Term Deposits (6) - Futures Market

When a bank accepts a term deposit and lends the funds for a longer term, it does not know where the funds will come from to repay the depositor when the term is complete. It is committing to obtain money in the future, without knowing whether this will be possible, or what the price will be. It is making a commitment to return something that it currently does not own.

A market where people buy and sell entities, which they do not own, is called a futures market. Futures markets exist for a number of commodities and for a variety of financial instruments. Such a market is legitimate for people who want to speculate on or hedge against future changes in price. All participants in the market understand that the person who is promising to sell at a future date does not currently own what they are promising to sell. There is a risk that when they try to buy what they have agreed to sell; the price may have risen so high, that they cannot afford to buy it. If that happens they might default on their agreement. Everyone in the market understands this risk.

Futures markets are inherently unstable, as prices can fluctuate rapidly and players default if unexpected events occur. This is fine for investors who understand the nature of market and are prepared to take on the risks involved. However, this type of arrangement will rarely be appropriate for people making term deposits in a bank. They put their savings in term deposits at a bank because they want their money to be safe. They are generally willing to accept lower interest rates in return for higher security. They are not choosing to lend to an entity that is speculating in a futures market.

Depositors might be able to get a higher rate of interest from a term deposit for a bank that borrows short and lends long, bit if they understood the risk, most would prefer a safer option.