How Daily Futures Settlement Reduces Counterparty Risk

# Why does Futures contract credit and debit a position daily, if it has "locked" the price?


# Why does Futures contract credit and debit a position daily, if it has "locked" the price?












I thought I had understood futures contract. But it seems the daily settlements betray my understanding.

Futures contract provides price & product safety to involved two parties. E.g. Wheat Farmer and Baker

It seems Futures contract poisitions (long, short) are credit/debit accordingly based on current market price using daily settlement.

If the price is locked then why is this daily settlement doing? The profits and losses of a futures contract depend on the daily movements of the market for that contract and are calculated on a daily basis..

- Are we talking about Famer and Baker here or about the traders who bid and trade on futures available in the exchanges?

- Or else, futures contract is not observed as an independent element but that has an effect pre/post transaction. e.g. Famer agreed to sell Wheat for 4 dollar per bussel in 1 years time. In one years time market price is 5 dollar. If he had sold wheat in the market he would have earned extra 1 dollar. But it doesn't mean he is at a loss. Is he? On the other hand Baker may choose to keep the wheat for bread production or sell it to get 1$ profit.

I just want to understand who is affected by daily settlement - the farmer/baker or traders.

In terms of interest-rate/credit/bond futures, I guess this could even be more confusing - unless I figure it out now with commodity aspect.

## Answer by Matt Wolf (score 2, accepted)

https://quant.stackexchange.com/a/11283

I try to answer your questions in the order asked:

- If the price is locked then why is this daily settlement doing? This mechanism is in place in order to reduce counterparty and credit risk. Each exchange maintains its own clearing house and each exchange member is obligated to clear their trades with the clearing firm at the end of each day. In turn the exchange member, settles their client accounts daily as well. The reason is that in case of a default at maximum one day's worth of price movement multiplied by the amount of defaulted contracts and contract multiplier is at risk. This makes it much less risky for the clearing house as well as for brokers and all market participants, evidenced through the fact that so far not one clearing house has gone into default.

- Are we talking about Famer and Baker here or about the traders who bid and trade on futures available in the exchanges? We are talking about everyone involved in the chain. If a farmer or baker were to receive one large sum at contract expiration and somewhat the payment fell through because someone defaulted in between this would cause serious economic damage no matter whether the payment is eventually made or not. Thus, daily settlement reduces risk for everyone. Equally traders (well the brokerage houses that employ traders) benefit from reduced risk through daily settlement. It really is a good system in place and so far I have not heard of serious contenders that challenged this specific mechanic.

- You need to familiarize yourself with the purpose of engaging in futures trades. There are speculators that simply buy and sell and there are hedgers. Farmers and bakers would belong to the hedger category. There have been well-covered scandals where commodity houses or commercial players heavily engaged in speculation (copper scandal at Sumitomo) but general commercial players engage in futures markets in order to hedge exposure. So, a baker would buy long futures contracts to lock in a price he would be paying at a future delivery date. Equally, a farmer would sell a futures contract that obligates him to deliver the underlying at a future date for a certain price in exchange. Keep in mind that anyone can trade futures, not just hedgers, hence the category "speculators". Depending on whether market participants buy/sell futures to open new positions or close positions, "open interest" in such futures contracts increases or decreases.

I recommend you read up on some futures basics such as in Hull "Options, Futures & Other Derivatives". You need to understand that daily settlement has nothing to do with the final contract settlement, regardless of whether it is cash settled or whether physical goods change hands.

I hope this answers your questions.

## Answer by RRG (score 1)

https://quant.stackexchange.com/a/11282

The daily mark-to-market reduces the counterparty risk by making sure every day that the counterparties can pay for their losses. For a forward contract, on the other hand, there is no daily mark-to-market and one simply have to trust that the counterparty can pay up (or deliver/take delivery of goods) at settlement.

Lets consider the Farmer. Yes, his price is locked by the futures contract but he might not actually have the crop right now. For example, he might want to lock in the price of next years crop. However the crop might go bad or the machinery breaks down so he might not have any crop to deliver. He then needs to buy the crop in the spot market to honor his contract or buy back the contract he sold in the market. This may realize a loss for him which he may or may not be able to take. So we can either trust that he can do it, or we can make sure he can do it by mark-to-market his accounts every day.

Lets consider the Baker. He might have locked in the price of wheat but the spot price has since plunged, bringing down the price of bread, and taking delivery on his contract will mean that he can't produce bread at a profit. By selling his contract in the market he realizes the same loss. If he doesn't have enough funds this will take him out of business and he hence might default.

By making sure that all accounts can meet the daily financial requirements of the contract, the mark-to-market is an important tool to reduce the magnitude of a counterparty default regardless if we are talking about farmer/bakers or traders.