Does introduction of exchange traded centralized derivatives contracts provide benefits beyond price discovery and hedging opportunity to value chain participants? The answer is YES!
Since time immemorial, market participants have been entering bilateral forward contracts for securing delivery and for hedging commodity price risks. In fact, the history of forward contract goes back to 620 BC. As the story goes, Thales, the ancient Greek Miletus-born philosopher, astronomer, and mathematician, who was considered one of the most erudite people at that time, was derided for not being able to use his wisdom for earning money. Just to prove a point, he predicted bumper crop of olive using his astronomical knowledge. He knew that with bumper crop, the demand for olive presses would go up. Hence, before the olive harvest season, he borrowed money and entered forward contract to rent all olive presses in Miletus and nearby areas. True to his prediction, there was bumper olive crop that year, and Thales charged olive farmers huge sums of money for using olive presses to extract olive oil. With this, Miletus proved to everyone that it is rather easy for philosophers to be rich, if they choose to be so!
Though history of forward contracts goes back to hundreds of years, these contracts have implicit counterparty risks. Hence, to reduce counterparty risk and to bring more structure and discipline to forward contracts, organised and rule-based entities emerged as regulated exchanges, with clearing houses, margining systems, etc. In fact, almost all major centuries-old commodity exchanges such as LME, CBOT, B3 S.A (Brasil, Bolsa, Balcão), and the Baltic Exchange have all followed similar growth paths. Major trading centres for spot buying and selling of few commodities started offering forward contracts on these commodities and slowly graduated to organised exchanges while beginning to offer derivatives contracts on many other commodities.
Why have exchange regulations?
Exchange regulations bring an order to the market, thereby helping the underlying product market in many ways. For example, the introduction of central clearing counterparties (CCPs) in coffee forward contracts traded at Le Havre in France in 1882 reduced the volatility in coffee prices and led to significant reallocation of coffee trade to Le Havre. In fact, this was the first time a clearing house guaranteed every contract by interposing itself between every buyer and seller. Since then, the centralised clearing house has become the backbone of every exchange for facilitating and guaranteeing every trade made in its platform.
As mentioned earlier, commodity exchanges offer a platform for hedgers to transfer the risk to those who are willing to take a risk for profit. In addition, futures contracts traded in these exchanges help in price discovery, a process of interaction among market participants by which fundamental value of an asset is uncovered. In case of futures price, the discovered price is nothing but the expected spot price to prevail at future date. As more and more participants trade, the market becomes more liquid and the futures price signal becomes more robust, thus giving a fair indication regarding the expected spot price. Commodity exchanges also put significant effort to on-board hedgers and other traders as liquidity is one of the key parameters for measuring the success of an exchange. In fact, it is a commendable effort by Indian commodity exchanges to on-board Farmer Producers Organization (FPO) to use the exchange platform for hedging the price risk. In addition, India commodity exchanges are disseminating spot price, futures price, trading volumes, etc. to commodity value chain partners (VCPs) via SMS.
Good for the community
Exchanges, therefore, not only facilitate aggregation of traders but also make the centralised price signal a public good by making the same available to all market participants. In addition, commodity exchanges put significant effort in collating and disseminating spot price, thus augmenting transparent information dissemination. On a daily basis, exchanges or the clearing houses associated with exchanges report the inventory level at exchange-approved warehouses, thus supplying another vital piece of information to the market.
Hence, commodity derivatives contracts not only benefit the hedgers who directly participate in exchange-traded derivatives contracts, but also render many positive spill-overs on the underlying commodity market itself. Exchange-traded derivatives market fosters product market competition, leading to a reduction in price dispersion among commodity producers, price level for that commodity in general and the producers’ profit in particular, and an increase in market share of cost-competitive commodity producers.
A 2021-study published by Thorsten Martin of Bocconi University, Milan, finds that the introduction of futures contracts on steel, hot rolled coils (HRC) contracts in 2008, and Bushelling scrap contracts in 2012 by NYMEX USA benefitted the steel market as a whole. After the introduction of these two contracts and the availability of futures price information to market participants, the steel industry became more competitive, as was evident from the reduction in price dispersion among steel producers. The researcher used proprietary data of prices charged by steel producers in the USA for six different steel products including HRC and Busheling scrap from 2007 to 2017, and compared before and after the price dispersion for each of these six products. Using difference-in-difference method, the study reported a reduction in the dispersion of prices as steel companies offered more competitive prices after the introduction of futures contracts. As buyers used futures price as a reference price while negotiating business with steel producers, the price dispersion among the steel producers narrowed down. In addition to the reduction in price dispersion, the study reported decline in the average level of prices charged by steel producers as the markets became more competitive. With an increase in the competition, least cost steel producers became more competitive and gained market share.
Another benefit, though not highlighted quite often, relates to the impact of the introduction of derivatives contract on bilateral forward contracts. Without derivative contracts and the accompanied centralised price signals, any forward deal is bereft of a fundamental piece of information and is left to the bargaining power between counterparties. But once a commodity contract trades in an organised exchange, counterparties benefit from not only centralised price signal, but also the other information disseminated by exchanges, such as available inventory in exchange-approved warehouses, percentage of derivatives contracts held by value chain partners, etc.
It is heartening to note that Indian commodity exchanges have been in the forefront of introducing contracts on different types of commodities. These exchanges have also been putting in significant efforts to on-board hedgers, develop warehouse ecosystem for these commodities, and add more delivery centres to reach out to a wider section of hedgers, improving quality assessment, and testing infrastructure at these warehouses. More importantly, these exchanges have been using technology to disseminate price and other trading information to VCPs, thus democratising market information.
It is only a matter of time until the benefits of these exchange-traded contracts spill over to the underlying commodity market.The views expressed in this article are personal.