Understanding corporate finance: derivative: exchange-traded contracts
An exchange-traded contract is bought or sold directly on a regulated exchange such as the former LIFFE (the London International Financial Futures and Options Exchange) or the CBOT (Chicago Board of Trade).
To make this possible, an exchange-traded product has a standard contract specification, which sets out
- exactly what the underlying consists of,
- where and how it is to be delivered (if it is deliverable),
- how much money the holder will gain or lose as the price of the underlying changes, and
- what each party is obliged to do when the contract matures.
Typical exchange-traded instruments include interest rate futures, currency futures and options, and Brent Crude oil futures.
In the past, most exchanges traded through open outcry, where each trader signified by shouting and hand signals what trade he was trying to execute. Almost all exchanges have now moved to electronic trading. The open outcry system brought buyers and sellers directly together. By contrast electronic trading is anonymous. An order input into the system is kept in a central order book until a matching order is received.
Once a match has been achieved, a clearing house interposes itself in the chain of transactions between buyer and seller. For example, in the past all LIFFE’s contracts are cleared through the London Clearing House (LCH). Both buyer and seller execute contracts with the clearing house, not with each other, and neither party has to worry about the credit rating of the counterparty.
There have been significant changes to derivatives exchange, stock exchanges and clearing houses and former alliances have been shaken up. There has been both international and functional consolidation. For instance in 2013, ICE, Intercontinental Exchange Inc took over NYSE, the New York Stock Exchange, but shortly afterwards, spun off its subsidiary Euronext which had included the Paris, Amsterdam, Brussels and Lisbon stock exchanges and which had previously taken over LIFFE. LCH and its French counterpart, Clearnet merged and now clears a wide range of financial derivatives through London and Paris.
The clearing process is complex, from a contractual point of view, involving successive novations of the contracts, such that eventually, the clearing house acts as a central counterparty, taking on one side of each novated contract. In order to minimise exposure to credit risk, each party is required to put up a collateral deposit with the clearing house, known as margin (CFM13070).