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State the function an exchange performs when futures are transacted.

FRM® Part I · Financial Markets and Products · Futures Markets · FRM1.FM.7.c

The idea

The exchange provides the organised venue, defines standardised contracts, and, through its associated clearing house, guarantees performance. Once a trade is matched, the clearing house becomes the buyer to every seller and the seller to every buyer. So the two original traders do not face each other, and neither bears the other's credit risk. This is why a long can close a position by selling an identical contract to anyone else, without involving the original counterparty. The clearing house protects itself with initial and variation margin, daily settlement and member default contributions. It carries no net market risk because its long and short positions always match, so its risk is default, not price movement. Trades by non-members are cleared through a clearing member.

A practice question

From the question bank, with the reason each wrong option is wrong.

Which description best fits the role of the clearing house when a futures trade is made?

  1. It acts as a market maker, quoting bid and ask prices and taking directional positions to supply liquidity.Why not: Confuses the clearing house with a dealer; it holds matched long and short positions and takes no directional view.
  2. It matches the two traders but leaves them to settle with each other and bear each other's credit risk.Why not: Describes a bilateral over-the-counter arrangement; the clearing house interposes itself to remove that risk.
  3. It becomes buyer to every seller and seller to every buyer, guaranteeing performance. - correct
  4. It sets the futures price each day according to a published formula.Why not: Prices are set by trading; the clearing house only uses the settlement price for margining.

Through novation, the clearing house stands between the parties, so each deals with it rather than with each other, and it guarantees performance.

A harder one

A trader buys 10 futures contracts (100 units each) at 100 and later sells 10 contracts of the same series at 103 to a different counterparty. What is the trader's position and result?

  1. Flat with the clearing house, with a gain of USD 3,000. - correct
  2. Flat with the clearing house, with a gain of USD 30.Why not: Multiplies the 3-point gain by the number of contracts but forgets the contract size of 100 units.
  3. Two open positions, one with each original counterparty, with credit exposure to both; gain USD 3,000.Why not: Ignores novation; the clearing house is the counterparty, so the long and short positions net to zero.
  4. Net long 10 contracts until delivery, with the gain of USD 3,000 paid at expiry.Why not: Treats the second trade as a new contract instead of closing out the first; offsetting positions net to zero immediately.

The clearing house becomes counterparty to both trades, so the purchase and sale offset. Gain = (103 - 100) x 100 x 10 = USD 3,000, settled through margin.

The hardest tier

A clearing house has 1,000 long and 1,000 short contracts outstanding, each for 100 units. The futures price rises by 2.00 per unit and every member meets its obligations. What is the clearing house's net variation margin gain or loss for the day?

  1. A gain of USD 200,000Why not: Counts only the amounts received from the short side and ignores the payments owed to the long side.
  2. A loss of USD 200,000Why not: Counts only the amounts owed to the long side and ignores the receipts from the shorts.
  3. A gain of USD 400,000Why not: Adds the long and short amounts together instead of recognising that they offset.
  4. Zero - correct

Longs gain 2 x 100 x 1,000 = USD 200,000 and shorts lose the same amount. The clearing house collects 200,000 and pays 200,000, so it bears no net market risk; its exposure is to default.

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