It may come as a surprise to many, but currency futures were the only vehicle for the individual Forex trader until 1996 when advances in PC’s and the internet allowed retail spot brokers to begin offering spot FX trading. Forex futures were first proposed by University of Chicago economist Milton Friedman, a champion of floating exchange rates, in 1971. After the dollar was floated in 1973, Friedman spoke with the chairman of the Chicago Mercantile Exchange, Leo Melamed, and Melamed hired Friedman as a consultant to design the new Forex futures market. Melamed’s autobiography Escape to the Futures is a fascinating read.
Before going into the details about how Forex futures work, we have to ask why retail spot Forex brokers were able to get an opening wedge into a market that had existed already for 25 years. The answer is a bit shocking — the CME was asleep at the switch. The new retail brokers had a terrific selling points — “trade with the big boys” — and a much needed trick: the contract size at the CME is 100,000 units of foreign currency (62,500 for Great Britain pound contract), and thus an extremely high dollar amount. The initial margin to trade this contract was about $1,500. But the retail brokers correctly identified that individuals wanted a smaller contract size and also a smaller initial margin. The CME did not offer mini contracts until the 2000’s.
Also, at the time (1996), the Chicago futures system was mostly focused on the day session, which runs from 7:20 to 14:00 CST. Trading beyond that session in the electronic market, Globex, was limited. Brokers did not “make a market,” i.e., provide liquidity, until a few years later in 1999. But the spot brokers were able to advertise “24 hours a day” and that, of course, appealed to individuals with a day job or other time constraints. The final reason the CME lost so completely to the new retail spot broker business is that its website was a Byzantine, overly complicated mess. You could not easily find anything, like initial margin minimum or even the dollar size of the mini contract. No wonder individuals prefer spot retail brokers — despite their many drawbacks.
All of this is a pity, because futures offer enormous advantages over spot to the individual trader.
First, futures are quoted in dollar terms, which was the norm before 1979, when the international foreign exchange dealers association adopted the European quotation convention. In futures, every currency is quoted in terms of how many dollars it costs, and therefore the value of a tick (minimum one unit price change) is a fixed number. It is far more useful for rapid mental calculation when you know that every tick in the CAD and AUD is worth exactly $10, in the UK pound, exactly $6.25 and in everything else, $12.50. Everyone can easily multiply 10 or 20 times the fixed tick value in his head, whereas in spot, it is not such an easy calculation.
Secondly, in futures you know exactly what the commission cost is per side of a round-trip trade. Commissions have been progressively cut from as much as $50 per round-turn to less than $10 today. The retail brokers’ claim that spot trading is commission-free is public relations bunk. For example, if you do 500 futures trades a year and pay $20 per round trip, the total commission cost is $10,000. Who would not want to save $10,000?
However, it is certainly misleading for retail brokers to imply that commission-free means free of transaction cost. In practice, spot platforms for retail customers offer a spread of 1-2 points in lieu of transaction fees. When you pay 2 points on every trade, it adds up to the same $10,000 per year if you do 500 trades a year.
The other advertised advantage of the spot market is its much-advertised vast liquidity, $5 trillion per day. However, let’s be realistic — how much liquidity do you really need? The average futures contract trades about 50-100 thousand contracts per day and total futures and options trading is on the order of 1 million contracts per day. Open interest, meaning positions not closed, in CME Forex futures was 2.8 million contracts on November 15, 2016. In practice, the futures market offers sufficient liquidity for the average trader.
As for “trading with the big boys,” let’s investigate whether the claims of the spot brokerage industry stand up to scrutiny. First, is it really possible that you are being allowed onto the same playing field as Citibank, JPMorgan Chase, Deutsche Bank, Barclays, and the other powerhouses of FX trading?
In a word, no. When Citibank does a trade with Deutsche Bank, the dollar amount of the trade is a standard $5 million in EUR/USD, USD/CHF, and USD/JPY. Size matters. Just as a wholesaler will not sell you a dozen plastic buckets for the same per-piece price he gives Walmart, which orders twelve million, it is not efficient for Citibank to do business with the small retail trader. It is also not profitable. Banks make the bid-offer spread when they trade with one another (plus whatever extra they get from positioning ahead of time), so on a bare-minimum basis, you need trades in the millions of dollars apiece to earn enough to justify maintaining an expensive trading room. On a EUR/USD trade where the ask/bid spread is 1 point (0.0001), for example, the bank makes $500. The same 1-point spread on your $100,000 trade delivers a mere $10. This is a key reason Citibank delayed so long in setting up a retail spot FX brokerage boutique.
So how do the retail spot brokerages do it? Easy. As noted above, they do not actually give you the true spot price – in practice they are adding on an extra pip or two or three. Let’s say the Australian dollar is trading at 0.7952-0.7954 in the “real” spot market. The simultaneous price quote on the retail broker’s quote page is 0.7951-0.7955, or 2 points wider. Alternatively, the retail broker’s price quote may be slanted to 0.7948-0.7952 if it believes the price is falling or to 0.7954-07958 if it thinks the price is rising. It takes a fair amount of skill to skew prices, of course, but it is only reasonable to expect that they are going to aim for a higher return than a measly $10 on your trade.
Other techniques to improve profitability include “bundling” a group of trades at or near the same level to offset them in the market all at once at a somewhat better price. Or, if the broker thinks it has a really good grip on the near-term direction of the market, it may not offset your trade at all. In other words, it sells you $10,000 worth of AUD, but never actually goes out and does the other side (buying the AUD from another party). If you have a close stop and the trade goes against you, you will be exiting the trade with a loss. The broker did not have to do anything, after starting out with a two-point advantage to begin with.
So what if you pay four points? Four points is $40, about double what you would pay as a straight commission to a futures broker. Moreover, it may be more than that. The farther away you are from the real wholesalers, the market-making banks, the more points you can expect to have added to the prices you see.
Some spot brokers do indeed offer you the same spot prices as seen to be on the “professional” trading quote screen, but beware – these prices are already marked up by the big banks in the first place. From the point of view of the real professional trading banks, any retail broker is not an equal party. It is a customer, not a fellow-market-maker, and it gets a mark-up.
The key difference between the real spot market and the retail brokers is that in the real spot market, the big players are market-makers. To be a market-maker means you are always ready to state a bid and an offer to your counterparty. It is that simple. Even if you are General Motors, Sony, or IBM, you still pay a price mark-up on FX trades to the dealing bank because the dealing bank is a market-maker and you are not. Being a market-maker entails tremendous risk. When you give a two-way quote, you do not know ahead of time which side your counterparty is going to take. He may be selling exactly when you want to be selling, too. The last thing you want is someone to push you into buying something that is falling. But that is how market-making works. Market-making takes gutsy traders – and lots of capital.
It is important to understand this aspect of market structure because the futures market builds on it to create a level playing field. In futures, for every buyer there is a seller. You know that the price is a true market price because if you are buying, some other real party is selling. It is true that futures brokers may add an extra point (and only one point) to the exchange’s own market makers, but that does not take away from the key difference between spot and futures. In futures, the broker is a middleman with no interest in the outcome of the trade. In the spot market, the big players have an intense interest in the outcome of the trade because they are taking positions, even if only for a nanosecond. Spot retail brokers also have an intense interest in the outcome of the trade if they are not offsetting every buy immediately with an offsetting sale.
To an experienced trader in either the spot or futures market, spot retail brokers’ claims that the little guy can trade in the same game as the big players is offensive. The spot market is tiered and the retail trader is the bottom tier. To anyone with a grain of experience, the claim is patently not true — it is marketing hype. Note that the US spot retail brokers are regulated by the Commodity Futures Trading Commission, which disallows exaggerated sales pitches. Evidently the CFTC is not offended by the claim that the retail traders is playing on the same field as the big boys.
If we concede that spot broker claims about “playing with the pros” and having endless liquidity are harmless exaggerations, experienced traders still have a grievance – most spot retail brokers suggest that trading is easy and that making profits is easy (because of leverage). Mr. Melamed told us in an interview that it is just wrong, factually and ethically, to say trading FX can make you rich and it will be easy:
Futures people won’t lie to you about anything in trading being ‘easy.’ These charlatans who put on expensive FX seminars are selling garbage and don’t even teach good rules of trading. But most of all, it’s a crime to say trading is easy.
Melamed agrees that in futures, you know the price is real because you know that there is a seller on the other side if you are a buyer and vice versa. And every party to the trade gets the same price. Aside from the 1-pip that the Globex market-makers take, the biggest hedge fund gets the same price for a $1 million trade as the guy doing a one-lot from his den.
However, Melamed goes on, there is another real cost to trading in spot – the infamous rollover cost, which has to be calculated and added every day in the spot market but is already built-in to futures contracts. Again, everyone is futures trading gets the same price. This may not be the case in rolling over spot contracts.
Here is how it works: A spot trade is for delivery in two business days. When you buy on Monday, you would have to make payment in one currency and receive payment in the other currency on Wednesday if you were actually going to take delivery. When you want to hold a position past the day of the trade, there is a price. And it is not a universally known price. The broker has a lot of latitude in assigning the cost to you.
In contrast, futures are contracts for delivery at a date in the future, starting generally three months from now and narrowing down to two days by the time the contract matures. Futures were designed for hedgers and speculators with the full knowledge that speculators would be adding much-needed liquidity. There is no additional rollover charge for holding a position past the trade date because the contract is already designed with a longer holding window. When a futures contract is new, that is, has become the “front month” that is the main focus of trading attention, it has three months to run. Let’s say you are holding US dollars and using them to buy Australian dollars. In theory, you are earning interest on your dollars and the guy who is holding your A$ until delivery date is earning interest on the A$. If the 3-month interest rate on the US dollar is 3% and the equivalent interest rate for the A$ is 5%, the interest differential is exactly 2%. Since the guy with the A$ gets to keep the interest earnings, he is willing to sell you A$ for three-month delivery at a discount to the spot price of 2%.
If you like formulas, think of it as the principal plus interest in one currency needing to be equal to the principal plus interest in the other. Since the interest rate is a given and the spot rate is a given, the only thing that can change is the discount or premium from spot that equilibrates the principal plus interest. In fact, a forward contract in the professional market for the identical delivery date will be the same 2% discount from spot. Arbitrageurs make sure that the equivalence between the forward and future markets is well-nigh perfect, too. Think about why this is so – if it were not, the country with the high interest rate would get flooded with foreign cash, since investors could take it out three months later on a forward contract, having earned a higher rate of return with no exchange rate risk.
So, a futures contract already incorporates the “cost of carry,” meaning the interest rate differential. The futures market has only four contracts per year, closing in March, June, September, and December. The cost of carry is already built in to the prices you see and therefore you have no daily re-calculation nightmare if you want to hold for an extra day. The cost is fixed upfront.
If you are buying a currency with a higher interest rate, the futures price is at a discount. If you are buying a currency with a lower interest rate, you are the one earning higher interest, and therefore the other currency is selling at a premium to the spot price. Now let’s shift to the spot market. You do a trade on a Monday but you do not close it out on Monday. You carry it over to Tuesday. You have to pay, or earn, one day’s worth of the interest differential. This sounds easy enough – apply the one-day interest rate differential. However, it is not easy at all. The cash or overnight market is another one of those professional markets that is available to the market-makers at the rates you see quoted in the newspapers, like the fed funds rate. Primary dealers are not in the business of making $100,000 worth of fed funds available to non-banks for your trade. Instead, the rate that is available to the broker acting on your behalf is marked up from the fed funds rate, or it is a one-week rate, or some other rate.
And you do not know what that rate is. Moreover, you cannot deduce it from published rate data, because each borrower/lender in the money markets gets a rate specific to the bank’s private credit rating of that broker. To make matters more complicated, the one-day rate is not simply one-seventh of the one-week rate, or one-thirtieth of the 30-day rate, or any other easy formula. In many cases, the overnight rate is higher than the one-week or one-month rate specifically to discourage exchange rate speculation. And number of central banks, such as the Swiss National Bank, maintain rates with that structure or impose it suddenly in times of FX market turmoil. One hedge fund went under in the late 1990’s because the Bank of Greece suddenly applied a 400% overnight rate. Again, it may not happen very often, but it does happen.
So how do you know if the rollover charges applied to your account are true and fair? You do not. They may be true and fair, or they may not. The point is that the calculation is usually not disclosed to the trader, unlike the futures market, where everyone gets the same discount and premium and we know it is true and fair because covered interest arbitrage exists in the spot/forward market to keep the futures price nearly perfectly in line with both the spot FX market and the interest rate markets.
This leads to a final point. In the event of a currency crisis in which a central bank suddenly applies punitive overnight carrying costs, the undercapitalized spot retail trader is going to be hit with huge carrying charges that he can either pay or lose his entire position. The futures trader sees the effect only in the price of the contract itself and never faces additional charges. Crisis or not, the futures contract is the more transparent instrument for the speculator who is going to hold a position for longer than the initial trade date.
In futures, every single broker and data vendor has the same open-high-low-close price points and over the course of the day, the same bid-offer. Moreover, most data vendors and some brokers offer something called “time and sales.” This is a minute-by-minute listing of every bid and every offer made in the futures market, plus every instance of when a contract changed hands and at what price. This is useful not only in technical analysis, but to check that your broker has not cheated you on a stop or target. For example, let’s say you placed a stop at 30 points under your purchase price but your broker claims you got filled at 40 points under. You can consult the time & sales table to see whether there was indeed a gap at any point during the trading day that would have forced you to get filled at 40 points under. If there was no gap, you have a basis to quarrel with the broker, and if the broker declines to back down, you can report the broker to the National Futures Association and Commodity Futures Trading Commission. Technically you can report malfeasance by a spot broker to the CFTC, too, but you will not have hard evidence as can be obtained from the time and sales report.
Finally, every futures trade is guaranteed by the exchange. If you are using a spot broker, you have no guarantee beyond its own capital base. However, in futures, every trade is guaranteed and if your broker fails, the exchange steps in to make every trader whole. When Refco failed in 2005, those who had futures trading accounts saw their accounts moved to another broker and their margin amounts were safe as well as any open trades. But spot Forex traders at the Refco spot brokerage lost everything.
So, if futures are so superior in so many ways to spot retail, why does it languish? Again, the ease of starting out, the leverage, and the required capital are still much better at spot FX than they are at the retail futures market.
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