Opinion ID: 386004
Heading Depth: 1
Heading Rank: 1

Heading: commodity futures markets

Text: 4 A commodity futures contract is simply a bilateral executory agreement for the purchase and sale of a particular commodity. The seller of the contract commits himself to deliver the commodity at a fixed date in the future, while the buyer commits himself then to accept delivery and pay the agreed price. 1 Bromberg & Lowenfels, Securities Fraud & Commodities Fraud § 4.6(421) (1979); H.R.Rep.No.93-975, 93d Cong., 2d Sess. 130 (1974), U.S.Code Cong. & Admin. News 1974, p. 5843. Every aspect of the futures contract is standardized except price. For example, the contract involved in this case, the May 1976 Maine potato futures contract, is for 50,000 pounds of Maine grown potatoes of a specified quality to be delivered at specified points in cars of the Bangor & Aroostook Railroad, between May 7 and May 25, 1976. Since price is the only variable, negotiations can readily proceed and the agreed prices can be speedily disseminated to other traders. Standardization also makes the contracts fungible. Original sellers and buyers can therefore offset their positions by acquiring opposite contracts, either paying or gaining any price differential. H.R.Rep.No.93-975, supra, at 130. 5 The person who has sold a futures contract, i. e., someone committed to deliver the commodity in the future, is said to be in a short position. Conversely, someone committed to accept delivery is long. It is a rare case, however, in which actual delivery takes place pursuant to a futures contract. 2 Save in these rare instances, the short and the long must liquidate their positions prior to the close of trading in the particular futures contract. Although the means by which this is done is routinely referred to as futures trading, futures contracts are not traded in the normal sense of that word. Rather they are formed and discharged. Clark, Genealogy and Genetics of Contract of Sale of a Commodity for Future Delivery in the Commodity Exchange Act, 27 Emory L.J. 1175, 1176 (1978). A person seeking to liquidate his futures position must form an opposite contract for the same quantity, so that his obligations under the two contracts will offset each other. Thus, a short who does not intend to deliver the commodity must purchase an equal number of long contracts; a long must sell an equal number of short contracts. Money is made or lost in the price different between the original contract and the offsetting transaction. If the price of the future has declined, usually because of market information indicating a drop in the price of the commodity, the short will realize a profit; if the futures price has risen, the long will realize a profit. See Cargill, Inc. v. Hardin, 452 F.2d 1154, 1157 (8 Cir. 1971), cert. denied, 406 U.S. 932, 92 S.Ct. 1770, 32 L.Ed.2d 135 (1972). Futures trading is a zero-sum game. Since money is made from the change in futures contract prices, and every contract has a long and a short, every gain can be matched with a corresponding loss. See Melamed, The Mechanics of a Commodity Futures Exchange: A Critique of Automation of the Transaction Process, 6 Hofstra L.Rev. 149, 166 & n.39 (1977). 6 The mechanics of the commodity futures market, and the roles of the various participants, can be illustrated by tracing a typical transaction. An individual wishing to invest in the futures market approaches a futures commission merchant (FCM). FCM's are defined in the Commodity Exchange Act as individuals or associations engaged in soliciting or in accepting orders for the purchase or sale of any commodity for future delivery ... on ... any contract market ..., § 2(a)(1), 7 U.S.C. § 2, and they are registered with the Commodity Futures Trading Commission (CFTC). The FCM will demand a margin payment from the customer, which is simply a security deposit designed to protect against adverse price movements. The amount of the margin is based upon the amount which the customer can lose in a day or two; when the margin is exhausted the FCM will call the customer for additional payment. The margin is generally only a small percentage of the value of the contract. See Melamed, supra, 6 Hofstra L.Rev. at 167 & n.41. FCM's are paid a commission on their customer's business. 7 The FCM relays its customer's order to one of its floor brokers trading on the exchange. The broker stands on the outside of a pit or ring around which are gathered other persons trading in the same contract. Some of the traders are brokers acting on behalf of customers, while others trade on their own account. Contracts are made by open outcry. The broker with an order will indicate his position at the pit by shouting and gesticulating with standardized hand signals. Someone willing to enter the contract responds across the pit in similar fashion, and the deal is made. Observers on raised pulpits alongside the pit record the transaction and feed the information into a communications system, publicizing it to other traders who, in any event, had an opportunity to witness the transaction in the pit. The broker relays the particulars of the deal to the FCM, who informs the customer. 8 When two traders have reached an agreement on the floor of the exchange, the role of the clearinghouse comes into play. The clearinghouse, a key link in the futures trading system, operates as the seller to all buyers and the buyer from all sellers, thus facilitating the interchangeability of the contracts and the cancelling of positions. H.R.Rep.No.93-975, supra, at 149; S.Rep.No.93-1131, 93d Cong., 2d Sess. 17 (1974), U.S.Code Cong. & Admin.News 1974, p. 5843; Cargill, Inc. v. Hardin, supra, 452 F.2d at 1156. Not all FCM's are clearinghouse members; those that are not must deal through one that is. The clearinghouse treats FCM's as principals in trading transactions and demands margin payments from them. The clearinghouse requires FCM's to mark to the market at the close of every trading day. Any net gain or loss which the FCM has sustained in the course of the day's trading is computed and margin adjustments are made accordingly. Melamed, supra, 6 Hofstra L.Rev. at 167-68. 9 Generally speaking there are two classes of traders in commodity futures contracts, although, as some of the facts of the instant cases indicate, the distinctions between them are often quite blurred. A hedger is a trader with an interest in the cash market for the commodity, who deals in futures contracts as a means of transferring risks he faces in the cash market. See H.R.Rep.No.93-975, supra, at 131, 133, 162. See also the complicated definition of bona fide hedging transactions and positions promulgated by the CFTC, 17 C.F.R. § 1.3(z). The owner of a commodity can hedge against declining prices by entering into equivalent short futures contracts for the month when he expects to be able to sell, and a processor (e. g., a miller) can hedge against increasing prices by going long for the month when he will need the commodity. Losses caused by a decline in prices on the cash market in the former case or an advance in the latter will be offset by profits in the futures transactions. See generally H.R.Rep.No.93-975, supra, at 130-34; Cargill, Inc. v. Hardin, supra, 452 F.2d at 1157-58; Note, supra, 73 Yale L.J. at 171-73. The benefits of hedging extend beyond the immediate participants in the transactions. Because hedging of price risks in a futures market enables a merchant to reduce the exposures he has in doing business, he is able to operate on a lower profit margin with consequent lower prices to the consumer. H.R.Rep.No.93-975, supra, at 132-33; see also S.Rep.No.93-1131, supra, at 18; Valdez, Modernizing the Regulation of the Commodity Futures Markets, 13 Harv.J.Legis. 35, 40 (1975). 10 The system would not function, however, if only hedgers sold and purchased commodity futures contracts. 3 While hedging performs an insurance function, it is actually quite different from insurance. The risks faced by those dealing in the cash market, the market for the actual commodity, are not spread among those similarly situated, as with insurance, but rather are shifted to others. Bianco, The Mechanics of Futures Trading: Speculation and Manipulation, 6 Hofstra L.Rev. 27, 32 (1977); Cargill, Inc. v. Hardin, supra, 452 F.2d at 1158. The speculative investor, with no underlying interest in the cash market, is essential to take on the risks which the hedgers want to shift. The critical role of the speculator was described at some length in the House Report on the 1974 amendments: 11 The principal role of the speculator in the markets is to take the risks that the hedger is unwilling to accept. The opportunity for profit makes the speculator willing to take those risks. The activity of speculators is essential to the operation of a futures market in that the composite bids and offers of large numbers of individuals tend to broaden a market, thus making possible the execution with minimum price disturbance of the larger trade hedging orders. By increasing the number of bids and offers available at any given price level, the speculator usually helps to minimize price fluctuations rather than to intensify them. Without the trading activity of the speculative fraternity, the liquidity, so badly needed in futures markets, simply would not exist. Trading volume would be restricted materially since, without a host of speculative orders in the trading ring, many larger trade orders at limit prices would simply go unfilled due to the floor broker's inability to find an equally large but opposing hedge order at the same price to complete the match. H.R.Rep.No.93-975, supra, at 138. 12 As commentators have noted, Congress itself has recognized that the investor-although he is commonly referred to as a speculator in this context-is what makes the commodity futures market work .... Bromberg & Lowenfels, supra, at § 4.6(462). 13 Indeed, there is no bright-line difference between hedgers and speculators. Hedgers frequently do not merely balance their cash market risks in the futures market but engage in some speculation as well, buying or selling more or less futures contracts based on price expectations. Note, Abuses in the Commodity Markets: The Need for Change in the Regulatory Structure, 63 Geo.L.J. 751, 768-70 (1975); Valdez, supra, 13 Harv.J.Legis. at 64-65. On the other hand, speculators can become involved in the cash market as the activities of the plaintiff Incomco will demonstrate. 14