Understanding the Scale and Mechanism of Futures Markets

How can a futures market be many times larger than the market for the physical underlying?

The primary reason for the vast disparity lies in the nature and measurement of market size and the arrangement of futures contracts to ensure that they are offset, leading to no physical delivery.

Market Size and Measurement

Market size is measured not just in terms of volume but in the economic activity exchanged over a defined period. Typically, this period can be a single day, a week, or even a year. When measured over a full year, a futures market can be over a hundred times larger than the same market measured over a single day.

This is because futures markets span multiple years, involving future exchanges that are aggregated over a shorter time period, such as a day. The daily market, for example, reflects the quantity of a commodity sold and delivered on that particular day, while the futures market for a given day encompasses commitments to deliver that commodity many years in the future.

Specificity and Versatility of Futures Contracts

A key reason for the size of futures markets is the specificity of the commodity contracts.

Take, for instance, the main crude oil futures contract. This contract requires West Texas Intermediate (WTI) oil shipments into Cushing, Oklahoma, with stringent specifications such as:

Sulfur: 0.42% by weight or less Specific Gravity: Between 37 and 42° on the API scale BSW Sediment Water and Other Impurities: Less than 1% by weight Pour Point: No greater than 50°F Micro Carbon Residue: Less than 2.40% by weight Total Acid Number (TAN): Less than 0.28 mg/KOH/g Nickel: Less than 8 ppm by weight Vanadium: Less than 15 ppm by weight

Traders use this contract to hedge against risks related to other types of crude oil from different locations or even other energy products, refined products, infrastructure, and businesses. The overall exposure to these hedged items can be many times greater than the value of the qualifying oil at Cushing.

Offsetting Positions and Hedging Strategies

A second reason is that individuals with long-term exposure often hedge it with short-term contracts. For example, if market participants are hedging ten years' worth of exposure, this would significantly exceed the amount of oil in storage facilities today.

A third key aspect is the use of offsetting positions. An oil refinery, for instance, might go long on crude oil futures and short on gasoline futures to hedge the price it can charge for refining. Each participant from the initial producer to the final user might use two contracts to hedge the same commodity, ensuring a balanced approach.

Ensuring No Physical Delivery

Nearly all futures market participants aim to exit their positions before physical delivery. Centralized exchanges facilitate this by ensuring there are always equal numbers of long and short contracts. Both parties in these contracts wish to exit before delivery, and the exchange mechanism makes this process smooth most of the time.

However, in some exceptional situations, such as disruptions in oil deliveries from the Middle East, more long futures holders might seek delivery than there is oil available, or short holders might insist on delivering more than the available storage. In these cases, the exchange intervenes, typically settling financially based on a set price.

Conclusion

The size and structure of futures markets are critical in managing economic risks and enabling greater financial flexibility. Understanding the reasons behind the scale of these markets and the mechanisms in place to ensure no physical delivery is essential for any participant or analyst.