The Role of the Exchange

Other than the trading that takes place in the more specialized over-the-counter markets and cash foreign exchange trading, the exchange is the centerpiece of much of the trading action in derivative instruments, whether trading is conducted via open outcry on a trading floor or electronically on a computer.

In recent years exchanges have been challenged to keep up with advances in technology, with changes in ownership from member-only entities to publicly traded companies and with the development and expansion of competitive new exchanges operating in a global environment. Technology requires huge investments in equipment and software applications as more and more participants trade electronically, but it also reduces the per-trade cost of trading, allows more new products to be offered online (sometimes the same product offered on another exchange) and improves the speed and efficiency of trading, which attracts even more trading.

Here are some roles that exchanges fill in the trading process:

Centralized Marketplace
Whether trading occurs in a pit or a computer, the exchange provides one centralized location where buyers and sellers can gather to match their orders. This pool of traders expedites the price-discovery and risk-transfer processes. Details about the results of this trading activity provide the price structure for many of today’s markets.

Product Offerings
Every viable business has to offer products or services. In the trading world it is the exchanges that create, develop and market the products that are traded, frequently doing the research to support the contract and producing the materials to promote their markets to traders. Exchanges do not own the product or carry an inventory; they just turn concepts into a tradable contracts and post them for the world to see and trade.

Trading Rules
Exchanges have developed a set of detailed trading rules over the years that govern how trading is conducted in a central location. These rules protect traders, whether on a trading floor or a computer screen, dictate how various orders should be handled and place restrictions on price manipulation, front-running or insider trading. Maintaining the integrity of the trading process is vital to building trust and confidence in the marketplace, which is what allows exchanges to function in the first place.

Futures exchanges also set performance bond requirements for all of its contracts, a role that the Federal Reserve has for the equities markets.

Trade Matching
For every buyer, there must be a seller, and for every seller there must be a buyer. The exchange provides the facilities and the rules to match buyer and seller and makes trading a more orderly process than the chaotic scene sometimes depicted in the media.

A clearing organization, sometimes operated by the exchange and sometimes a separate entity, works with clearing members of the exchange to make sure that all positions balance out, assuring that the appropriate amounts of margin money are deposited and resolving any discrepancies. In futures, the clearing organization actually acts as the buyer to every seller and the seller to every buyer to protect against the risk that a counter-party will not hold up its side of a transaction.