what are futures contracts

A futures contract is the right to own or to purchase an asset at a fixed price later in the future. Futures contracts typically trade for hard and soft commodities, but they can be for used for almost any asset type, including cryptocurrencies.

History of The Future

Trading futures is not a new concept at all. In fact, it goes way back to at least the beginning of civilization to around 1750 BCE in Mesopotamia.

The Babylonian king, Hammurabi, created one of the first futures contracts. The Code of Hammurabi is the most ancient code of law known in existence. The code permitted for the trading of assets at an agreed upon price at some point in the future. Much like today’s legal contracts, it was necessary for this to be written in as well have an eye witness. Temples became one of the first futures exchanges where Mesopotamians would trade.

Ancient Greece

Even the Greeks were into futures trading. Thales of Miletus is one of the first futures traders. Being the clever philosopher and mathematician he was, people like Aristotle thought he could accurately predict the future.

futures contracts

A challenge by someone prompted Thales to take interest in generating wealth. If philosophy is so useful in the real world, why wasn’t he rich? Thales wanted to prove that philosophy was useful. Thales thought there was going to be a particularly good olive harvest that year. So he purchased contracts for olive presses earlier in the year at a discount. The press owners wanted to protect themselves against the risk of a bad harvest, which is why they were willing to sell it to him.

The harvest was quite good that year and Thales rented out his olive presses at a high price. He profited quite handsomely from this and proved his detractors wrong. This was one of the first uses of something resembling a futures contract.

Modern Futures Exchanges

Dojima Rice Exchange

Japan started trading rice futures in the 1700s at the Dojima Rice Exchange in Osaka. Rice was an important part of the Japanese economy and used as currency. The Japanese could use paper rice vouchers to pay for goods and services. You could even use the vouchers to pay for your taxes! Declining rice prices lead to a revolt against the rice speculators and privatization of the futures industry. The government then took over the market and created a fixed price of rice. However, by the 1900s, rice trading would flip back to a free market with futures being reimplemented.

The London Metal Exchange and The Chicago Mercantile Exchange

By the late 1800s, The London Metal Exchange in London would also be trading futures on metals like copper and zinc. Around the same time, The Chicago Mercantile Exchange created one of the more modern and standardized versions of future contracts. The exchange grew to be one of the largest futures exchanges in the world.

Hedging against risk is one of the main reasons why the commodity industries utilize futures contracts. Uncertain weather conditions can lead to varying outputs in crops and turbulent prices of agriculture products. Farmers can actually sell their crops before the harvest or even before planting the crop. This reduces their risk because if the price of the crop falls before harvest season, they have already profited. Doing this allows them to have a steadier stream of income so they are prepared for a rainy day. That is one of the main benefits of future contracts for economies.

How Future Contracts Work

If you were a rice farmer and on average produced several tonnes of rice every year, you could wait and sell your rice for the spot price at harvest time. The problem is a lot of commodities like rice are volatile. If the farmer thinks it will be a good season with a large harvest, then it’s possible that the price in the future could be much lower due to increased supply. To hedge against this, the farmer can “lock in” the current price of rice and sell their harvest immediately rather than waiting until the next harvest.

In reality, the price of these futures would likely have some other facts taken into account. Traders and commodity producers use various models to come up with the price of the futures contract. Things like storage and transportation costs need to be included in the price. These will vary depending on the commodity in question. Apples go bad much faster than a barrel of oil so this will lead to slightly different valuations, all other things being equal.

In traditional markets standardization of these contracts occurs. Standardization means that each contract has represented a specific asset in specific quantities. After all, there are many types of rice from different places so it’s important to know what exactly you are buying. The Chicago Mercantile Exchange has the contract specs on their website, which you can view for all their futures contracts. A coffee futures contract unit is equivalent to 37,500 pounds of coffee, for example. Although depending on the exchange, the exact amount will vary.

Advantages of Futures Contracts

Clearly, investors and traders alike don’t actually want 37,000 pounds of coffee. The trader is interested in the profit from the trade not the underlying asset per se. There are several advantages to trading futures over other types of financial products.

Diversification

Trading contract futures gives you exposure to tons of different markets such as the hard and soft commodity markets. Futures can help you mitigate risk in your portfolio and hedge in different ways. It is also often much more cost effective to purchase futures than the underlying asset. This is obvious with commodities, but futures contracts can also be for stocks and other assets, as with bitcoin futures.

Cost Efficiency

In many of countries, it is more tax efficient and there are fewer regulations around futures trading.

Liquidity

Futures markets tend to be more liquid than other markets. This is very crucial for traders who have tight profit margins. If the asset isn’t liquid enough, it can make things too risky to trade.

Futures in Crypto-markets

Some cryptocurrency exchanges have futures. Kraken has futures for the trading of Ethereum, Litecoin, Bitcoin Cash, Ripple, and Bitcoin. As cryptocurrency adoption continues to grow, other established and traditional platforms are taking a piece of the pie. TD Ameritrade, for example, offers Bitcoin futures. The CBOE exchange also had Bitcoin futures until recently but stopped issuing them due to lack of interest.

The advantage of trading futures instead of the crypto-asset directly is the fact that most contracts are cash settled. There is no need to touch the actual cryptocurrency as a trader.

The blockchain industry promises to revolutionize if not replace the finance industry. Part of that promise is allowing a free market to emerge with virtually any asset type. So what use would it be if blockchains didn’t harbor futures contracts? Luckily there are already some projects that do! [Update: On September 2, 2019, Binance announced the launch of two futures contracts platforms that would compete with each other.]

Digitex Exchange

Digitex is a hybrid decentralized/centralized exchange. All funds are assigned to your wallet of which you are the custodian. Buy and sell orders are signed by your wallet, but the actual order book runs on a centralized server. This design gives you almost the same amount of trustlessness as a normal decentralized exchange but with the efficiency of a centralized one. Later, Digitex will be implementing an Ethereum side chain and will become fully decentralized.

Digitex operates much like a DAO where token holders get voting rights on things like new token issuance. It’s also necessary to hold an amount of the token to use the exchange instead of trading fees.

Projects like this are quite exciting for the blockchain space. Diverse asset types and markets help to keep money flowing in the cryptocurrency market. If blockchain is to succeed in revitalizing finance, decentralized or trustless futures contracts will surely be needed.

Unfortunately, Digitex Exchange did have a bit of a set back recently with issues regarding contracted developers causing them to delay the launch of their exchange. CEO Adam Todd released a video on their youtube channel showing the issues with the exchange. Despite the drop in the token price they are promising to continue to push forward to a release of their product with a new development team.

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