1. From forward to future: the contract, the clearing house and the margin

Derivatives 1: Futures

Everything you have bought in a market so far was a thing. A share is a slice of a company; a bond, a loan with a date on it. A derivative is not a thing: it is an agreement about a thing. That distinction changes entirely what can happen to your money, because an agreement has a counterparty, and a counterparty can fail.

What a derivative is and why it was invented

A derivative is a contract between two parties whose value depends on the price of another asset, called the underlying: an index, a barrel of oil, a currency, an interest rate. It does not make you the owner of anything; it makes you party to an agreement whose outcome is worked out by looking at that underlying.

The oldest of them is the forward: two parties agree today to buy and sell something on a future date at a price fixed now. A farmer and a miller settle in March the price of September's wheat: neither knows what the market will do and both would rather know where they stand. It was not born for speculation, but so that whoever has to buy or sell anyway stops depending on chance.

From forward to future: what standardization adds

The forward has two serious defects. It is a bespoke suit, with a quantity, a quality and a date that suit only the people who signed it: if you want out halfway through, you have to persuade the other side or find somebody to take your place. And if, when the day comes, that party cannot deliver, you are left with a signed piece of paper and a lawsuit.

The future is the industrial answer to both problems: a forward turned into a catalog product. The exchange fixes in advance everything that used to be negotiated case by case:

• The size, by means of a fixed multiplier: every point of the underlying is worth the same number of euros in every contract.
• The quality and the form of settlement: what is delivered, where, and whether it is settled with physical goods or with cash alone.
• The expiries, which are a handful of dates a year, and the minimum step by which the price moves.

Price is the only thing that is negotiated. And because every contract of the same expiry is identical, they are interchangeable: to get out you do not go looking for your original counterparty, you simply do the opposite trade and your position nets to zero.

The clearing house steps in between

The piece that makes this possible is the clearing house. When two parties cross a trade, the clearing house interposes its own balance sheet: it becomes the buyer facing the seller and the seller facing the buyer. The original contract disappears and two contracts remain, each one against the clearing house. You therefore no longer need to know who is on the other side: it makes no difference whether it is an enormous fund or a private individual at home, your counterparty is always the same institution.

Margin and daily settlement: this is where money moves every single day

The clearing house protects itself with two mechanisms.

The first is initial margin: a deposit demanded when the position is opened, sized to cover a plausible daily loss under stressed conditions. It is not a payment on account of the price: it is a security deposit that remains yours and is returned to you when you close.

The second is the daily settlement of profits and losses. At the close of each session, the clearing house works out what each position has made or lost and moves real money, that very night, from the losing accounts to the winning ones. In a future there is no such thing as the paper loss you can ignore as long as you do not sell: here you are charged daily.

The numbers make it clear. A future on an index with a multiplier of 50 euros a point, with the index at 5,000, controls a notional of 250,000 euros. Initial margin tends to sit in the region of 20,000 euros, though the figure is set by each clearing house and goes up when volatility bites. If the index closes 30 points lower, your loss for the day is 30 times 50: 1,500 euros, which leave your account that same night.

If the balance drops below a threshold called the maintenance margin (say 18,000 euros), you get a margin call. And take note: getting back to the threshold is not enough, you have to top up to the full initial margin. With a balance of 17,400 euros you do not pay in 600, you pay in 2,600. If you fail to do so in time, the position is closed without anybody asking your opinion.

The clearing house does not eliminate risk: it transforms it and concentrates it

It is tempting to conclude that with a clearing house in the middle counterparty risk disappears. It does not disappear: it moves house and concentrates itself in a single point. If a member defaults, a waterfall of defenses is applied:

• The defaulter's margin and the resources that member has contributed to the clearing house.
• The mutualized default fund, paid into by all members: here the problem stops belonging to the defaulter.
• The clearing house's own capital and, if need be, extraordinary contributions demanded of the survivors.

The system turns many small bilateral risks into a single systemic one. It works almost always; when it does not, the problem belongs to the whole market at once.

A real case: the Nordic clearing house, September 2018

In September 2018, a Norwegian trader dealing on his own account in electricity futures defaulted against the Nasdaq group's clearing house in the Nordic countries. His position was a spread between German and Nordic prices that moved far more than his margin covered.

The hole exceeded what had been deposited and the mutualized fund had to be tapped: the published figures point to roughly two thirds of a fund of around a hundred and sixty million euros. The other members, who had nothing to do with that trade, had to replenish it.

No investor lost their contracts and the market carried on working: the clearing house did what it was designed to do. But a single trader came close to exhausting the defenses of an entire piece of infrastructure. That is the lesson: you buy day-to-day safety in exchange for concentrating the risk in one point.