Associate Professor and Professor of Finance, Virginia Polytechnic Institute and State University, Falls Church and Blacksburg, VA, respectively. The authors have benefited from the comments of Don Chance, Andrea Corcoran, Joel Houston, Roger Rutz, Cliff Smith, Paula Tosini, and participants in the Virginia Tech Finance Seminar Series. Of course, the authors are responsible for any remaining errors.
Default Risk in Futures Markets: The Customer-Broker Relationship
Article first published online: 30 APR 2012
1990 The American Finance Association
The Journal of Finance
Volume 45, Issue 3, pages 909–933, July 1990
How to Cite
JORDAN, J. V. and MORGAN, G. E. (1990), Default Risk in Futures Markets: The Customer-Broker Relationship. The Journal of Finance, 45: 909–933. doi: 10.1111/j.1540-6261.1990.tb05112.x
- Issue published online: 30 APR 2012
- Article first published online: 30 APR 2012
The traditional view of the futures clearinghouse as an insurer that eliminates the need for customers to evaluate default risk is inaccurate. A clearinghouse member default in 1985 confirms that the clearinghouse only guarantees payment from member to member, not from customer to customer or member to customer. Thus, non-defaulting customers are subject to losses as a result of the action of individuals with whom thay have no contractual obligations. This study models the behavior of customers choosing a futures commission merchant (FCM) given the current legal position of the clearinghouse. In a single-period model with symmetric information, customers can eliminate their exposure to defaults of other customers or of their FCM only by choosing to trade through “boutique” (undiversified) FCMs. In practice, monitoring and rebalancing costs may impede the attainment of zero default risk. However, FCM diversification remains an important factor in customer choice of an FCM. When setting capital requirements, clearinghouses and government regulators need to consider the implications of diversification for both customer and market protection.