How to Form a Commodity Trading Firm

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Start a firm to trade commodities.
Start a firm to trade commodities. (Image: farmland with cereal crops image by david hughes from Fotolia.com)

Commodity trading consists of physical trading in the wholesale markets and derivative trading in commodity exchanges. Physical trading can take the form of either spot trades or forward contracts, while standard derivative trading most commonly refers to things like commodity futures and options. The majority of commodity trading is through standard derivatives. Even physical trading will use commodity exchanges for hedging. In the U.S., the trading of commodity derivatives is regulated under the Commodity Exchange Act of 1936. The appropriate authority is the Commodity Futures Trading Commission (CFTC) and the self-regulatory organization is the National Futures Association (NFA).

Physical Trading

Decide on the nature of the firm's business. For example, a commodity broker and a commodity dealer are both involved in commodity trading but with different business practices that require unique skills and expertise respectively. A broker focuses on the networking ability of soliciting potential clients of commodity buyers and sellers, including dealers, and brokering deals for them. A dealer emphasizes things like the transporting capability of moving commodity goods around between buyers and sellers with or without a broker's assistance.

Get registered and licensed. Physical commodity trading is enforced by the Model State Commodity Code as adopted by individual states. Therefore, unlike exchange trading, registration and licensing of the off-exchange transactions are handled by states. Check with the appropriate department of your state and file required registration.

Choose the types of commodities that the firm will specialize in. Trading physical commodities requires extensive product knowledge as the business involves conducting many physical activities such as inspection, transportation and storage. In exchange-commodity trading where price movement dominates, financial institutions and various investors can easily participate in a range of commodity trades such as in agricultural commodities, petroleum products and both precious and industrial metals.

Exchange Trading

Decide on the nature of the firm's business. Four kinds of commodity exchange-trading companies are under direct CFTC and NFA regulations: Futures Commission Merchant (FCM), Introducing Broker (IB), Commodity Pool Operator (CPO) and Commodity Trading Advisor (CTA). A FCM is a full service commodity brokerage. An IB is a commodity broker specializing in client solicitation but without futures floor operations that must be delegated to a futures commission merchant. A CPO pools investors' funds and invests them in commodity futures and other derivatives. A CTA receives compensation by giving its clients commodity trading advice.

Prepare for registration and arrange for proficiency examination. Individuals and organizations that intend to do business as a futures professional must register under the Commodity Exchange Act with the CFTC and apply for membership with the NFA, which handles all registrations. Individuals involved in all categories of commodity futures trading--commodity brokerage, commodity pool and commodity advisory--must pass the the National Commodity Futures Examination or Series 3. The persons include employees of a commodity firm, its partners or sole proprietor.

Apply for trading privileges with an commodity exchange if a firm wishes to become a member of an exchange. All forms of commodity trading firms are eligible for becoming a commodity exchange member. Commodity pool operators and commodity trading advisors may choose to have their own floor operations. Other membership companies may include non-CFTC regulated companies such as commercial entities and certain physical commodity trading firms that use exchange trading for hedging. A membership can be owned or leased.

Tips & Warnings

  • All employees of a commodity futures firm must be registered as associated person, partners and sole proprietor as principal with the NFA.
  • Participants in the exchange-related commodity trading business also include hedge funds, banks, securities brokers and dealers, commercial entities and proprietary trading firms. These players are not under direct regulation of the CFTC and the NFA, as other federal and state authorities have jurisdiction over them.

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