This article is written by Swaroopa V Royadu, pursuing Diploma in Advanced Contract Drafting, Negotiation, and Dispute Resolution from LawSikho.

Introduction

Have you ever wondered why people enter into futures contracts rather than trading in the spot market? Are futures contracts really a good option? If yes, How? How will the futures market work? To understand these concepts first we should understand, what futures contracts are?

Futures or futures contracts are financial derivatives. What are derivatives? Derivatives are financial arrangements whose value is dependent on underlying assets or commodities. A very simple example is sugar and sugarcane. The value of sugar increases when the value of sugarcane increases. Here sugarcane is the underlying commodity and sugar derives its value from sugarcane. Another example is the value of Wipro derivatives increases when the share value of Wipro increases.

Thus, futures contracts are financial derivatives and are standardized contracts between buyer and seller for future exchange of assets or commodities. Futures contracts obligate the parties to buy and sell some underlying commodities/assets at predetermined future date and price by depositing certain margin money with registered custodians[Broker] of Exchange. Futures contracts are regulated by SEBI [Security Exchange Board of India]. Long wants to buy shares of ICICI bank of 2 lot size on 26/July/2021 by depositing margin money with a registered custodian. Does this transition make any sense? Of course not! To understand the above transaction it’s very important to know the terms that are used in futures contracts with their meaning.

Important terms used in futures contract

1. Long: Buyer is called “long” or buyer holds “long position”
2. Short: Seller is called “short” or seller holds “short position” 
3. Delivery date: The future date is called “final settlement date or delivery date”
4. Future price: Preset price is “future price”
5. Settlement price: The price of underlying asset is called “settlement price”
6. Lot size: Purchase in specific quantity 
7. Contract value: Lot size multiplied by the price of an asset
8. Margin money: This is a certain percentage of the contract value to be paid as a deposit to the broker to protect the trader and broker against possible losses.
9. Underlying asset: An underlying asset is security on which a derivative is based.
10. Square off: To clear trading position.
11. Custodian: Custodians are the clearing members or brokers. They settle trade on behalf of their clients that are executed through other trading members.
12. Exchange: Exchange is a marketplace where commodities, derivatives, securities and other financial instruments are traded.
13. Cash settlement: In cash settlement commodities or assets are not delivered physically, but only the difference of profit or loss amount is settled.
14. Physical settlement:  In physical settlement commodities are actually delivered.

The above transaction in simple words means the buyer wants to buy a specific quantity of shares of ICICI Bank from the seller on 26/July/2021 by paying certain deposit money with the broker.

How does the future contract work? 

Most of the futures contracts are traded through electronic mode these days. In future contracts, the transactions are done through registered custodians [clearing house or brokers] and not directly between buyer and seller. These clearing houses or brokers are registered members of the exchange. To trade in futures contracts one should follow the following steps

1. The buyer and seller should have a trading account.
2. Buyer and seller should arrange and deposit margin money with the broker. The broker in turn deposits that amount in the registered exchange.
3. Once margin money is deposited, orders can be placed with the broker by specifying details of the size of the contract, quality of commodities or assets, predetermined price, predetermined date and expiration date. The brokers will then provide options to select from various contacts available.
4. Futures contracts can be settled on or before the expiry date. It can be done either by cash settlement or physical settlement. 
5. Closing the transaction: once the transaction is complete and if the buyer/seller has made a profit, then the broker will deduct the margin money paid from the profit and the profit earned will be deposited in the trading account after deducting a small commission fee.

If the buyer/seller ended up with a loss, then the amount will be deducted from his trading account.                                        

A futures contract is an agreement where one party believes the price of the underlying asset increases while the other believes the price will drop down in future. With this concept in mind, both parties enter into futures contracts. So, in futures contracts, if one party makes a profit the other party will surely be under a loss of the same amount.

Are future contracts really a good option?

Let’s understand this with a simple example:

Mr. John has Rs 50,000/- and he wants to buy shares. He decides to buy shares of the Reliance Industry whose value is Rs2,500/share. John has 2 options; 

• He can invest in future market, by paying a margin money of Rs. 41,250/- he can buy 150 shares of Reliance Industry.
• He can invest in spot market, by paying Rs. 50,000/- he can buy 20 shares of Reliance Industry.

1. How to spot market works: With available Rs.50,000/- John can buy 20 shares. 

2500[value per share] x 20[Number of Shares] =Rs.50,000/-

2. How the futures market works: John just needs to pay margin money and buy shares in lot size.

Let’s consider 1 lot size has 150 shares then ;

Calculation of contract value

150 [lot size] x 2500[value per share]=Rs. 3,75,000 

Calculation of margin money

Let’s say margin money is 11%of contract value which is 

3,75,000(contract value) x11/100(margin Percentage)= Rs.41,250/-

Rs.41,500/- is the margin money  that Mr John  should pay to buy 1 lot[150] size of shares 

In future contracts, one can enjoy the benefit of high leverage. As futures are legal agreements and regulated by SEBI [security exchange board of India] the contracts are binding on both the parties and both parties are obligated to honour the contract on or before the expiration date. 

Important clauses to be included in future contract

• Title of agreement

The title of the agreement reflects the nature of the contract. The title of the agreement for the purpose of this article shall be “Future Agreement”, or if we want to be more specific it can be “Commodity Future Agreement or Index Future Agreement or Currency Future Agreement and so on” here the name clearly states the parties have entered agreement to buy and sell commodities/securities for some future date. There are no rules and regulations in law as to how the Title of the agreement should be. But in general, once we read a title, one should easily understand what the agreement is about. The title is generally in capital letters, centred and underlined. Example: the future agreement

• Date of execution and effective date

Agreements have an execution date [the date when the agreement was agreed and signed] and an effective date [the date from when the contract actually commences and the day from which the terms and conditions become legally binding].

• Name of the parties

The name and address of all the contracting parties should be clearly mentioned without any spelling mistakes. This part or clause should include contact details such as the name of the person/company, address, Fax number, phone number, email address, if it’s a company then the company’s identification number, the registered office should be specified.

• Recitals

Recital clauses give details of the party’s background. In futures contracts, this clause includes details like parties occupation, business, details of brokers, details about registration with an exchange, registration number of broker etc or sometimes Recitals gives details about the background of how and why the parties are entering this particular contract. A recital clause mostly begins with the word “WHEREAS” [which means “considering that” or “that being the case”]. Recitals in a contract play a major role, they introduce the nature of contractual relations of parties, plus they also specify the contribution made by each party.

• Definitions

Every different agreement has a different set of words that have a specific meaning related to that particular agreement. 

Example: 2 people enter into a Futures agreement to trade corn, sugar and wheat. Every time instead of mentioning the words “corn, sugar and wheat” in the contract, parties can use the term “Grains” in the definition clause. This means, for the purpose of this agreement the word “Grain” means Corn, Wheat and Sugar, though “Grains” has a wider meaning in general. 

The first letter of the word specified in the definition clause should be capitalized so as to differentiate it from other words. Such words can be specified either in definition clauses separately as in the above example or they can be written in double inverted commas and in brackets. 

Example corn, sugar, wheat [hereinafter “Grains “].

• Obligation

The obligation of the broker towards the client in a futures contract is to pay the dues as and when they arise, settle the agreement, inform the client about trading, settlements, delivery, payments or about any changes in the contract. 

Similarly, the obligation of the client is to notify the broker if there is any change in the information provided by him to the broker. It is the obligation of the client to pay brokerage fees, transition fees to brokers, the client is also obliged to maintain a minimum balance in his trading account etc. Every Obligation must be specified clearly by both parties.

• Confidentiality

All the information provided by the client to the broker at the time of opening an account and other confidential information should be kept secret. The broker should not use any of the information for his personal benefits other than the purpose mentioned in SEBI Rules and Regulation.  

• Term of contract

The term represents the duration of the contract period. The duration of the future contracts of the contract is predetermined. The contract terminates after the term is over. Future contracts are transferable contracts. This means if the contract is transferred to a 3rd person, that person is obliged to fulfil obligations, rights of that contract till the term of that contract.

• Termination

Even if the duration or term of the contract is fixed in the contract, the contract can come to end before the specified period either by mutual consent of parties or on the happening of a specific event, change of ownership, due to death, disability or insolvency of either party or because of force majeure. However, proper written notice should be served before termination.

In future contract the contract can be terminated;

1. By mutual consent,
2. Delivery of commodity [in case of commodity futures],
3. Futures contracts can be terminated by an offsetting transaction [ here long takes the position of short to equalize the transaction],
4. Future contracts can also be terminated by cash settlement between parties.

• Liquidation of position

Futures contracts are standardized contracts. Buyer or seller can sell/buy commodities or securities even before the expiry period and make cash. However, the terms, responsibility, and obligation transfer to the person with whom it is traded. 

• Electronic trading

Most of the futures contracts are traded through electronic mode. In most cases both the parties sign another agreement or draft a detailed clause that will govern the use of electronic devices, and such agreement contains details of roles, responsibilities, obligations of parties with respect to the use of electronic or digital devices. 

• Terms of settlement

In futures contracts, commodities/securities are exchanged through custodians [clearing house, brokers]. So here, under the futures contract both the parties pay certain margin money to the custodian. once the transition  is complete the settlement of money can be made in 2 ways:

1. Cash Settlement: Under cash settlement, the parties exchange only the difference of money they paid. Example:

• ABC purchased 1000 shares of Tata Motors for Rs.350/share. 
• He paid the margin amount of 12% of the contract value. That is 1000 x350= 35,00,000/-.
• 12% of 35,00,000 is Rs 4,20,000/- and this is the margin amount paid by XYZ.
• The share value increased after 2 weeks to Rs370/-.
• 1000×370 =37,00,000/- is the profit earned.
• Here in cash settlement only the difference Rs2,00,000/- is paid rather than 37,00,000/-.

2. Physical settlement: Payment is made on the physical delivery of goods to the extent agreed upon in the contract. 

• Representations and warranties

A representation is an assertion that the representation of facts made here in this contract is true, that is given to induce another party to enter into a contract or take some other action. Representation can relate to either party/company. Warranties on the other hand do not merely give assurance about the party/company or product, but also promise to indemnify in case warranties specified doesn’t meet the standards.

• Consideration

Consideration means something in return. No contract is valid without consideration. Like any other contract Futures contracts are also traded for consideration which can be either commodities, Index, Currencies, stocks[share, debentures, bounds].

• Indemnification

Indemnify means to make good the loss. Indemnity is a promise made by one party to another to hold the other party harmless as a result of the action of another party.

Example: The crude oil which was agreed to be delivered by seller [short] to buyer [long] on a certain future date could not deliver it on time. As a result of which the buyer [long] suffers a loss. Now the seller is liable to make good the loss caused by him. 

• Force majeure

As we all know certain acts of nature are beyond human control. For example; floods, earthquakes, Pandemic like Corona, mobs etc are all the acts that are not in control of parties. Adding such a clause in a contract helps the parties to act without any confusion or ambiguity. 

• Governing laws

Governing laws play a significant role in all kinds of contracts, especially when it comes to international contracts. If governing laws are not properly specified then multiple sets of laws will apply which results in confusion and lay grounds for future disputes.

• Jurisdiction

Jurisdiction means territorial jurisdiction. Parties to the contract may not reside in the same place or same country. So it becomes of utmost importance to add this clause in the contract to decide where the litigations should be filed in case any dispute arises. To avoid complications it is better to use exclusive jurisdiction. In case of jurisdiction is not specified in the contract then principles of jurisdiction under civil procedure code, 1908 will apply [in case parties are from India]. Choice of jurisdiction must be connected with the choice of governing law. Freedom to choose jurisdiction has limitations. 

Example: A futures contract is entered between India and USA. The Jurisdiction to settle any dispute arising in this contract should be either in India or USA and not Germany, which is totally not connected.

• Assignability

Futures contracts are assignable. One can add an assignable clause in the contract to ensure the liability of the person to whom it is assigned will not change after the contract is assigned to him.

• Notice and communication

In futures contracts, notice and communication are made through electronic mode. All such electronic communication is legally binding on both parties. Parties should be capable of having proper internet access and should be able to print, download the information exchanged as a matter of record. Telephonic conversations can be recorded and monitored. Details of how the notice should be sent and methods of communication such as [express mail, email, website (where information is posted), messages (made in trading platform)messages through websites or telephone and sometimes telephonic conversation should be clearly mentioned in the contract. 

Electronic signatures on futures contracts are legally binding in the same manner as if such a document has been signed manually. 

• Signature

Both the parties to the contract should sign the contract to make it legally binding. It can be an electronic signature or a manual signature.  

Here is the sample draft of the futures customer account agreement

Futures customer account agreement

This future customer account Agreement (“Agreement”)dated 26/July/2021, between Zeo traders, a registered Custodians of Bombay Stock Exchange (“Broker”) and Kamal Mehata Long/short (“Customer”)shall govern all transactions that Zeo traders may execute, clear and carry on customers behalf for purchase, sale and clearing of futures contracts. 

• Applicable laws: Every contract and transaction in respect to this agreement shall be regulated by the SEBI (Security Exchange Board of India). Any laws, rules, regulations, policies, procedures, interpretation, customs and usages as in force from time to time are herein collectively called applicable laws. 
• Obligations:

1. 1. 1. The payment obligation of customers: With respect to every contract purchased, sold or cleared the Customers shall pay the Broker (on demand) all brokerage charges, fees, commission, service fees as applicable from time to time. Customers shall also pay any tax imposed by the competent authority, debt balance or deficiency on account as and when needed. 
      2. Obligation to pay margin money: With respect to every contract purchased, sold or cleared, the customer shall make applicable initial margin, variation margin, intraday margin, as the case may be to the Broker. Requests to deposit margin money shall be communicated to the Customer orally, telephonically or in writing.

• Responsibility: Broker shall be solely responsible for the execution, carrying and clearing of all contracts in accordance with the terms agreed in this agreement.

• Limitation of brokers liability: Brokers are not liable for any acts in connection with transactions by 3rd parties that are not employed by them. Acts that cause directly or indirectly occurrence of any contingency beyond Broker’s control of any nature, the broker shall be excused from performance of such obligation for reasonable time and obligation shall be performed after finding a remedy to the effect therefrom.

• Settlement: Parties to the agreement have agreed to a cash-based settlement. Once the ‘term’ of the contract is complete, the Broker shall transfer the excess amount to the  Customer’s account in case the Customer makes a profit, in case of loss, the same amount will be deducted from the Customer’s account.

• Customer representation and warrant: Customer represents, warrants and agrees as of the date hereof and executes hereunder that Customer has full right, power, and authority to enter into this agreement. Customers can lawfully establish and open an account for the purpose of effecting purchase and sale of contract through Brokers. Customer is ‘eligible contract participant’ as such in terms defined in section 11 of Indian contract act 1872.
• Term and termination: 

7.1 The term of this agreement shall be for 3 months. 

7.2 This Agreement may be terminated even before the expiry date.

7.3 This Agreement may be terminated by Customer or Broker by sending a written notice to others. In the event of such notice, no later than 15 days following such notice, customers shall either close out open positions in the Account or transfer such open positions to another. 

• Indemnification: Customer hereby agrees to pay, indemnify and hold Broker harmless from and against any and all loss, liability, damages, cost, penalty, fine or tax incurred by Broker in connection with the account, contract or position maintained therein. 
• Governing law and jurisdiction:

 a.] The construction, validity, performance and enforcement of this agreement shall be governed by the laws of India. 

 b.] Any dispute arising under this agreement or any dispute arising in connection with this agreement shall be resolved in a court of Mumbai.

• Notice and reports: Except as otherwise expressly provided in this agreement all notices or other communications shall be given orally unless requested to be in writing. All oral and written communication, notices shall be directed as follows:

(i) If to Zeo traders,

Zeo traders, 7th street, #2121

Mumbai (Registered brokers of Mumbai stock exchange)

Telephone: 57975xx34.

Email: [email protected]

(ii) If to Customer: At the address, telephone, email, as specified in the future account application form. If there is any change in the customer’s address, telephone number or email ID it should be communicated to the broker. 

IN WITNESS WHEREOF, the customer has executed this Agreement as of the date set forth below

Customer

Account Name: Kamal’s trading account                          By:__KAMAL. MEHATA _ 

Date: ______26/July/2021_________                       Print name: KAMAL MEHATA

Title: Individual trader

Zeo traders

By: Zeo traders, Registered Custodians of Bombay Stock Exchange

Print name: Gautam.Tim

Title: Broker of Zeo traders.  

Conclusion

Futures contracts help the investors to reduce the risk of future price fluctuations and protects investors from paying high prices. A futures contract also allows a trader to speculate the price fluctuation on various commodities and financial instruments before the expiration of the term and helps the trader to offset the trade and close the position. Futures contracts are highly leveraged and thus proper knowledge of the market helps to yield high profits. As futures contracts are traded through Custodians [registered brokers] chances of dishonouring contract and chances of dispute are very less. 

But, on the other hand, if there is a price swing and the price of the commodity or financial instruments drops then there is a chance of losing even the margin money that has been invested. Thus one should have enough knowledge, skill, and experience to trade in the futures market.

Reference

• https://zerodha.com/varsity/module/futures-trading/
• https://www.tdameritrade.com/forms/TDA600.pdf
• https://financetrain.com/how-futures-contracts-are-terminated-settled
• https://www.sec.gov/Archives/edgar/data/1522699/000119312512433267/d183545dex99107.html

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