Size of market for physically delivered futures

Question

I understand the difference between cash settled and physically setted futures contracts. I also know that most physically settled contracts end up not being exercised and are closed before expiration.

Now - is the market size for physically settled futures limited by the underlying asset? Who controls that there are not more contracts bought than what the volume of the physical asset (copper, cattle, electricity) is? Even when there are such controls, what happens in case of an abrupt supply shock? Will the contract turn into cash settled one as there is no one who can deliver?

Answer 1

It's a great question. Few people know or care about the actual details and mechanisms of this sort of thing.

I'm pretty sure there are clearing houses involved and they carry the (ultimate) risk. I hope someone can give you a more detailed answer.

So it's "CME Clearing" ...

Turns out there is an obscure entity called "CME Clearing" which is the clearing house for CME.

On this CME page ...

https://www.cmegroup.com/clearing.html

they rattle on about the features of "CME Clearing" but the only reason it exists is to payout in exactly the situation asked about in this question.

The default waterfall ..

Indeed this exactly explains the default waterfall: https://www.cmegroup.com/clearing/risk-management/financial-safeguards.html

How much they got?

This random wiki article http://www.marketswiki.com/wiki/CME_Clearing mentions they have eight billion.

This doco https://www.cmegroup.com/clearing/cme-clearing-overview/safeguards.html suggests about five billion?

Note that once that runs out (in a really dramatic event - so a war halts the oil supply or the like) the original question posed here remains. IMO in such a historic situation, as usual the government would step in and print money to bail out all banks universally, then bail out favored parties, and then have a small bailout ("up to 100k" or such) for individuals. (Just like everyone got 300 bucks for covid!)

Other random info...

There's a random comment here that: https://www.investopedia.com/terms/l/limit-move.asp

The CME requires institutional members to contribute to a fund to cover defaults by counterparties, as do all futures exchanges

I've never heard of that and don't know any details on it and dunno how factual it is. It could be the person is referring to "CME Clearing", or it may just be mixed-up information.

You may be aware (I've always found this strange) most commodities actually have a daily limit (!) on how much the price can change. (!) The exchange and underwriter just state that that's it, it can't rise or fall by more than X. When this does happen, you tend to get a few days in a row where it just limits out (sort of instantly first thing in the morning!) with people desperately trying to clear out exactly the "disastrous endgame" you ask about in the question. Example article on daily limits on oil, etc https://www.investopedia.com/terms/l/limit-move.asp

Answer 2

The seller controls the limit on what's available through contracts. Who would offer more for sale than they could deliver? That wouldn't make sense, just in the event the contracts are exercised. In such an event, the seller of the contract would have to go out into the open markets to buy whatever it takes to make good on the contracts they sold. That CAN happen, but it's a very dangerous and risky proposition.

Answer 3

The same thing that happens when I can’t deliver the car you bought

I’m in breach; you’re entitled to damages for my breach and maybe you can terminate the contract for cause. Commodities futures contracts are just contracts and follow the same legal rules.

Now, they are far more likely to be standardised than bespoke and the damages are very likely to be liquidated damages; that is, the amount of the damages is agreed in advance, possibly by reference to the spot price on the day of settlement.