How does an exchange guarantee both legs of a calendar spread are executed atomically to give a specific spread?

Question

In commodities/oil you have monthly contracts for a given Future, e.g. on CME the Crude Oil Futures (CL) monthly contracts can be trades, and have Globex codes such as CLZ8(Crude Oil Dec18 Future), CLF9...etc

The monthly futures are liquid and it is often the case where traders long one month (near month) and short the other (far month) or vice versa to obtain a spread between the 2 months. The reason being there is correlation between the months and by being long and short the different months, you can hold a spread position between these contracts.

To manually obtain a spread position of -10, one must put an order for the first contract and then the other

e.g. BUY CLZ8 @ 60 and then SELL CLF9 @ 70.

But the price of the CLF9 contract could move from 70 to 68 which would mean that you'll end up with a spread of -8 rather than -10.

CME and other exchanges often offer intra-commodity spreads (also know as Calendar Spreads, or Time Spreads) where the spread values for a given Commodity and underlying months can be traded.

My question about these spread. For example lets say in the DOM (Depth Of Market) for the CLZ8-CLF9 spread contract the Best Ask is -10, which means i can buy it at this price, if i enter a market order to buy this spread, then what really happens:

1. Does the exchange simply offer this by putting in a Buy order for CLZ8 and a Sell order for CLF9?
2. If (1) is true, then how does the exchange handle the scenario where if the the it fills the Buy order of CLZ8 at 60 but the prices of the CLF9 moves away from 70 and does not go back to 70 so the exchange cannot reach the CLZ8-CLF9 spread value of -10
3. Or is (1) false and the when a spread contract is traded then you do not enter 2 orders for the different months, you get filled straight away as the spread contract market is a market of its own and separate from the individual month future contracts.
4. If (3) is the way it works such that spread-contracts have a market of there own then what price do you receive for the 2 separate future months? does putting a spread-contract contract show up or affect the DOM(Depth Of Market) for the underlying individual month contracts?

Answer 1

You misunderstand the role of the exchange. The exchange does not guarantee anything. It only (1) Decided that spreads can be traded between willing counterparties (the exchange disseminates bid and ask and other information for spreads through its regular systems) and (2) The exchange provides a convention to ease the reporting of spread trades, the spread trades will be reported as two separate outright trades, as explained below.

Party A wants to buy (Long Sep, Short June) spread and Party B wants to sell it. The agree on a spread price of 5. That is what really matters.

For reporting purposes on leg is considered the main leg, and the other the derived leg. Let's say the nearer month is considered the main leg (convention may differ among exchanges). The main leg is priced at a price consistent with the quote for the outright contract, and the derived leg is priced at that price plus/minus the spread (ignoring the price of the corresponding outright contract).

So if June is priced at 66.0, and the agreed spread was 5: PArty A will report to the exchange Buy Sep at 71 and sell June at 66, and Party B will report the opposite (Sell Sep at 71 and buy June at a price of 66).

This convention has the effect of making the prices of both contracts look plausible. But you will see that any other method would also work: the main leg could be priced at 1000 and the other at 1005 and the economic results would be identical in the long run (i.e. once both positions are closed out). The only consequence would be funny looking prices for the two contracts.

This reporting of 2 outright trades is only for the back office, after the trade is made. The live quotes, depths, etc. for the outright contracts are not affected by the spread trades (your Q. 4).

You may ask? What then guarantees that the spread price is consistent with the prices of the two outright contracts at a point in time? The answer is: only the self-interest of the two parties (again: the exchange has nothing to do with this). Party A would not have paid 5 if he thought it was too expensive compared to the where he saw the two contracts trading, and Part B would not have sold if he thought 5 was too cheap. But no one is "guaranteeing" that this was the right spread at a point in time.