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    Growing the Agricultural DerivativesExchange Market

    Rod Gravelet-Blondin

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    O

    verview

    Rod Gravelet-Blondin The Agricultural Derivatives Marketin South Africa

    Lecture / Discussion Topics - The

    Raison-dtre of the Exchange - TheElements of the Exchange - TheBusiness of the Exchange - The Face ofthe Exchange

    Conclusion /The Way Forward

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    RodGr

    avelet-B

    londin

    Born and bred in South Africa. Studied Economics and

    Agricultural Economics.

    Worked for National Departmentof Agriculture for 20 years 10years spent as Agric Attach.

    Challenged by the interactionbetween the public and private

    sector in agricultural policy

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    RodGr

    avelet-B

    londin

    In 1995 established theAgricultural Markets Division ofthe South African FuturesExchange (SAFEX).

    In 2001 moved with SAFEX to the

    JSE to head up the AgriculturalProducts Division of the JSELimited.

    Presently heads up theAgricultural Products Division ofthe JSE effectively theagricultural derivatives market inSouth Africa

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    IMP

    ORTANT

    ANNOU

    NCEME

    NTS

    Please note that I do not have all theanswers I speak from experienceand from what I have learnt, BUT I amstill learning.

    Please note that my objective is to beobjective. No one person has all the answers

    and I do not think there is oneblueprint for the establishment and

    growth of an agricultural derivativesmarket

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    IMP

    ORTANT

    ANNOU

    NCEME

    NTS

    Together we will do our best to find theanswers, to your questions and to myquestions.

    I would really appreciate yourparticipation because we will have funfinding the answers.

    There is no such thing as a stupidquestion.

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    TheAgriculturalDerivatives

    Market

    inSouthAfrica

    Direct government intervention in

    agricultural marketing policy since 1930 Indications in early 1990s that move away

    from government intervention might beimminent.

    Research undertaken by South AfricanFutures Exchange (SAFEX) on viability ofan agricultural derivatives market(1993/1994)

    Business plan / prospectus compiled and

    trading seats issued.

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    TheAgriculturalDerivatives

    Market

    inSouthAfrica

    84 trading seats taken up by

    interested parties @ R50 000.00 eachto form start up capital of R4.2m(about US$ 1m).

    Seat holders included banks, existingfinancial trading houses, newcommodity trading houses andagricultural interest entities - allprivate money.

    Agricultural Markets Divisionestablished in 1995 as division ofSAFEX licensed to trade derivatives in

    terms of the Financial Markets ControlAct and regulated by the FinancialServices Board (FSB).

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    TheAgriculturalDerivatives

    Market

    inSouthAfrica

    1995 government steps away frommost forms of intervention in thepricing of agricultural products

    The AMD lists physically deliveredchilled beef futures in August 1995

    and cash settled potato futures inOctober 1995. Grain products stillsubject to a form of price intervention.

    Neither beef contracts nor potatocontracts are a success.

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    T

    heAgriculturalDerivatives

    Market

    inSouthA

    frica

    Feb 1996 AMD lists white and yellowmaize futures.

    Nov 1997 AMD lists wheat futures.

    Feb 1998 AMD lists maize options.

    Aug 1998 AMD list wheat options. Feb 1999 AMD lists sunseed futures

    Aug 1999 AMD lists sunseed options

    April 2002 AMD lists soya futures Oct 2002 AMD lists soya options

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    T

    heAgriculturalDerivatives

    Market

    inSouthA

    frica

    August 2001 SAFEX becomes partof the JSE Securities Exchange andagricultural derivatives trade withina division of the JSE.

    June 2006 the JSE demutualizes

    and becomes a company. July 2007 the JSE lists on itself

    The JSE limited is a multi-instrument exchange, regulated by

    the Financial Services Board (FSB)in terms of the Securities ServicesAct (SSA).

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    Clearing Member Clearing Member

    Broking Trade BrokingMember Member

    Client A Client XClient B Client Y

    Client C Client Z

    Clearing HouseCCP

    Structure of the Agricultural Derivatives Market

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    JSE Limited BESA

    Financial

    Derivatives

    Agricultural

    Derivatives

    Trading

    Clearing

    Management

    CCP Clearing

    & Risk

    Settlement

    Equities

    JSE JSE JSE

    Interest rate

    products

    SAFCOMSAFCOM

    STRATE

    STRATE

    STRATESAFCOM SAFCOM-cashJSE - products

    Exchange Environment (Capital Markets)

    Financial Services Environment

    JSE NO CCP

    (regulated by Financial Services Board)

    Insurance

    Industry

    Retirement

    Funds

    Collective

    Investment

    Schemes

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    NEARBY W HITE M AIZE PRICE SINCE J

    0

    5 00

    1000

    1500

    2000

    2500

    199

    8/05/01

    199

    8/02/06

    27/10/98

    24/3/99

    23/8/99

    20/1/2000

    20/6/2000

    200

    0/11/13

    200

    1/04/11

    200

    1/09/10

    200

    2/02/06

    200

    2/07/05

    200

    2/11/28

    200

    3/05/02

    200

    3/09/25

    200

    4/02/20

    200

    4/07/21

    200

    4/12/14

    200

    5/05/16

    200

    5/10/07

    200

    6/03/06

    200

    6/08/03

    200

    6/12/29

    200

    7/05/30

    200

    7/10/23

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    T O T A L A G R I C U L T U R A L D E R I V A T I V E C O N(F U T U R E S A N D O P T I O N S )

    0

    5 0 0 0 0 0

    1 0 0 0 0 0 0

    1 5 0 0 0 0 0

    2 0 0 0 0 0 0

    2 5 0 0 0 0 0

    3 0 0 0 0 0 0

    1 9 9 8 1 9 9 9 2 0 0 0 2 0 0 1 2 0 0 2 2 0 0 3 2 0 0 4 2 0 0 5 2 0 0 6 2 0 0 7

    F u tu re s O p t i o n

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    2007 Breakdown of Contracts Traded

    White Maize Futures

    Yellow Maize Futures

    Wheat Futures

    Sunseed Futures

    Soya Futures

    White Maize Options

    Yellow Maize Options

    Wheat Options

    SS & Soya options

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    Fu tures C on tracts an d F utures D eals 19

    199 199 200 2001 200 200 200 200 200 200

    0

    200000

    400000

    600000

    800000

    1000000

    1200000

    1400000

    1600000

    1800000

    2000000

    C

    ontractsTraded

    0

    50000

    10000

    15000

    20000

    25000

    Average deal size8 contracts

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    Op tion C on tracts and O ption D eals 199

    0

    100000

    200000

    300000

    400000

    500000

    600000

    700000

    800000

    ContractsTraded

    0

    10000

    20000

    30000

    40000

    50000

    60000

    70000

    Average deal size12 contracts

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    Fu tures C ontracts T raded and Fu tures C on tracts Op

    (on m on thly b asis from 1997 to d ate)

    0

    50000

    100000

    150000

    200000

    250000

    0

    1000

    2000

    3000

    4000

    5000

    6000

    7000

    8000

    9000Futures Contracts Tr

    Futures Contracts O

    Interest

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    T

    heAgricu

    lturalDerivatives

    Market

    inSouthA

    frica

    The Exchange added value to the marketplace exchange objectives

    Contracts and Specifications Timing

    Role of Government

    Role of Brokers (especially banks)

    Education and Marketing

    Systems (functionality esp spreads)

    Reasons why the Market Workedin South Africa

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    T

    heAgricu

    lturalDerivatives

    Market

    inSouthA

    frica

    Integrity of the delivery process

    Convergence of futures price to the economic value of theunderlying product

    Consistency of application of the rules Market orientation (constant months, contract size)

    Exchange personnel

    Reasons why the Market Workedin South Africa cont.

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    T

    heAgricu

    lturalDerivatives

    Market

    inSouthA

    frica

    Concentrated trading times (09h00 12h00)

    Physical delivery (incl foreign product)

    Daily price limits

    Speculative position limits

    Option expiries

    Margin requirements (increase as risk increases)

    Some Specifics in our Agric Market.

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    T

    heAgricu

    lturalDerivatives

    Market

    inSouthA

    frica

    Warehouse receipt case.Fraudulent certificates purchased in spotmarket by long position holder and tenderedfor delivery. Remedial action changed

    delivery rules and ensured Clearing Memberswere aware of responsibilities.

    Pension Fund loss. Large lossesincurred by pension fund. Remedial action regulator to ensure pension fund activity in

    derivative market is strictly adhered to.

    Major Problems Experienced

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    T

    heAgricu

    lturalDerivatives

    Market

    inSouthA

    frica

    Too slow in launching new contracts

    System replacement slow

    Maintain integrity

    Applicability to small producer

    Government understanding

    Increasing liquidity but maintainingauthenticity

    Continue adding value

    Challenges and Shortfalls

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    ?Question

    What are the objectivesof an Agricultural

    Derivatives Exchange?

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    TheRais

    on-dtreofthe

    E

    xchange

    The Objectives of an AgriculturalDerivatives Exchange

    Primary Objectives

    Price Risk Management Transparent Price Formation

    Secondary Objectives

    Price Integrity

    Liquidity Secure Settlement

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    TheRais

    on-dtreofthe

    E

    xchange

    These are NOT the Objectives of anAgricultural Derivatives Exchange

    to satisfy political aspirations

    to justify academic and theoreticalreasoning

    to provide employment to some veryclever and hard working people

    to make use of empty office space

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    TheRais

    on-dtreofthe

    E

    xchange

    An exchange MUST add value

    Areas where an exchange canadd value:

    price risk managementprice transparency priceintegrity securesettlement (deliveryand payment)

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    TheRais

    on-dtreofthe

    E

    xchange

    Can value be added to the agricultural

    market without an Exchange?

    Yes/No How

    Price RiskManagement

    PriceTransparency

    Price Integrity

    Securesettlement

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    TheRais

    on-dtreofthe

    E

    xchange

    Can value be added to the agricultural

    market without an Exchange?

    Yes/No How

    Price RiskManagement

    yes Forward contracts,vertical processing

    PriceTransparency

    ? Conditional on reporting

    Price Integrity ? Conditional on sources ofreporting

    Securesettlement

    ? Conditional on thirdparties

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    TheRais

    on-dtreofthe

    E

    xchange

    Better Faster Cheaper

    Price Risk Management

    Price Transparency andIntegrity

    Settlement

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    TheRais

    on-dtreofthe

    E

    xchange

    Value Add is CORE to the sustainability of

    the Exchange

    No Value Add = No Growth

    Value Add = Growth

    The USE of the exchange is directlyproportional to the VALUE ADD of theexchange

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    TheElementso

    fthe

    E

    xchange

    Regulation (legislation & rules)

    Direct legislationClear Objectives

    Market Orientated

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    TheElementso

    fthe

    E

    xchange

    Regulation (legislation & rules)

    Direct legislation

    Enabling / Supporting legislation

    Legal Processes (contract law)Financial Processes (flow of funds)

    Agricultural Policies (consistency, storage)

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    TheElementso

    fthe

    E

    xchange

    Regulation (legislation & rules)

    Direct legislation

    Enabling / Supporting legislation

    Exchange rules

    ClearApplicableConsistentDeveloped with marketLimits (price & position)

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    TheElementso

    fthe

    Exchange

    Exchange Structure

    Trading and Clearing Horizontal ORVertical

    Depends largely on country set-upJury out on comparative benefits

    Should be based on cost and efficiency(the outcome is important)

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    TheElementso

    fthe

    Exchange

    Exchange Structure

    Trading and Clearing Horizontal ORVertical

    Self Regulation / RegulatedWhat works best for country

    Consistent with country legislation

    No compromise on Integrity

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    TheElementso

    fthe

    Exchange

    Exchange Structure

    Trading and Clearing Horizontal ORVertical

    Self Regulation / Regulated Ownership

    mutual membership structure

    unlisted company

    listed company

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    TheElementso

    fthe

    Exchange

    Exchange Structure

    Trading and Clearing Horizontal ORVertical

    Self Regulation / Regulated

    Ownership Divisions

    No set blueprint

    Cost and efficiency

    Focus of operation

    Functional / Product based

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    TheElementso

    fthe

    Exchange

    Exchange Structure

    Trading and Clearing Horizontal ORVertical

    Self Regulation / Regulated Ownership

    Divisions

    Physical PresenceYes / NoPrestige / Cost

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    TheElementso

    fthe

    Exchange

    Systems Trading / matching system

    In house / TurnkeyCost and efficiencyOrder driven / Quote Driven

    Functionality - market use- the more it hasthe more will be used)- dynamic spreads- delta options

    Flexible (provide the market what it wants- EFP, EFR)

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    TheElementso

    fthe

    Exchange

    Systems

    Trading / matching system

    Clearing system

    fully integrated

    cost and efficiency

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    TheElementsofthe

    Exchange

    Products to Trade

    Contract Specifications

    - expiry settlement (cash /physical delivery)cash easier, but must be

    non manipulatable

    physical delivery

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    TheElementsofthe

    Exchange

    Products to Trade

    Contract Specifications- physical deliverylocation - single point

    - multiple points- multiple points with

    differentialsallocation - random

    - fifo- short position decides- long position decides- matching requests

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    TheElementsofthe

    Exchange

    Products to Trade

    Contract Specifications- physical deliveryprocess - clear rules

    - notice day (who)- delivery day- risk mitigation

    warehouses and receipts- administration- central register- security (paper / electronic)- logistics- relationship between exchange and

    warehouse

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    TheElementsofthe

    Exchange

    Physical Delivery Case Study

    Through the agreed delivery process of the Exchange,Client A as short position holder gives notice ofdelivery and in accordance with Exchange deliveryprocedure tenders the exchange approved warehousereceipts to the Exchange. The warehouse receiptswere obtained by Client A from the Exchange as aresult of an earlier long position.

    The Exchange assigns the delivery to a long positionholder in accordance with delivery procedure andnotifies the new owner accordingly. The buyer of theproduct pays the full value sum for the productthrough the exchange and collects the warehousereceipts.The new owner of the product notifies the warehouseowner of his intention to take physical delivery of theproduct represented by the warehouse receipts on acertain date.

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    TheElementsofthe

    Exchange

    Physical Delivery Case Study cont.

    The owner of the warehouse notifies the new ownerthat the product represented on the face of thewarehouse receipt is subject to a dispute regardingstorage costs between the storage owner and theoriginal owner of the product (not Client A) and that noproduct can be outloaded as requested. The warehousereceipt tendered to the exchange in completion of thefutures contract carries no indication of any lien nor

    any reference to any dispute.The new owner of the product, holder of thewarehouse receipt, refers the matter to the Exchangeas a matter of urgency because the new owner needsthe product to process.

    WHAT COURSE OF ACTION SHOULD THE

    EXCHANGE TAKE ?

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    TheElementsofthe

    Exchange

    Participants

    Government

    Financial Communityrisk in agricultural sector

    understanding

    support

    hedge funds

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    TheBusinessofthe

    Exchange

    Utility

    Pros Service

    Orientated Easily compatiblewith Agriculturalpolicy

    Cons Lack of focus

    Lack of drive Lack of

    development

    Stagnation

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    TheBusinessofthe

    Exchange

    Income Generation

    Trading feesFair

    Incentive basedMust leave room for brokers fees (look attotal trading cost)

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    TheBusinessofthe

    Exchange

    Income Generation

    Trading fees

    Clearing fees

    FairRemember total cost of trading

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    TheBu

    sinessofthe

    Exchange

    Income Generation

    Trading fees

    Clearing fees

    Margin management fee (haircut) Data sales

    public vs private data

    be aware of total picture (can be verygood marketing)

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    TheBu

    sinessofthe

    Exchange

    Income Generation

    Trading fees

    Clearing fees

    Margin management fee (haircut)

    Data sales

    Training (courses, material)

    income generation / marketing

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    T

    heFaceoftheEx

    change

    Exchange Interface

    Government

    Regulator

    Agricultural Policy

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    T

    heFaceoftheExchange

    Exchange Interface

    Government

    Direct exchange participants

    Indirect exchange participantsIntegrity

    Consistency in application of rules andprocedures

    Communication (especially media)Consistency of message (spokesman ?)

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    T

    heFaceoftheExchange

    Exchange Interface

    Government

    Direct exchange participants

    Indirect exchange participants Education sector

    Curriculum (universities & schools)

    Lecturing

    Educational material

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    ?Question

    Is there anything we haveheard that can be applied tothe agricultural derivative

    market in Thailand

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    Conclusionan

    d

    Way

    Forward

    Application to Thailand

    The Elements of the Exchange

    Are all the elements of the exchange

    in place and operating efficiently ?

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    Conclusionan

    d

    Way

    Forward

    # 1 exchange growth promoter

    Access to the exchange

    Market participants (especially hedgers)

    must have easy and cheap access to theexchange so as to benefit from the valueadd benefits that an exchange brings to themarket place.

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