By Hann Wu

In financial markets, the differentiation between forward and futures transactions has become increasingly important. Some financial transactions, though technically resembling forward contracts, are futures transactions in essence. This article examines the distinctions between these two forms of trading.

Formal Distinctions

During the 2010s, with the rise of commodity forward transactions, issues of futures trading being disguised as forward transactions gradually emerged. To mitigate financial risks and regulate market order, the State Council issued the " Decision of the State Council on the Cleanup and Rectification of Various Trading Venues to Effectively Prevent Financial Risks" (State Council Document [2011] No. 38) and the "Implementation Opinions of the General Office of the State Council on the Cleanup and Rectification of Various Trading Venues" (State Council General Office Document [2012] No. 37) in 2011 and 2012, which provide standards for identifying disguised futures transactions based on their form.

These documents specify that except for securities and futures exchanges established in accordance with the law or trading venues for financial products approved by the financial regulatory authorities of the State Council, any trading venue and its branches that violate any of the following provisions shall be subject to rectification and reorganization:

1.Prohibition on Splitting Equity Interests into Equal Shares for Public Offering

No trading venue shall split any equity interests into equal shares for public offering. A trading venue that uses its services and facilities to divide equity interests into equal shares and then sells them to investors shall be deemed to have engaged in “public offering of equal shares.” Public offerings of shares by a joint-stock company shall be subject to the relevant provisions of the Company Law and the Securities Law.

2.Prohibition on Centralized Trading

No trading venue shall engage in trading through centralized trading methods. The term “centralized trading methods” referred to in this Opinion includes methods such as collective bidding, continuous bidding, electronic matching, anonymous trading, market-making, etc. However, negotiated transfers and auctions conducted in accordance with the law are not included.

3.Prohibition on Continuous Listing of Equity Interests Based on Standardized Trading Units

No trading venue shall continuously list equity interests for trading based on standardized trading units. The term “standardized trading unit” as referred to in this Opinion refers to a minimum trading unit set for interests other than equity interests, with trading conducted in the minimum unit or its multiples. “Continuous listing for trading” refers to the act of listing the same type of trading product for sale within five trading days after purchase or for purchase within five trading days after sale.

4.Limitation on the Number of Equity Holders

The total number of equity holders shall not exceed 200. Unless otherwise specified by laws and administrative regulations, the total number of actual holders of any equity interest during its term, whether in the issuance or transfer phase, shall not exceed 200. In cases of trust, agency, or other forms of indirect holding, the number of actual holders shall be calculated based on the actual holders.

5.Prohibition on Centralized Trading of Standardized Contracts

No trading venue shall engage in centralized trading of standardized contracts. The term “standardized contract” as referred to in this Opinion includes the following two situations:

(1)A contract uniformly formulated by the trading venue, where all terms except for the price are fixed, and it specifies the delivery of a certain quantity of the underlying asset at a certain time and place in the future.

(2) A contract uniformly formulated by the trading venue, where the buyer has the right to buy or sell the specified underlying asset at a specific price at a certain time in the future.

The aforementioned documents, to some extent, provided key elements for formally distinguishing futures transactions from forward transactions. However, with the development of international derivatives trading, the structure of derivatives transactions has undergone significant changes, transitioning from traditional over-the-counter, one-on-one agreements between counterparties to standardized contracts. An increasing number of market participants now offer standardized derivatives trading agreements, and the standardization of over-the-counter derivatives has substantially expanded the volume and scale of derivatives trading. Furthermore, the rapid advancement of information technology and the emergence of electronic trading platforms have facilitated a shift towards electronic matchmaking of derivatives transactions, utilizing exchanges or clearinghouses as central counterparties for centralized settlement. This evolving landscape has exposed the inadequacy of relying solely on formal distinctions to differentiate futures transactions from forward transactions.

The Expansion of Centralized Trading

In recent legal cases, courts have often expanded the interpretation of centralized trading. For instance, on certain platforms where individual investors conduct one-on-one transactions with platform members, courts have determined that while each individual transaction between an investor and a platform member is one-on-one, the platform member engages in transactions with multiple investors simultaneously, which constitutes centralized trading, thereby making the transaction disguised futures trading. In another case, "clearing by trading centers and custodial banks, which unify the settlement of member and client funds," has been considered a form of centralized trading. Such broad interpretations may hinder financial innovation, as they adhere rigidly to formal definitions without considering the evolving nature of financial products and services.

The judgment criteria for distinguishing between forward and futures trading should shift from a formalistic approach to one based on the substance of the transactions. The trend towards standardized and centralized derivative trading calls for abandoning reliance on the general characteristics of futures contracts, such as standardized contracts and margin requirements, as the sole criteria for differentiation.

Forward Contracts: Traditional Roots

Forward trading originated in the context of maritime trade, where merchants engaged in transactions involving goods to be delivered in the future. The essence of forward trading is rooted in traditional spot transactions, where goods are exchanged for payment immediately. However, forward contracts differ by separating the contract's conclusion from its execution, with a delay between agreement and delivery. Despite this, both spot and forward trades are centered on physical delivery of goods.

The main purpose of forward contracts is to lock in future prices to hedge against price fluctuations. These transactions are typically private and involve personalized terms, making them prone to default and limited in liquidity. As a result, forward contracts are often less secure and harder to transfer.

Futures Contracts: Standardized Evolution

Futures trading emerged as a response to the need for greater security and liquidity in financial markets. Futures contracts are standardized versions of forward contracts, created by exchanges to promote safer and more liquid trading. Standardization involves setting uniform terms, including contract names, commodities, trade units, quotation units, minimum price fluctuations, price limits, contract delivery months, delivery dates, and delivery locations.

Although futures contracts maintain the possibility of physical delivery, their primary purpose has evolved. Investors no longer trade futures to acquire physical commodities; instead, they use them primarily to hedge against price fluctuations or speculate on market movements. As such, futures trading is now characterized by features such as margin requirements, daily settlement of positions, forced liquidation, and cash settlement.

Substantive Distinctions: Purpose of the Transaction

While forward and futures contracts may appear similar in form, they are fundamentally different in terms of their objectives. The core distinction lies in the purpose of the transaction: whether it aims to facilitate the physical transfer of goods or to hedge against risks and speculate on price movements.

As the Beijing Financial Court has noted, "Investors do not pay the full price of the commodity when entering a futures contract but rather deposit a margin. After the contract is concluded, investors may settle their obligations not through physical delivery but by taking opposite positions or closing out their positions." This statement reflects the essence of futures trading: the goal is not the transfer of ownership of physical goods but the generation of profits through price fluctuations.