Emerging commodity exchanges

UNCTAD, Commodities BranchUNCTAD, Commodities Branch

Olivier Combe, Lamon Rutten, Leonela Santana-BoadoOlivier Combe, Lamon Rutten, Leonela Santana-Boado

When is it useful to start the creation of a commodity exchange?

What does an exchange provide?

Transparency in pricesTransparency in prices

Everybody can Everybody can know at what price know at what price

is each product is each product soldsold

Avoid Avoid manipulation, manipulation,

provide a provide a benchmark price benchmark price for transactionfor transaction

Reduces cost transactionReduces cost transaction

Everybody is in the Everybody is in the same place, no need same place, no need to look for buyer or to look for buyer or

sellerseller

Provides price discoveryProvides price discovery

What will be the What will be the price of Robusta price of Robusta

coffee next coffee next month?month?

Sorry, I only deal Sorry, I only deal with love affairs, with love affairs,

look at the look at the commodity commodity exchangeexchange

BuyerBuyer SellerSeller

Why Have a Commodity Exchange?

Reduce counterparty risk.

It’s the most competitive trading mechanism available

It gives a competitive price quote

Increases sources of finance

Allows price risk management

Reduce counterparty risk.

It’s the most competitive trading mechanism available

It gives a competitive price quote

Increases sources of finance

Allows price risk management

Through theThrough the exchangeexchange

The development of a commodity exchange;preconditions

A real willingness from politiciansA real willingness from politicians

A sound legal A sound legal framework framework

Sound infrastructuresSound infrastructures

A real interest from exporters, A real interest from exporters, traders and producerstraders and producers

I will reach itI will reach it

Commodity

Exchange

The development of a commodity exchange;settings

And now our daily And now our daily report on wood report on wood

prices quoted at the prices quoted at the exchangeexchange

Availability of information Availability of information through mediasthrough medias

Building settingsBuilding settings

Clearing house floorClearing house floor

Telecommunications Telecommunications between traders and the between traders and the

trade floortrade floor

Trade floorTrade floor

Brokers ’ floorBrokers ’ floor

controlscontrols

Law modificationLaw modificationAllow the existence of the exchange and its practices, Allow the existence of the exchange and its practices, provide incentives to deal in the exchangeprovide incentives to deal in the exchange

What would be the components of a detailed action plan

Necessary infrastructure:Necessary infrastructure:

trading roomtrading room

many telephonesmany telephones

weighting and quality weighting and quality control equipment control equipment

a system to record pricesa system to record prices

Trading rules:Trading rules:

choose the rightchoose the right language for the orders language for the orders

best bid/offer should bebest bid/offer should be automatically accepted automatically accepted

register the dealregister the deal immediately on standard immediately on standard form form

Need to be trained:Need to be trained:

those active on the exchangethose active on the exchange

exchange officialsexchange officials

exchange users outside the exchange users outside the exchange exchange

create some awareness amongcreate some awareness among local bureaucrats and politicians local bureaucrats and politicians

Contract formulation including:Contract formulation including:

the minimum quality acceptablethe minimum quality acceptable

discount or premium if quality is discount or premium if quality is lower or higher lower or higher

traded quantitytraded quantity

delivery conditionsdelivery conditions

procedures to follow in case of disputeprocedures to follow in case of dispute

11 22 33

44 55

Exchange organization / Exchange organization / rules to determine:rules to determine:

formal criteria forformal criteria for access access

financial guaranteefinancial guarantee

which staffwhich staff

the trading periodthe trading period

Operating systems; telecommunication costs

Buyers and sellers interconnected through a computer network

More adapted to risk-management

Easy to add new products; long trading hours; perfect recording of operations

Buyers and sellers are dispersed

It’s a centralized trading It’s a centralized trading floor, with buyers’ and floor, with buyers’ and sellers’ representativessellers’ representatives

It’s a centralized trading It’s a centralized trading floor, with buyers’ and floor, with buyers’ and sellers’ representativessellers’ representatives WhatWhat

WhyWhy

WhereWhere

CostsCosts

AdvantagesAdvantages

More adapted to More adapted to physical tradephysical tradeMore adapted to More adapted to physical tradephysical trade

Buyers and sellers need Buyers and sellers need to be in one placeto be in one placeBuyers and sellers need Buyers and sellers need to be in one placeto be in one place

Physical infrastructures; Physical infrastructures; relocationrelocationPhysical infrastructures; Physical infrastructures; relocationrelocation

Role for locals; low Role for locals; low risk of breakdownrisk of breakdownRole for locals; low Role for locals; low risk of breakdownrisk of breakdown

Open-outcry versus Electronic trade

Steps of development

TradersTraders

ProducersProducersForeign tradersForeign traders

11

Easier to deal first only on Easier to deal first only on physical goodsphysical goods

CommoditCommodity y

ExchangeExchange

Producers Producers may come may come

with with warehouse warehouse receipts or receipts or

with sampleswith samplesTrade

rs m

ay

Trade

rs m

ay

trad

e with

trad

e with

spot

or

spot

or

forw

ard

forw

ard

cont

ract

s, th

ey

cont

ract

s, th

ey

may

choo

se

may

choo

se

the

good

s

the

good

s

Foreign

Foreign

traders may

traders may

directly

directly

negotiate with

negotiate with

producers,

producers,

they may trade

they may trade

with spot or

with spot or

forward

forward

contracts

contracts

Learning stage of trading mechanisms, most Learning stage of trading mechanisms, most trades aretrades are spotspot, some are , some are over-the-counterover-the-counter

Steps of development

C O N T R A C TC O N T R A C T

- facilitate planning and marketing- facilitate planning and marketing- lock in forward prices- lock in forward prices- secure a processing margin- secure a processing margin

AdvantagesAdvantages- tailor made- tailor made- ensures physical market for - ensures physical market for the commodities produced the commodities produced- can make production or pre-export- can make production or pre-export finance possible finance possible

DisadvantagesDisadvantages- difficult to revert initial decision- difficult to revert initial decision- major counterparty risk- major counterparty risk- possibility of profiting favourable- possibility of profiting favourable spot market developments is lost spot market developments is lost

22 Creation of contractsCreation of contracts

PurposePurpose

Steps of development

33 Creation of a new futures exchangeCreation of a new futures exchange

The underlying product should really The underlying product should really be different from already traded ones be different from already traded ones in other futures markets (problem of in other futures markets (problem of basic risk)basic risk)

The volume of traded contracts should be The volume of traded contracts should be sufficient (problem of liquidity)sufficient (problem of liquidity)

The futures contracts will be more The futures contracts will be more successful when located in a region which successful when located in a region which is an important produceris an important producer

Public

Brokers

Clear brokers’ accounts

Clear brokers’ accounts

Clearing house

Market floor Trade according to their Trade according to their client’s mandateclient’s mandate

Control trades Control trades and pricesand prices

Giv

e m

anda

tes

of

Giv

e m

anda

tes

of

purc

hase

s an

d sa

les

purc

hase

s an

d sa

les

Con

vey

orde

rs fr

om th

e

Con

vey

orde

rs fr

om th

e

clea

ring

hou

se

clea

ring

hou

se

Public is:Public is:

-speculators-speculators-bodies which hedge-bodies which hedge-arbitrager-arbitrager

Roles of Roles of equal equal significancesignificance

Counterparty risk is absent from futures market

Example of a futures market and its components

Steps of development

C O N T R A C TC O N T R A C T

- hedge price risk- hedge price risk- lock in the value of inventories or finance- lock in the value of inventories or finance part of storage costs part of storage costs- secure a processing margin- secure a processing margin

AdvantagesAdvantages

- no need to negotiate contract specifications- no need to negotiate contract specifications- minimal counterparty risk- minimal counterparty risk- initial position can easily be reversed- initial position can easily be reversed- delivery is not necessarily implied- delivery is not necessarily implied

DisadvantagesDisadvantages- working capital is frozen up in margins- working capital is frozen up in margins- possibility of profiting from favourable - possibility of profiting from favourable spot market development is lost spot market development is lost- prices of the hedged product and the - prices of the hedged product and the futures contract may diverge futures contract may diverge

33 Creation of contractsCreation of contracts

PurposePurpose

Steps of development

C O N T R A C TC O N T R A C T

- obtain protection against unfavourable- obtain protection against unfavourable price movements while retaining the price movements while retaining the possibility of benefiting from favourable ones possibility of benefiting from favourable ones- valorize inventories- valorize inventories

AdvantagesAdvantages- available in standardized form on exchanges,- available in standardized form on exchanges, and tailor-made over-the-counter and tailor-made over-the-counter- no “funding risk”: the costs of protection are - no “funding risk”: the costs of protection are

known up-front known up-front- possibility of benefiting from favourable- possibility of benefiting from favourable price movement price movement

DisadvantagesDisadvantages- up-frpnt premiums can be expensive,- up-frpnt premiums can be expensive, especially in times of volatile prices especially in times of volatile prices- selling options can be highly risky- selling options can be highly risky- options sellers need to pay margin calls- options sellers need to pay margin calls

44 Creation of contractsCreation of contracts

PurposePurpose

Roles of Government and International Organisations

Tax speculation and hedging differentlyTax speculation and hedging differently

Do not change price policy too oftenDo not change price policy too often

In building infrastructure In building infrastructure

In providing training and In providing training and spreading information spreading information

For reliable quality specifications For reliable quality specifications and warehouse receipts and warehouse receipts

For reliable trading system, prices, contracts, For reliable trading system, prices, contracts, brokers and tradersbrokers and traders

In the design of contractsIn the design of contracts

Motivate producers to deal through the exchangeMotivate producers to deal through the exchange

Arrange that quotas for low-tariff entry of Arrange that quotas for low-tariff entry of selected products into other countries are traded selected products into other countries are traded through the exchangethrough the exchange

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