Class 2: Introduction to futures and over-the-counter markets

* History* Functioning* Evolving forms* Why manage price risks - or just forecast?* Organized exchanges and over-the-counter markets* The actors, and their roles* The economic functions of futures trading* The organization of futures trade

Tracing the origins of commodity futures markets

Markets and fairs were institutionalized during the Middle Ages. Merchant law was codified and local rulers were required to have an official charter to hold a regular fair. Products were physically brought to the marketplace and sold. Eventually, sales by sample were developed. Deals were made for delivery of larger quantities of a product based on the sample displayed. The concept of buying “sight unseen” evolved and if the bulk did not match the sample, recourse to an arbitration panel was possible.

In parallel, the globalization of trade brought with it the need for “long-distance” middlemen, who could act as brokers or agents for sellers or buyers. Trading centers sprung up in seaports and large distribution hubs. Trade was not only in local goods, but also in goods produced in distant places. “Arrival dealings”, agreements for delivery and settlement on arrival of ships or other modes of transport, were developed.

Improved communications made it possible to fix the time of arrival. Prompt dates, when the goods could be expected to arrive, initiated the start of the forward contract. These contracts became tradable, but the trader could not take any profit until the actual delivery of the merchandise.

Commodity exchanges soon followed. They established price transparency, created a secure market place and reduced transaction costs. Futures markets are highly transparent and are highly regulated providing protection against fraud, manipulation, abuse and possible market default. In addition, prices on the exchanges are almost instantly distributed worldwide. The introduction of the clearinghouse established a guarantee that all traders honour their obligations as it adopts the role of buyer to seller and seller to buyer, thus eliminating the problem of risk of default by the counterparty.

Tracing the origins of commodity futures markets (2)London Metal Exchange. Metals traders tended to meet in the Jerusalem coffee house. In 1869, they decided they should create a meeting place of their own, the “Lombard Exchange and News Room”. Provided them with locker space to keep some ledgers. Trade was still fairly chaotic, and they decided to set up a formal body, governed by standard rules: some of the leading firms set up the London Metal Exchange Company in 1876, with its own building. A telegraph was installed, in 1880 the first permanent staff member was engaged. Open outcry trading times were defined (12.30 to 13.15 and 16.00 to 16.15), with all members present. The Board of the Company published daily market prices. The 300 members of the exchange started to believe that these daily market prices were not properly determined, and pushed for an independent reporting committee. A clearing house was only formed in 1985, after the costly tin debacle.

Today, while new commodity futures exchanges are still being created in countries where agricultural policy is being liberalized, existing exchanges are consolidating and seeking out new technologies. Exchanges have determined that they must increase volume in order to be competitive. Therefore there has been an increase of mergers and acquisitions in recent years. It is likely that exchanges will cover more and more countries, but the number will shrink as the global economy becomes more integrated.

The old open-outcry trading system is being replaced by electronic trading systems, as trades are conducted through computers rather than on a floor packed with shouting traders. Electronic trading systems tend to be less expensive and are more reliable, as the percentage of mistakes in passing or receiving orders is around 2% in open outcry markets. The Internet provides easy access to many people.

Dealing with the uncertainties of physical trade

Commodity trade and production are exposed to a large number of risks, not just price risk. E.g.

• Price risk

• Counterparty risk: what will happen with my transaction if my counterparty defaults?

• Timing risk: e.g., will the hedge still be good if there is a delay in shipment?

• Quantity risk: how do I deal with uncertain production/supply

• Competition risk: how do I avoid that competitors take my market away?

Why manage price risks?Why manage price risks?

TO HAVE A BETTER TO HAVE A BETTER CASH FLOW MANAGEMENT.CASH FLOW MANAGEMENT.

In order not to lose opportunities, by In order not to lose opportunities, by having access to the funds you need having access to the funds you need to undertake the activities that you to undertake the activities that you

want to undertake;want to undertake;

and not be forced to borrow and not be forced to borrow expensively;expensively;

and not leave scarce funds lie and not leave scarce funds lie around unproductively.around unproductively.

• To secure revenue streams to cover operational expenditures

• To ensure that rising costs or falling revenues do not jeopardize other programs

• To facilitate capital raising and debt rescheduling • To enhance the value of assets to be sold• To generate revenue from assets, stockpiles and

reserves

Market-based price risk management is Market-based price risk management is particularly useful for strategic reasons: to particularly useful for strategic reasons: to make sure one can do what one wishes to do.make sure one can do what one wishes to do.

Prices are basically unpredictable.

Price forecasts do not replace proper risk Price forecasts do not replace proper risk management practices.management practices.

2000 2001 2005 2000 2001 2005

2000 2001 20052000 2001 2005

158

95103

185

1300

21

13

23

12

25

11

286

178

319

154

373

13498

263

2100

1200

2400

1300

3100

Cocoa

Crude oil

Copper

Coffee (arabica)

Cts

/kg

Cts

/kg

US

$/ba

rrel

US

$/to

nne

Confidence intervals for price projections, 70 % probabilityW

orld

Ban

k

proj

ectio

ns m

ade

in

July

199

9

85

29

Relying on guessing how prices will Relying on guessing how prices will develop (“forecasts”) can cause develop (“forecasts”) can cause

problemsproblems….….

Mongolia --> 11% budget from copper, 5% Mongolia --> 11% budget from copper, 5% from gold. Actually obtained: 2% copper, from gold. Actually obtained: 2% copper,

2% gold. 2% gold.

19981998

Mexico --> budget USD 15.5 per barrelMexico --> budget USD 15.5 per barrel

Price drop from USD 17 to USD 9.69 per barrelPrice drop from USD 17 to USD 9.69 per barrel

Venezuela --> budget USD 15.5 per barrelVenezuela --> budget USD 15.5 per barrel

Drop in price to USD 10.60 per barrelDrop in price to USD 10.60 per barrel

Risk management: market Risk management: market intervention, international earnings intervention, international earnings

stabilization, self-insurance, and stabilization, self-insurance, and externalizing risksexternalizing risks

Market Market interventionintervention

Earnings Earnings stabilizationstabilization

Self-insurance Self-insurance

Externalizing Externalizing risksrisks

International International commodity commodity agreements, agreements, OPECOPEC

Compensatory Compensatory financing funds financing funds (IMF, EU)(IMF, EU)

Stabilization Stabilization funds (dozens of funds (dozens of countries) countries)

Using risk Using risk management management marketsmarkets

Sometimes work for Sometimes work for some time (OPEC), some time (OPEC), but but mostly failed.mostly failed.

Didn’t work. Now Didn’t work. Now discontinued.discontinued.

Virtually never Virtually never worked, for a series worked, for a series of reasons.of reasons.

Used by Used by ++ all large all large companies and some companies and some government entities. government entities. Mostly successful, Mostly successful, but some big losses.but some big losses.

A commodity exchange of the past

A commodity exchange of the 1980s

A commodity exchange evolving to electronic trade - in a somewhat misguided format

Legend

Country has activefutures exchange(s)

Country has activeexchange(s) tradingin contracts for spotor forward delivery

Plans for thecreation of acommodityexchange

Legend

Country has activefutures exchange(s)

Country has activeexchange(s) tradingin contracts for spotor forward delivery

Plans for thecreation of acommodityexchange

Commodity exchanges are taking off around the world.

The roots of commodity exchanges

Successful commodity exchanges have been set up as tools for physical trade.

Not as tools of government policy.

Not for the purpose of creating a place for gambling (partial exception: China).

Throughout tumultuous decades, surviving wars, government interventions and the advent of “destructive technologies”, commodity exchanges have survived, because they have continued providing valuable services to commodity players.

The difficulty of changing

The bricks and mortar of the established

exchanges…...

…..can be a barrier to

seeing existing opportunities.

Buyer

Computer

Clearing memberClearing member

Clearing house

Check credit risk Check credit risk

Computer

Seller

Execution

Electronic trading

Position and margin

settlement

Confirmation Confirmation

Order input Order input

Orders are matched

Transfer of positions

Verification Verification

Legitimate orders are

transferred

Legitimate orders are

transferred

Futures markets are highly organized - whether they are electronic or not. In contrast, OTC markets are rather informal.

Futures and options exchangesare anonymous. Contracts tradedare standardized, it is easy to buyand sell (and thus reversepositions), and no negotiationsrequired

Largely a direct market, betweentwo parties who know and trusteach other; contracts are directlynegotiated, tailor-made for theneeds of the parties and often noteasily reversible

Mostly follows the open-outcrysystem, with its chaotic shoutingand hand-waving. The system ishighly transparent: transactionsare, atl least in theory, highlycompetitive, the market reactsvery fast, and prices andtransactions are monitored everysecond. Prices on the exchangesare almost instantly distributedworld-wide.

Public price quotations are onlyjust being introduced, and only forthe more heavily tradedinstruments; even these quotationsare not instantaneous, and onlyindicative. To get a fair deal, goodinformation gathering andnegotiation skills are required.

Futures MarketFutures Market OTC MarketOTC Market

Futures and Over-the-Counter MarketFutures and Over-the-Counter Market

Transactions are guaranteed by aclearing house; a default by anintermediary is unlikely to lead tolosses for market users (althoughusers do need to exercise caution,as clearing house guaranteesdiffer from country to country)

Transactions are guaranteed onlyby the reputation of thecounterpart; if the counterpart goesbankrupt (as has happened to somevery large trading houses andbanks in recent years), large lossedmay ensue

This market is highly regulated.Regulation provides protection,not only against a possible defaultof the market, but also againstfraud, manipulation and abuse.

The main protection on this marketis the fact that big, powerfulplayers, who are the main users ofthis market, police each other andeffectively have the power tosanction abuse. Nevertheless theytake on some risks of falling victimsto market abuse.

Futures MarketFutures Market OTC MarketOTC Market

Futures and Over-the-Counter MarketFutures and Over-the-Counter Market

Actors in futures marketsActors in futures markets

Hedgers

Speculators

Arbitrageurs

Traders, processors, producers….

Do they hedge, speculate or manipulate…

Perhaps they hedge….How do they behave?

Floor traders, individuals managed funds, institutions….

Individuals, specialized entities

Very little arbitrage is really risk-free…

Functions of a commodity exchange

Transparency in pricesTransparency in pricesEverybody can know at

what price is each product sold

Avoid manipulation, provide a benchmark price for transaction

Reduces transaction costsReduces transaction costsEverybody is in the same place, no need to look for

buyer or seller

Provides price discoveryProvides price discovery

What will be the price of onions next

month?

Sorry, I only deal with love affairs,

look at the commodity exchange

What services can a forward exchange provide? Some possibilities

The exchange as meeting place

Seller BuyerContract

Exchange

Information on contract price

Information on market prices

Price transparency is already a major gain - everyone knows how to

use information.

What services can a forward exchange provide? Some possibilities

The exchange as vetting mechanism (e.g., eBay)

Seller BuyerContract

Exchange

Information on contract price

Information on market prices

Database on reputable buyers and sellers

Blacklist of unreliable

counterparties

Information on contract performance

Information on contract performance

EXCHANGE

What services can a forward exchange provide? Some possibilities

The exchange as regulatory framework, using contract law

Seller BuyerContract

Membership requirements

Rules and bye-laws

Agreed quality standards

Arbitration panel

Note that banks can also become a member of the exchange and thus benefit of the same contract-based legal protection as other members - allowing them to provide finance without having to rely mostly on the country’s legal and regulatory framework.

Some level of contract

standardization

What services can a forward exchange provide? Some possibilities

The exchange as an auction place

Seller

Buyer

Exchange-provided bidding floor (physical,

electronic)

BidsBuyer

Buyer

Buyer

offer

Order-matching

Requires significant logistical skills

What services can a forward exchange provide? Some possibilities

The exchange as clearing house to all transactions

Seller Buyer1. Agreement on contract

Exchange clearing house

The clearing house system guarantees that all traders will honor their obligations, as the clearing house adopts the role of buyer to every seller and seller to every buyer, thus eliminating the problem of trust. The clearing house acts like the central bank in the clearing of checks in a normal banking system. The clearing house therefore helps in boosting the depth of the market.

2. Exchange clearing house becomes automatically buyer of commodities

3. Exchange clearing house becomes automatically seller of commodities

What services can a forward exchange provide? Some possibilities

The exchange as a facilitator of finance

Cattlemen

BNA (exchange)

Centralized Securities Deposit

Trust

Bank

Investors

Insurance

US$ 150,000 bank guarantee (only for first issue, June 2000)

Insurance against larceny and terrorism. Insurance value increases in line with price increase of animals.

Assigned responsibility, as agents for the trust, for fattening of cattle, for 11 months.

Transfer of ownership of young cattle and of pasture rights.

Issuance of securities up to 75% of value of the cattle

Selection of the regions, ranches and cattlemen suitable for inclusion in the securitization (security conditions, cattle experience, infrastructure, etc.)

Technical supervisor

Guarantee in case cattle fails to reach anticipated

weight gain.

Extension services

Registration of the securities (which enables public trade)

Marketing agentSale of animals

Buyers of fattened cattle

Sales proceeds

Fattened cattle

Client

“Intermediary”

Clearing member

Clearing house

Check credit risk

Execution

Trading

Position and margin

settlement

Confirmation

Order input

Orders are matched

Transfer of positions

Verification

Legitimate orders are

transferred

The organization of futures tradeThe organization of futures tradeDifferent motives: hedging, speculation, arbitrageDifferent entities: large/small; direct/indirect..…

Direct access is fairly limited, even if the clients has the means to do so. Generally, access through a broker and/or an electronic system.

Floor traders

Order matching systems are on a “first come, first served” basis

Positions only open during the day.

The functions of the clearinghouse

Obligations without a clearinghouse

BUYER Seller

Contract for future delivery of goods

Funds, or credit risk

Obligations with a clearinghouse

BuyerClearinghouse

sellerSaleSale

Margin Margin

The clearing house guarantees that all traders will honour their obligations by adopting the role of buyer to every seller and seller to every buyer, thus eliminating the problem of risk of default by the counterparty.