Futures Contract: Profits and Vulnerabilities of Markets

Table of Contents

Futures Contract

What is a Futures Contract?

A futures contract refers to a legal agreement to purchase or sell a commodity, asset, or security at a specified price and date. Futures contracts trade on official exchanges such as the foreign exchange (a.k.a. FX or forex) or S&P 500, allowing for quality and quantity standards.

Futures contracts enable investors to use leverage to speculate on the price of a security, commodity, or financial instrument. If, for example, an airline purchases a futures contract for jet fuel, the company could save or lose money depending on the later market price of the fuel.

Futures markets are often contrasted with spot markets, where payment and delivery (theoretically) happen immediately. Both will use the current market price, but the delivery and payment come at that designated future date for futures. 

In this article, the Zero Theft Movement will cover futures contracts and examine how they have been potentially vulnerable to market manipulation. FInd out how you can keep yourself and other traders protected from bad actors.

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Types of Futures Contracts

Futures come in a number of forms: commodities, currencies, stocks, and bonds. 

Commodities 

Commodities refer to physical assets such as coffee beans and rare metals. Commodity prices tend to be quite volatile, which makes these investments risky.

Commodity prices

Source: OliverWyman

Currencies

Future contracts for currencies involve an exchange of a specific amount of currency for an amount of a different currency. If a trader thinks the value of the U.S. dollar will increase in relation to the value of the Canadian dollar, then they will buy a USD/CAD future that reflects their prediction. 

Currency Fluctuation

Source: Trevor Stone via LiveJournal

Stocks and Bonds

Traders can also buy and sell financial instrument futures if they believe an economic shift might occur. In the case they believe rates might drop in price, traders would buy a futures contract for bonds. That’s because bond prices increase when interest rates drop. 

Stocks and Bonds

Understanding Futures

A futures contract obligates buyers and sellers to exchange an asset(s) for payment at a predetermined date and price. Therefore, the asset’s market price at the time of the trade dictates the payment, not the future market price when the trade occurs.

Naturally, due to the myriad commodities, financial products, securities, etc. that can trade as futures, a wide range of inventors, speculators, and companies have a use for the market. From coffee beans to futures offered through an established exchange, most financial players can find futures that align with their business or investment goals. 

Futures contracts present two main avenues for profit or savings: hedging and speculation.

Hedging

Some financial players purchase futures contracts to safeguard against fluctuations in the underlying commodity’s price. It also allows businesses to budget for the future, as well. 

Let’s return to the jet fuel and airline example to illustrate how hedging works. On the side of the jet fuel provider, it might want to lock into a futures contract because its executives believe prices will drop in the future. The airline’s executives, however, believe fuel prices will experience a spike soon, so they would want to secure jet fuel (essential to the business) at the current market price. The two parties can agree to a futures contract, hedging their exposure to the potential market volatility. 

Hedging either allows for extra savings for the buyer or extra profits for the seller. It is ultimately impossible for both sides to benefit, however marginal the price fluctuations end up being. 

Speculation 

Speculators treat futures contracts like stocks or bonds. They are independent traders and investors who might be trading in futures for clients or brokerage firms. Investing in futures comes with a high degree of risk and reward. 

  • The futures market tends to experience much more volatility than the stock or bond markets. That means you can make quick gains OR losses in the short term
  • Futures contracts are also highly leveraged investments, requiring that the trader put up only 10%-15% of the value of the underlying asset

Beyond the rewards, investors might want to buy futures contracts for a number of other reasons:

  • It’s difficult to commit insider trading on futures contracts with underlying commodities. Any number of uncontrollable and unforeseeable variables can affect a physical product (e.g., weather, climate, etc.) 
  • Commission charges on futures remain relatively low in comparison to other investments
  • Commodity markets are usually liquid. A good amount of cash flows through these markets, and transactions get executed quickly.

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Futures Contracts vs Forward Contracts

Forward contracts are quite similar to futures contracts, but they do differ in some key ways. 

The main difference between forwards and futures ultimately comes down to personalization. Forward contracts trade “over-the-counter” (OTC), which means these transactions occur directly between parties and do not happen on a standardized exchange. 

The perk of forwards is that buyers and sellers have the opportunity to tailor the deal to meet their respective needs. They can negotiate delivery time and purchase price, for example.

The disadvantage of forwards is that trading outside of standardized exchanges has little protections in place. Accountability can be hard to come by. Furthermore, the risk of default can be high.

Futures ContractsForward Contracts
Trade on exchangesTrade over-the-counter (OTC)
StandardizedPrivate and tailored
Safer than forward contractsRiskier than futures

Market Manipulation in Futures Markets

The futures market has experienced market manipulation over the years. Let’s take a look at some (relatively) recent cases. 

Spoofing

In 2016, the Securities and Exchange Commission (SEC) and Commodities Futures Trading Commission (CFTC) investigated a case of ‘spoofing’ (i.e., disruptive algorithmic trading to get an edge over other traders). 

According to a Department of Justice (DoJ) press release, “In the first federal prosecution of its kind, a high-frequency trader was sentenced today to three years in prison for disrupting commodity futures prices in a $1.4 million fraud scheme…MICHAEL COSCIA, 54, used an automated trading technique known as ‘spoofing’ to earn illegal profits from orders he placed through Chicago-based CME Group and London-based ICE Futures Europe. Coscia commissioned the design of computer programs, known as algorithms, to implement the fraudulent strategy at his New Jersey trading firm.” 

Precious Metals

In 2019, the DoJ announced it had charged three precious metal traders “for their alleged participation in a racketeering conspiracy and other federal crimes in connection with the manipulation of the markets for precious metals futures contracts, which spanned over eight years and involved thousands of unlawful trading sequences.”

The press release linked above goes on to claim: “…between approximately May 2008 and August 2016, the defendants and their co-conspirators were members of Bank A’s [bank not named] global precious metals trading desk in New York, London and Singapore with varying degrees of seniority and supervisory responsibility over others on the desk… The indictment alleges that the defendants engaged in widespread spoofing, market manipulation and fraud while working on the precious metals desk at Bank A through the placement of orders they intended to cancel before execution (Deceptive Orders) in an effort to create liquidity and drive prices toward orders they wanted to execute on the opposite side of the market. In thousands of sequences, the defendants and their co-conspirators allegedly placed Deceptive Orders for gold, silver, platinum and palladium futures contracts traded on the New York Mercantile Exchange Inc. (NYMEX) and Commodity Exchange Inc. (COMEX), which are commodities exchanges operated by CME Group Inc.  By placing Deceptive Orders, the defendants and their co-conspirators allegedly intended to inject false and misleading information about the genuine supply and demand for precious metals futures contracts into the markets, and to deceive other participants in those markets into believing something untrue, namely that the visible order book accurately reflected market-based forces of supply and demand.  This false and misleading information was intended to, and at times did, trick other market participants into reacting to the apparent change and imbalance in supply and demand by buying and selling precious metals futures contracts at quantities, prices and times that they otherwise likely would not have traded, the indictment alleges.”

Have you Lost Money due to Manipulation in Futures Contracts?

Futures contracts offer investors great opportunities to hedge and speculate. Nevertheless, ase seen in the two cases above, bad actors have allegedly managed to manipulate futures markets. Investors must remain vigilant and informed to make sure they aren’t trading in a rigged market. 

 

On a large scale, we cannot allow manipulators to make undue profits off of the unknowing public. The Zero Theft Movement is dedicated to finding and eliminating the rigged parts of the U.S. economy so that American businesses and citizens can flourish. Our community works to calculate the most accurate estimate for the monetary costs of corruption in the United States. 

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