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Chapter 1. Basic training: a futures primer > The regulators and regulations

The regulators and regulations

The first level of regulation is the Exchange. If you recall from earlier in this chapter, the Exchange does not take positions in the market. Instead, it has the responsibility of ensuring that the market is fair and orderly. The Exchange does this by setting and enforcing rules regarding margin deposits, trading procedures, delivery procedures, and membership qualifications. Members who violate the rules can be fined and expelled. A sophisticated, intricate system of safeguards virtually guarantees against counterparty credit risk and default. Although an individual member may default, the party on the other side of the transaction always gets paid. This statement cannot be made for over-the-counter, or non-Exchange, markets. Each Exchange is composed of non-clearing members and clearing members. All members need to meet business integrity and financial solvency standards, and all members can trade on the Exchange, but the standards are higher for clearing members.

Each clearing member (the NYMEX alone has more than 60) must show a minimum working capital of $2 million and own two seats. Clearing members must also deposit 10% of the firm's capital (up to $2 million) into the guarantee fund, which is $160 million for the NYMEX. Still, even if one clearing member goes under, and the guarantee fund cannot cover it (which has never happened), every clearing member has agreed to cover a loss on a prorated basis. The clearing members represent some of the largest firms in the world, from Merrill Lynch to Citibank to Exxon. As a result, the financial strength of the Exchange is based on the combined financial capability of all its clearing members. The clearinghouse ensures that all trades are matched and recorded, and that all margin is collected and maintained. The clearinghouse also is in charge of ensuring that deliveries take place in an orderly and fair manner. The compliance department of the Exchange set capital-based position limits on each clearing member. In addition, the Exchange places position limits on customers. The limits are always lower in the spot, or delivery, month. For example, the maximum number of contracts any customer or entity can hold in crude oil is 10,000 in all months, with 5,000 in any one month and 1,000 in the spot month. There is an exemption from position limits for bona-fide hedge transactions.

Looking over the Exchange regulators are the governmental regulators. In the United States, the Commodity Futures Trading Commission (CFTC) regulates the futures and options markets. Customers who maintain large positions are required to be reported to the Exchange and to the CFTC by the customer's futures commission merchant. The reporting level in crude oil, for example, is 300 contracts. In addition, in the United States, the National Futures Association, a self-regulatory body, oversees its members, which make up the brokerage community. Finally, the world's major Exchanges (in the United Kingdom, for example) have an agreement with the Securities Investment Board (SIB) to share financial information on common members.

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