A trader’s activity mainly consists of tracking prices and striking the right deal. However, there’s another side to Futures trading that receives a lot less attention. The systems outlined earlier have mostly been automated, and Mark to Market is part of this process. One of the reasons that made this necessary was for Futures trading to compete with its European cousin: Contracts for Differences, or CFDs.
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The Regulatory Background That Gave Rise to CFDs
The bulk of a brokerage’s daily work consists of clearing, contract settlement, and back-office work. It also involves managing all the rules, regulations, and procedures that trading requires
One factor that makes this kind of work even more complex is that most global financial markets have vastly different rules for these processes. Being able to purchase Futures for the Japanese yen or the Hang Seng index from the comfort of our own bedroom could lead us to believe that the rules for settling contracts and issuing account statements in these countries are at least somewhat comparable to our own.
The truth is that the USA’s laws & regulations are not in sync with those of other regions. For example, Mutual Funds shares issued in Europe cannot be sold in the US or to US citizens. Meanwhile, Europeans are unable to purchase the ETFs traded on the US stock market. However, the same restriction doesn’t apply to stocks or futures. The two regions are equally divided on the access of currencies and CFDs.
Futures Contracts versus Contracts For Difference
At first, one would assume that this some kind of market protection measure. Although that’s part of the reason, it’s not the entirety of it. Consumer habits and the business strategies of individual brokerages also play a large role in developing these conventions. There’s no doubt that the US is the center and origin of modern futures trading. It’s also from there that Europe adopted most of its assets. That’s why it made sense for them to try and recreate the same standards as Chicago.
Unfortunately, European investors didn’t have the same amount of available capital as their US counterparts, so there was a significantly lower interest in the same large-scale commodity contracts. Instead, they chose to break down the larger contracts into smaller increments. This led to market makers basing their prices on the CBOT, CME & NYBOT while offering their own contract sizes with Contracts For Differences.
How Do CFDs Work?
A contract on oil, for example, represents 1,000 physical barrels of oil. At a nominal value of $64, it has an actual value of $64,000. In this case, the smallest movement, one tick, is 0.01 points or $10. To serve small investors’ needs, the European CFDs were split into 10 and 100 barrel increments. The result was margin requirements being reduced to one-tenth or one hundredth respectively. This was possible because the investors’ trades never made it to the market. Instead, they stayed in the books of the market makers. Once the market maker had enough investors, they’d use the ones with opposing positions to mitigate each other, then either aggregate the rest into full-size positions to place it themselves or keep it in their own books if the investors were unsuccessful.
The resulting situation was a conflict of interest where the market maker’s profit came from traders losing. This led to the creation of a wave of brokerages offering CFDs in Europe’s financial offshore centers. The list includes places such as Malta, Cyprus, Switzerland, and Liechtenstein. These providers often didn’t even forward contracts to the regulated markets, meaning they themselves weren’t subject to the same strict regulations.
US Resistance to CFDs
The US opposed the domestic appearance of these CFD products from the onset. The stated reason was to protect both its market and traders. US brokers also attempted to open the door for small investors. Their method was lowering margin requirements. However, the relevant supervisory bodies stopped these attempts in their tracks. Instead, they developed a system of mini & micro contracts. This allowed them to keep investors within the regulated framework of the market. These mini & micro assets have been wildly successful, proving that it’s possible to remain flexible while being regulated.
The Origin of Mark to Market
These regulated assets still had one major drawback compared to CFDs, namely expiry. The latter are instruments with no explicit expiry, meaning the trader could hold them for as long as they chose. Index CFDs would even pay interest in many cases. This gave traders the option to hold their positions until they either reversed or the more likely scenario of the investor losing all their capital. At the same time, they also lowered their base margin requirements. In fact, they were so low that brokers only liquidated these positions when their value only had cents left.
The US came up with a creative solution to resolve the issue of expiry. It did so by requiring the closing and physically settling of every futures contract at the end of each trading day. This process became known as Mark to Market. At first, it’s uncomfortable since the trader has to see their potential losses every day. However, their actual balance doesn’t change until the moment the position itself is closed. It’s merely a difference in optics. On the other hand, when they see the position is settled daily, they become less concerned about simply opening a new position when the current one expires. In a way, it gives them the same sense of security they get from continuous CFDs.
Futures Trading Rollover
The final difference is that futures contracts can only be rolled over if the required initial margin is available in the trader’s balance. This amount tends to be higher than the regular maintenance margin necessary for (as the name implies) simply maintaining the contract. By extension, this means that if the trader doesn’t have the required margin due to accumulated losses, the position will simply close on expiry. It’s worth asking whether this process is unfair or actually to the trader’s benefit. Obviously, a trader who had to face a loss due to this settlement method could think that they lost the opportunity for their position to rebound. However, there’s only a very slim chance for a poor position to suddenly and miraculously turn around in reality.
Approximately 75-80% of traders who deal in CFDs tend to lose money at the end of their trades. Losing 95% of your capital should definitely sting more than only losing 70% of it. The US settlement model acts as a safety net for the vast majority of traders. Even so, some traders still fall through the cracks in the end.
