Contract Market: What It is, How It Works, History

What Is Contract Market?

Contract market, or designated contract market, is a registered exchange where commodities and options contracts are traded. It is sometimes known as a "designated exchange."

Understanding Contract Markets

A contract market, or designated contract market (DCM) is any board of trade (exchange) designated to trade a specific options or futures contracts. It must register with the overseeing regulatory authority, most notably the Commodity Futures Trading Commission (CFTC), pursuant to Section 5 of the Commodity Exchange Act (CEA). Most large futures markets also provide clearing and settlement functions.

A contract market, otherwise known as an exchange, provides the environment, whether it be a physical market floor or virtual electronic platforms, where futures and options contracts are bought and sold. It is a marketplace in which securities, commodities, derivatives, and other financial instruments are traded. The core function of an exchange is to ensure fair and orderly trading, financial controls, and the efficient dissemination of trade price information.

To maintain liquidity, contracts trading on a contract market have standardized sizes, expiration dates, and, for options, strike prices. This standardization can be contrasted with the over-the-counter (OTC) market where buyers and sellers customize and agree to the terms.

History of Contract Markets in the U.S.

The largest futures exchange in the U.S., the Chicago Mercantile Exchange (CME), was formed in the late 1890s, when the only futures contracts offered were for agricultural products. The emergence of interest rates, or bond futures, and currency futures in major foreign exchange markets came in the 1970s. Today's futures exchanges are significantly larger, with hedging of financial instruments via futures. These futures hedging contracts comprise the majority of the futures market activity. Futures exchanges play an important role in the operation of the global financial system.

Financial exchanges have seen many mergers, with the most significant being between the CME and the Chicago Board of Trade (CBOT) in 2007. Rebranded as the CME Group, it then acquired NYMEX Holdings Inc., the parent of the New York Mercantile Exchange (NYMEX) and Commodity Exchange Inc. (COMEX) in 2008. Growing again in 2012, it added the Kansas City Board of Trade, which is a dominant player in hard red winter wheat.

Another major player in the U.S. is the Intercontinental Exchange (ICE). Born as an electronic exchange in 2000, ICE acquired the International Petroleum Exchange (ICE) in 2001. In 2007, it obtained both the New York Board of Trade (NYBOT) and the Winnipeg Commodity Exchange (WCE). Finally, it expanded into equities with the acquisition of NYSE Euronext in 2013.

As a result of Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank), legislation enacted in 2010, DCMs are one of two types of exchanges on which mandatory cleared swaps may trade. The other type of exchange is called a swap execution facility (SEF). The legislation attempted to move what were contracts between two parties onto the two types of exchanges so that they were available to many counterparties.