Commodity markets: Trading Financial Instruments
In 1972, a subdivision of the Chicago Mercantile Exchange offered futures trading on foreign exchange rates, ending the reliance on trades solely based on physical resources. The development of this type of futures contract spread quickly to other exchanges. Areas such as interest rates and mortgages were added during the upcoming decade. Many see the culmination of this move being the trading of stock futures that began in 1982. Early critics of this form of commodity charged that future trading on stocks increased the price swings for the underlying stocks. However, once established the trading of financial instruments, or derivatives, became a staple of most commodity exchanges. The importance of trading financial “commodities” has increased dramatically.
During most of history, items being bought and sold were present for the buyer to examine, to make certain they were of the type and quality that the seller claimed. Early commodity markets worked this way.With the development of futures contracts as the trade mechanism of choice, however, no items can be physically present to be examined, since they do not yet exist. What are bought and sold are electronic entries, formerly paper certificates, giving ownership of a preset amount of goods of a certain quality at a specific date in the future at a specific location.
Modern commodity markets work only because buyers have confidence that the exchanges (and government regulators) will enforce the contract in terms of the quality of the goods that will be delivered. Without this type of enforcement mechanism, modern commodity markets could not operate. At times in the past, the government attempted to limit participation in commodity trading to those who already had, or would have, goods to sell or those who could take delivery of the goods. However, from the 1960’s on, this type of regulation of the commodity markets gradually decreased, so that anyone with adequate financial resources was able to trade on the markets.
Individuals, often called speculators, can buy or sell commodity contracts even if they do not have any of the commodity or have any use for it. As long as they do not have an open contract to ship a commodity they do not have, or conversely, receive the commodity on the delivery date, any amount of buying or selling futures contracts is legal. This means that only a small percentage of the contracts sold on commodity exchanges actually result in the delivery of the commodity. Most contracts are canceled out by individuals purchasing the opposite type of contract prior to the delivery date of the commodity.