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All deals are cleared through a clearing house that is usually separate from the exchange. The clearing house may be regarded as being responsible for the management of the market.
We noted earlier that as soon as a deal is struck, the exchange interposes itself between the two principals that concluded the deal. This means that it takes on the opposite side of each leg of each deal. Most exchanges are backed by a Fidelity and Guarantee funds.
Margining and marking to market
The exchange requires that for each transaction the client is obliged to place with it a "good faith deposit', which is called the margin deposit. At the start of a deal this is called the initial margin, and this is set by the exchange (see contracts below). It is usually 5-8% of the value of the contract. The initial margin may be defined as a deposit required on futures deals that will ensure that the obligations under the contracts will be fulfilled.
The initial margin essentially protects the exchange from default because it is extremely unlikely that losses on positions will exceed the initial margin. At the end of each day the margin account is topped up, where required (i.e. in the case of losses). Each contact is marked to market every day, meaning that at a point in time each contract is "valued". This takes place at the end of the trading day and it is based on the last settlement price.
The purpose of the marking to market is to ensure that the margin account is kept funded. If the mark to market price is lower that the purchase price, i.e. if the holder of a future is making a loss, she has to top up the margin account to the proportionate level it was. This amount is called the variation margin. If a holder makes a profit, a credit to the margin account is made. The ultimate purpose is to ensure that the exchange, which has taken on the risk of guaranteeing the trades, is protected.
From this it follows that if a holder of a future makes a loss and is unable to top up the margin account, the exchange will "close the member out". This means that the exchange takes an offsetting contract. The loss in then deducted from the client's margin account balance, and he is paid out.
A term that often crops up in the futures market is "open interest". This is the term for the number of outstanding contracts of a particular contract, i.e. the number of contracts that are still open and obligated to delivery (physical or cash settlement). Double counting is avoided in the number. If broker-dealer A takes a position in a future and B takes the opposite position^ open interest is equal to 1. Open interest on a particular contract may be depicted as in Figure 5 (daily from start of contract to its expiry date).
Figure 5: open interest
When a contract is launched by an exchange, open interest is zero. As participants begin to trade, open interest rises, and this continues until the maturity date approaches. On maturity date the future is "closed out" and open interest is again zero (because the contract is replaced with another that has a new maturity date).
Cash settlement versus physical settlement
In many of the commodities markets physical settlement takes place. This means that the commodities that underlie futures contracts are delivered at expiry of the contract. In the financial futures markets, physical delivery also takes place in some cases (for example, certain of the bond contracts), but in the majority of cases settlement takes place in the form of cash settlement.
Many traders in futures markets where delivery is required resort to trade reversing prior to expiry of the contract, and the reason for doing so is that they do not want to deliver or receive the physical goods/metals etc. These traders are involved in the market for speculative or hedging reasons, and take an opposite position to the one they hold prior to maturity, in so doing liquidate their position at the clearing house.
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