from Party 2 1 SEP contract for oats and to pay 171 cents per bushel

Table 1.2 shows a typical trading situation.

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Chapter 1 19

Futures Market Obligations

Based on Table 1.2, a trader purchases an oat Contract at 171 cents/ bushel at the close of day 0. The initial margin is $1,400.

DAY 1

Contract closed @ 168 cents/bushel.

Loss: 3 cents/bushel or $150 .

Required maintenance margin: $1,100.

Initial Margin $1,400(-) Daily Settlement 150New Margin Balance $1,250

DAY 2

Loss: 4 cents/bushel or $200

Margin Balance $1,250(-) Daily Settlement 200New Margin Balance $1,050

Trader’s margin is below the maintenance margin. Margin call occurs.

Variation Margin needed: $350

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Chapter 1 20

Account Equity & Margin Requirements

Figure 1.3 illustrates the account equity and margin requirements at different price levels.

Insert figure 1.3 here

Notice that the trader would have received two margin calls.

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Chapter 1 21

Margin Cash Flows

Trader A

Trader B

Non-clearingmember

Clearingmember

Clearinghouse

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Chapter 1 22

Closing a Futures Position

There are 3 ways to close a futures position:

1. Delivery or cash settlement

2. Offset or reversing trade

3. Exchange-for-physicals (EFP) or ex-pit transaction

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Chapter 1 23

Closing a Futures Position: Delivery or Cash Settlement

Delivery

Most commodity futures contracts are written for completion of the futures contract through the physical delivery of a particular good.

Cash settlement

Most financial futures contracts allow completion through cash settlement.

In cash settlement, traders make payments at the expiration of the contract to settle any gains or losses, instead of making physical delivery.

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Chapter 1 24

Completion of Futures Contracts

Table 1.3

Completion of Futures Contracts via Delivery or Cash Settlement

October 1, 2002BSeptember 30, 2003

Delivered or Settled in Cash

Commodity Group

Volume

Contracts

Percentage Grains

28,917,090

98,235

0.33

Oilseeds

30,917,636

51,143

0.17 Livestock

7,190,906

36,107

0.50

Other Agricultural

15,560,473

95,344

0.61 Energy/Wood

94,635,656

839,221

0.89

Metals

18,602,108

209,186

1.12 Financial Instruments

760,292,234

7,115,757

0.94

Currencies

30,032,897

682,095

2.27 All Commodities

986,149,000

9,125,088

0.93

Source: Commodity Futures Trading Commission, Annual Report, 2003.

Notice that very few contracts are delivered or settled in cash.

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Chapter 1 25

Delivery Differential

Sometimes the quantity and quality do not exactly match the quantity and quality specified in the contract. In these cases, shorts are given the option of delivering non-standard commodities at non-standard delivery points. However, they may have to pay a surcharge or “delivery differential” relative to standard terms of the futures contracts.

There are 2 types of delivery differential:

1. Quality Differentials

2. Location Differential

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Chapter 1 26

Delivery Differential

Example: CBOT Corn Contract

Quality differentialGrade differential based on the standard “par” delivery grade.

Premium grade: No. 1 YellowPremium grade price differential : 1.5cents/bushelPrice: $3.015/bushel

Par grade: No. 2 YellowPar grade price: $3/bushel

Lower grade: No. 3 YellowLower grade Price differential : 1.5 cents/bushel or Price: $2.985/bushel

Location differential Based relative to the standard delivery point or points specified in the futures contracts.

Premium Location: 2 cents/bushel for delivery at terminals between Lockport & Seneca, Illinois

Par Location: Terminals between Chicago & Burns Harbor, Indiana

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Chapter 1 27

Closing a Futures Position: Offset or Reversing Trade

If you previously sold a futures contract, you can close out your position by purchasing an identical futures contract. The exchange will cancel out your two positions. Table 1.4 illustrates a reversing trade.

Table 1.4

The Reversing Trade

Party 1's Initial Position

Party 2

May 1 Bought 1 SEP contract for oats at 171 cents per bushel

Sold 1 SEP contract for oats at 171 cents per bushel

Party 1's Reversing Trade

Party 3

May 10 Sells 1 SEP contract for oats at 180 cents per bushel

Buys 1 SEP oats contract at 180 cents per bushel

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Chapter 1 28

Closing a Futures Position: Exchange-for-Physicals (EFP)

Two traders agree to a simultaneous exchange of a cash commodity and futures contracts based on that cash commodity. Table 1.5 illustrates a EFP transaction.

Table 1.5

An Exchange-for-Physicals Transaction Before the EFP

Trader A

Trader B Long 1 wheat futures Wants to acquire actual wheat

Short 1 wheat futures Owns wheat and wishes to sell

EFP Transaction Trader A

Trader B

Agrees with Trader B to purchase wheat and cancel futures Receives wheat; pays Trader B Reports EFP to exchange; exchange a-djusts books to show that Trader A is out of the market

Agrees with Trader A to sell wheat and cancel futures Delivers wheat; receives payment from Trader A Reports EFP to exchange; exchange adjusts books to show that Trader B is out of the market

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Chapter 1 29

Types of Futures Contracts

In this section, we will examine the following types of futures contracts:

• Physical Commodity

• Foreign Currency

• Interest-Earning Asset

• Index (Stock Index)

• Individual Stocks

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Chapter 1 30

Future Contracts: Physical Commodity

Contracts on physical commodities include:

1. Agricultural contracts

2. Metallurgical contracts

3. Energy contracts

These commodities, excluding electricity, are physically settled and are highly storable.

Trading varies from commodity to commodity.

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Chapter 1 31

Future Contracts: Physical Commodity

AGRICULTURAL METALLURGICAL ENERGY

Grains - corn, oats, rice, wheat

Livestock - live hogs, cattle

Forest - lumber and plywood

Textiles - cotton

Foodstuffs - rice cocoa, coffee, orange juice, sugar

Gold

Silver

Aluminum

Platinum

Heating oil

Crude oil

Natural gas

Unleaded gasoline

Coal, propane

Electricity

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Chapter 1 32

Futures Contracts: Foreign Currency and Interest-Earning Asset

Foreign Currency Interest-Earning Assets

Australian dollar

Brazilian Real

Russian Ruble

New Zealand dollar

Swedish Krona

South African Rand

Norwegian Krone

British pound

Canadian dollar

Japanese yen

Swiss franc

Mexican peso

Euro

Treasury bills

Notes

Bonds

Eurodollar deposits

Interest rate swaps

Fed funds

Municipal bonds

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Chapter 1 33

Futures Contracts: Index Based

Traders must fulfill their obligation by reversing trade or cash settlement at the end of trading.

EXAMPLE OF INDEX BASED CONTRACTS

US Exchanges Foreign Exchanges

Broad-Based stock indexes

S&P 500

Dow Jones Industrial Average

Russell 2000

NASDAQ 100

Style-Based Indexes

S&P Barra Growth

S&P Barra Value

Foreign Stock Indexes

British FTSE 100

French CAC 40

Dow Jones Euro Stoxx 50

German DAX

Brazillian Bovespa stock

Japanese Nikkei 225

Korean KOSPI 200

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Chapter 1 34

Future Contracts on Individual Stocks

Permitted for trade in United States after the passage of the Commodity Futures Modernization Act of 2000 (CFMA).

Also called “single stock futures” in the United States and “universal futures” in Great Britain.

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Chapter 1 35

Relative Importance of Commodity Types

INSERT FIGURE 1.5 HERE

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Chapter 1 36

Changing Commodity Trading Volume

INSERT FIGURE 1.6 HERE

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Chapter 1 37

Social Function of Futures Markets

Futures markets meet the needs of three groups of users:

1. Those who wish to discover information about future prices of commodities

2. Those who wish to speculate

3. Those who wish to hedge

There are two main social functions of futures markets:

1. Price discovery

2. Hedging

Speculation is not regarded as a social function by itself, but it may have socially useful by-products.

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Chapter 1 38

Social Function of Futures Markets

PRICE DISCOVERY

Futures market information helps people make better estimates of future prices.

Futures market information helps people with their production or consumption decisions.

Example: silver Mine

HEDGING

Hedging is the prime social rationale for futures trading.

Hedgers have a pre-existing risk exposure that leads them to use futures transactions as a substitute for a cash market transaction. By doing so, they are able to reduce or eliminate their risk.

Example: wheat Farmer

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Chapter 1 39

Regulation of Futures Markets

CEA

Grain Futures Act of 1922, superseded by the Commodity Exchange Act (CEA) of 1936.

The CEA was last amended by the Commodity Futures Modernization Act of 2000 (CFMA).

CFMA

Promotes competition and innovation in futures markets.

Provides a predictable and calibrated regulatory structure tailored to the product, the participant, and the trading platform (the three P’s).

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Chapter 1 40

The CFMA’s Three Tiers of Regulation

First Tier- Agricultural Commodities

Futures on commodities (agricultural commodities) that Congress judged to be potentially susceptible to manipulation and that are offered to members of the public.

Second Tier- Exempt Futures Contracts

Futures contracts on metals and energy that are judged to be less susceptible to manipulation.

Third Tier- Trade Principal to Principal Basis

Contracts on financial products (swaps) that are privately-negotiated between large, sophisticated contract counterparties.

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Chapter 1 41

Futures Markets Levels of Regulation (Market Regulators)

1. Brokers

2. Exchanges and clearinghouses

3. National Futures Association (NFA), industry self-regulatory body

4. Commodity Futures Trading Commission (CFTC), federal governmental agency

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Chapter 1 42

Market Regulators: Brokers

The Broker is responsible for:

1. Knowing the customer's position and intentions.

2. Ensuring that the customer does not disrupt the market or place the system in jeopardy.

3. Keeping the customer's trading activity in line with industry regulations and legal restrictions.

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Chapter 1 43

Market Regulators: Exchange & Clearinghouses

Futures exchanges and clearinghouses formulate and enforce rules to:

1. Prohibit fraud

2. Prohibit dishonorable conduct

3. Prevent defaulting on contract obligations

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Chapter 1 44

Abusive Trading Practices

Table 1.8

Abusive Trading Practices Pre-arranged trading

Agreeing to some aspect of a transaction before it is openly executed on the exchange floor.

Accommodation trading Entering transactions to assist another floor partici-pant in accomplishing improper trading objectives.

Trading before custom-ers orders, front running

Trading for one's personal account or an account in which one has an interest, while having in hand any executable customer order in that contract.

Bucketing Failing to introduce an order to the marketplace, traditionally occurring when a broker noncompeti-tively takes the other side of a customer order to the detriment of the customer or other members.

Wash trading Entering transactions to provide the appearance of trading activity without resulting in a change in market position.

Curb trading Trading after the official close of trading.

Source: Government Accounting Office, “Automation Can Enhance Detection of Trade Abuses but Introduces New Risks,” September 1989.

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Chapter 1 45

Market Regulators: National Futures Association (NFA)

The NFA seeks to prevent fraudulent and manipulative acts by:

1. Screening and test applicants for registration.

2. Requiring members who handle customer funds to maintain adequate capital.

3. Requiring members to keep accurate trading records.

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Chapter 1 46

Market Regulators: Commodity Futures Trading Commission (CFTC)

CFTC protects market participants from manipulation, abusive trading practices, and fraud by enforcing regulatory oversight of:

1. Futures exchanges

2. Futures clearinghouses

3. NFA

The heart of the CFTC’s market surveillance is its large-trader electronic reporting system. This reporting system helps identify potential concentrations of market power within a market and to enforce speculative position limits.

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Chapter 1 47

Insert figure 1.7 here

Figure 1.7 shows the place of the CFTC in the regulatory structure of the futures industry in the United States.

Insert Figure 1.7 here

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Chapter 1 48

Recent Regulatory Initiatives

FASB ACCOUNTING RULES

In 1998, The FASB adopted new rules for disclosure of risk positions in firms’ derivatives positions.

CFMA 2000

Allows futures trading on individual stocks and narrow-based stock indexes.

Clarifies the legal status of privately-negotiated swap transactions.

Provides a predictable and calibrated regulatory structure tailored to the product, the participant, and the trading platform.

Allows exchanges to bring new contracts to market without prior regulatory approval.

Establishes a set of standards, that permit futures exchanges and clearinghouses to use different methods to achieve federal requirements.

Gives the CFTC clear authority to stop certain illegal, foreign exchange transactions aimed at defrauding small investors.

Gives the CFTC separate oversight authority with respect to clearinghouse organizations.

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Recent Regulatory Initiatives

TAXATION OF FUTURES TRADING

1981 LAWFutures positions must be marked-to-market at the end of the year.

ACT of 1986Stipulates that short-term and long-term capital gains will be taxed at one rate.