1. Performance on a futures contract is guaranteed by a clearinghouse – a financial institution associated with the futures exchange that guarantees the financial integrity of the market to all traders.
2. The clearinghouse acts as the intermediary counterparty to the buyer and seller in each trade.
3. The clearinghouse adopts the position of the buyer to every seller and the seller to every buyer.
4. Every trader in the futures markets has obligations only to the clearinghouse, and the clearinghouse guarantees the fulfillment of the contract of the trading parties.
5. Since the clearinghouse is well-capitalized, its default risk is very small.
In contrast, there is no clearinghouse in a forward market.
The clearing house has no net commitments in the futures market. It acts only to guarantee performance to both parties.
Since the clearing house guarantees performance on all futures contracts, it is now exposed to the risk of default by the traders.
To protect itself and the exchange, the clearing house rules provide for collecting a ‘margin’ in the form of a cash deposit or short-dated liquid security.
The margin acts as a good faith deposit and may be seized to cover trading losses. The margin provides a measure of safety to the broker, the clearing house, and the exchange.
The margin deposit is normally quite small – 5 to 10 percent of the contract value. As such, the clearing house needs protection from potential default.
In order to provide this, the clearing houses have devised a mechanism known as ‘daily settlement’ or ‘mark to market’. This means that the futures traders realize their gains/losses in cash every day.
The trader may withdraw his gains and must pay the day’s losses. The margin remains with the broker and may be seized, only if the trader fails to settle the day’s losses and liquidate the trader’s position.
By this mechanism, the exchange is able to limit its losses to the extent the day’s losses exceed the margin amount.