Managed Futures Today Magazine

Because the term “derivatives” has been tossed around so casually in the media in recent years, futures (and options on futures) have often gotten lumped together in the public mind with the unstructured and unregulated over-the-counter instruments, such as credit default swaps, that were so enmeshed in the 2008 financial market crisis.

Yes, futures contracts are, technically, derivatives — meaning they are derived from, or based on, an underlying asset — but they have nothing in common with the infamous “credit default swap” and similar over-the-counter derivatives. Futures contracts are standardized investments traded on federally regulated exchanges designed to minimize counterparty risk, and money managers who trade futures are subject to the same type of licensing and regulation that exists for equity market professionals.

The regulatory framework of the U.S. futures industry, the origins of which date back more than a century, consists of oversight at both the federal and industry level.


The CFTC
Exchange-traded futures began trading in the U.S. in 1848, and federal regulation of futures trading dates back to the early 1920s. Today, all futures and options on futures in the U.S. are traded on exchanges regulated by the Commodity Futures Trading Commission (CFTC), which is the federally mandated U.S. futures market regulator — the equivalent to the Securities and Exchange Commission (SEC) in the equities market. The CFTC was established as an independent agency in 1974, and was the successor of the Commodity Exchange Authority, which dated back to the 1930s.

The CFTC’s mandate is to maintain fair, open, and competitive markets while protecting market participants against fraud and manipulation. Among the other services it provides investors, the CFTC also compiles and publishes market and industry data such as the Commitments of Traders (COT) report (also known as the “large trader report”), which shows the futures (and options on futures) positions held by different types of futures investors (large speculators, commercial hedgers, etc.).

In addition to overseeing U.S. futures exchanges, approving all listed futures contracts, and ensuring the financial integrity of the trade-clearing process, the CFTC also requires professional futures money managers — Commodity Trading Advisors (CTAs) or Commodity Pool Operators (CPOs) — to register with the agency and meet certain guidelines regarding how they operate, how they solicit investment funds, and the information they must provide investors.


The NFA
CTAs and CPOs must also register with the National Futures Association (NFA), the futures industry’s self-regulatory organization that includes anyone conducting business with the public on U.S. futures exchanges — more than 4,200 firms and 55,000 individuals, according to NFA data. The NFA’s purpose is to screen potential futures industry professionals’ “fitness to engage in business” and identify those individuals and organizations that are subject to federal regulation. The NFA also maintains an online database potential investors and investment managers can use to perform background searches on any NFA/CFTC-registered futures firm or individual.

Finally, CTAs and CPOs must pass the Series 3 licensing exam (equivalent to the Series 7 exam required of stock brokers and traders) in order to trade futures professionally. (Individual futures brokers and brokerage firms are also under the supervision of the CFTC and the NFA.)


Managing risk
One of the benefits of the futures market’s framework is the minimizing of counterparty risk — the risk that the other side of your trade will default. With centralized trade clearing, futures exchanges effectively remove counterparty risk by becoming the seller to every buyer and buyer to every seller, guaranteeing transactions while independently ensuring all member firms meet their fiduciary responsibilities and capitalization requirements. (Notably, there were no defaults on U.S. futures exchanges at any point during the 2008-2009 financial crisis.)

This high level of transparency and regulation contrasts to some less-opaque areas of the investment industry that are not subject to regulation and sometimes trade OTC derivatives. In fact, one of the changes prompted by the financial crisis is the standardization of credit default swaps and their listing and clearing on futures exchanges, in order to make them less risky.