A Buyer and a Seller comply with trade an FFA contract and through their broker, they're going to agree on the route, period and negotiate a price. Trades aren't published and everyone deals are done on the idea of trust. When the contract expires (settlement date), if the agreed price is above the settlement price, the vendor will compensate the customer for the difference.
On the opposite hand, if the fixed price is less than the settlement price, the customer will compensate the vendor for the difference. The settlement price is typically the typical of the month for the T/C average routes of BCI, BPI, BSI and BHSI or the typical of the month for tanker routes, while in some cases/routes, the typical of the last seven days of the month could also be used. The difference between the contract price and therefore the settlement price is multiplied by the cargo size (in case of the voyage) or voyage duration (in case of T/C) to work out the payoff of the contract.
Since FFAs were initially traded Over-the-Counter, there was always a risk involved which was borne by each party. This was the most problem when trading FFAs during the first years since the losses from counterparty defaults were high. For this reason, a clearing system was developed by which the FFA contracts (either exchange-traded or OTC traded) are guaranteed. With this clearing system, upon fixing an FFA contract, each counterparty deposits his account with a clearing member initial margin (deposit).
This initial margin is in the form of cash or securities and it is usually about 5-10% of the open position. If the margin account falls below a predetermined point (“maintenance margin”) which is about 3-5% of the open position, a top-up is required (“variation margin”) to raise it to the initial margin level.
Due to the huge losses which may be suffered just in case of a default the FFA market has been totally transformed within 10 years and while more than 90% of the trade 2004 wasn't cleared, we now see that quite 95% of the FFA transactions undergo a financial institution with the method analyzed above.
