Market Structure for Futures

Question

I'm confused about how payment for futures contracts works if one sells before expiry. Consider the following scenario with a contract for delivery of good X:

1. A sells a futures contract to B for $50
2. Later B sells the same futures contract to C for $60
3. C holds the futures contract until expiry when they collect good X

My questions are:

• I assume A delivers X for $50. However, the contract is now held by C who bought it at $60. Who delivers to C for $60? Who receives from A for $50?

• A way that I can envision the market working is as follows: At expiry A sells X to B for $50, B sells X to C for $60. Thus everyone gets their "correct" price/good. However, clearly people make PnL before expiry. Where does this PnL come from? No goods/money has changed hands yet, so how can B immediately collect their $10 of profit before expiry, when they sell their contract?

Answer 1

Futures contracts are technically not "bought" or "sold". They are just a contract to buy in the future at a prearranged price. So no cash would be exchange upfront between A and B.

If B then "sells" that contract to C (which means that C agrees to enter into a new contract for $60), then the futures exchange simply creates a new contract between A and C and cancels the contract between A and B with whatever financial consideration is necessary to account for the change in contract price. In your example, B would receive $10 from the exchange when "selling" the contract.

The futures exchange (technically the clearinghouse that is used by the exchange) handles all of those interactions in a way that's largely transparent to A and C. From A's point of view, they still have a $50 futures contract (they have no idea who B is, let alone that they "sold" their contract), and C has a $60 contract. If that contract were held to expiry, C would pay $60 and A would receive $50 from the clearinghouse. The $10 difference will be reconciled by the exchange when the contract expires.

Keep in mind, however, that the vast majority of futures contracts, especially in regards to physical commodities, are not actually held to expiry. Most positions are closed out by entering into an offsetting position (as in your "selling" example above), often right before expiry.