A historical perspective of Futures Trading

Commodity trading is the actual trade of a commodity.  However, many people get this confused with Futures Trading.  This articles explains what Futures Trading actually is and how it developed.

Futures trading (in commodities) is essentially an insurance instrument. A futures contract utilises the underlying asset of a commodity (and hence belongs to a family of financial instruments called derivatives) by speculating whether the price of that commodity will go up or down in the future. Such speculative purchases have no purpose other than to make money for the speculator which can be at the expense of both the producer and the ultimate consumer. This is a very different proposition from agricultural commodity futures that have been the means by which a limited number of traders stabilise future prices and enable farmers to finance investments in future crop production.

Commodities are often sold forward at a fixed price. When this type of contract is concluded informally, it is known as a “forward contract.” However, when the transaction is organised and regulated through a recognised exchange, in a standard size and delivery period, with an implicit performance guarantee through the institution of a clearing house, then this is known as a “futures contract” in the underlying asset.

Hence, an important aspect of futures trading today is that traders buy and sell future contracts on an exchange, which is essentially a marketplace operated by a voluntary association of members. The exchange provides buyers and sellers with an infrastructure, legal framework, contract specifications and clearing mechanisms, specifically a clearing house.

The concept of futures trading has been around for some time. There are written examples that the English Cistercian Monasteries sold their wool in the thirteenth century for up to twenty years in advance to foreign merchants. The concept of “Futures” as financial instruments was well known in Southern Europe and the Muslim world during the Middle Ages. In the seventeenth century, at Dojima in Japan, a futures market in rice was developed to protect sellers from bad weather or warfare.

Yet it was the Dutch in the seventeenth century who “refined and institutionalised it to a degree never before seen. By selling futures, Dutch farmers and merchants could be assured of a given price for their products six or twelve months hence. By purchasing futures, buyers could avoid disastrous price rises in the interim.” (Bernstein, 2008)

However, futures trading as we know it today developed in the USA in the nineteenth century. US financing became increasingly sophisticated between the 1840’s and 1880’s, a change essentially driven by dramatic developments in the supply of foodstuffs, particularly grain. In particular, improvements to the transport infrastructure for grain providers in the vicinity of Lake Michigan, in the 1840’s, forced a reevaluation in financial practices, as larger and more expensive shipments needed to be financed. Merchants found that as long as they obtained firm prices and quantity commitments from their buyers, the easier it became able to secure larger loans at lower rates from financial institutions.

Meanwhile, commodity exchanges, which serviced the trades needed for fungible grain, were also emerging. In the 1840’s and 1850’s, these exchanges emerged as associations for dealing with local issues such as harbour infrastructure and commercial arbitration. By the 1850’s they had established a system of staple grades, standards and inspections. They acted as collection points for grain, cotton and other provisions and weighed, inspected and classified commodity shipments that passed from one side of the country to the other. They also facilitated organised trading in spot and forward markets. (Santos, 2010)

The largest and most prominent of these exchanges was the Board of Trade of the City of Chicago (now known as the Chicago Board of Trade or CBT) and on 27th March 1863, this board adopted its first rules and procedures for trade in forwards on the exchange. From here it became only a short step to futures trading. The inception of organised futures trading is difficult to date, but generally speaking, grain trade historians agree that a combination of storage, shipment and communication technology developments, plus a system of stable grades and standards and the impetus to speculation provided by the Crimean and US Civil wars, enabled futures trading to occur around 1874. However, it was not until the mid 1880’s that clearing houses appeared. (Santos, 2010)

Almost simultaneously, on the other side of the world in India, a long history of trading commodities – the Romans regularly seasoned their food with Indian pepper (Turner 2004) – meant that derivatives trading was being incorporated into business practices there too. The first derivatives market was set up in 1875 in Mumbai, where cotton futures were traded. This was rapidly followed by the establishment of futures markets in edible oil seeds, raw jute, jute goods and bullion.

Maria Narancic from Point to Point Export Services is an independent international trade adviser who assists organisations world wide with their international trade projects, documentation, Documentary Credits and import/export training. She is based in the United Kingdom. If you require any further assistance with the matters mentioned above, please do contact us by e-mail on info@point-point.com or check out other useful articles on exporting on the Point to Point Export Services website at www.point-point.com

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