Futures markets

Futures contracts (or ‘futures’) are agreements between two parties to buy or sell an agreed quantity of an asset (commodity) at a certain future date for an ex ante agreed price. These contracts are typically negotiated on open platforms that match buyers’ and sellers’ interests in one or multiple assets across space and time. This market accommodates the intertemporal choice of commodity producers, users and traders (so called ‘risk transfer’). It allows the management of demand and supply risks through the expectations on inventory levels, which are the response function of physical demand/supply imbalances reflected by spot market prices.

Take, for example, a wheat producer that wants to protect its core business from a drop in prices during the next harvest period, perhaps resulting from oversupply due to very good weather conditions. The producer therefore decides to sell a quantity of futures contracts approximating the estimated production level with a contract expiration corresponding to the end of the harvest. In this way, the producer can almost fix the price of its harvest well before the harvest takes place. This gives the producer the ability to plan investments over the long term and to restrict potential losses within a predictable range. Before the expiration date of the futures contract, if the price of the original futures sale is higher than the prevailing market price, the producer would buy back the futures with an offsetting transaction at a lower price generating a profit. This profit would hedge losses in the physical market incurred by selling at a lower market price than initially forecasted. However, if the market price is higher than the original futures sales price, the producer will sell the cash commodity in the marketplace and the higher cash price received would cover the losses caused by buying back

17 To understand better the intensity of the link between supply and demand elasticity to market changes, please see markets descriptions in the following chapters.

the initial futures sale at a higher price. In the futures transaction, the difference between the initial futures price and the daily settlement price is marked-to-market by the exchange clearinghouse which maintains the financial integrity of the exchange by requiring initial margins for any new transaction and by collecting or remitting variation margins on a daily basis for all open positions. If the producer gains from the futures transaction, they would collect the value of the initial margin deposit plus the difference between the original and final price.

1.2.2.1 The development of futures markets: a brief history

The origins of modern futures markets date back to the 19^th century, but physical commodities and archaic forms of futures markets have even more ancient origins going back to the beginning of the civilised world (Berg, 2011). Futures markets, as a market supporting the activities of physical commodities markets to reduce inefficiency and transaction costs, have been around for a little over a century and began operations with very simple contracts. The first futures contracts were effectively just delivery contracts, or ‘to arrive’ contracts (Gray and Rutledge, 1971), for producers in the surrounding areas of Chicago. The first exchange, the Chicago Board of Trade (CBOT), started operations in 1848 and soon became the point of reference for similar platforms across advanced economies. Over the years, these platforms have spread close to large consumption areas market hubs to allow commodities actors to trade spot or transfer risk to those that could actually bear it. Dramatic price fluctuations and disputes among buyers (e.g. merchants) and sellers (e.g. farmers), especially in agricultural commodities where external factors such as the weather and means of transport had unforeseeable impacts, have made futures markets an indispensable tool to run a competitive commodities business.

Technological developments during the 1970s and 1980s made trading from remote locations possible. Following these important changes, a process of consolidation among exchanges to benefit from economies of scale began, first at the regional level and gradually now at the global level. The computerisation of trading has made competition among national exchanges possible. This process culminated in the 1990s with the gradual liberalisation of the sector in key advanced economies.

Exchanges in Europe and the United States, for instance, have become for-profit entities looking for business diversification and higher volumes of transactions to increase liquidity. Growing competition has also created an additional boost to technological innovation, thus improving direct access to capital markets for end users. As a consequence of these market changes, commodities markets have expanded their volumes of transactions during the beginning of the 21^st century, both on exchanges and over-the-counter bilateral markets. Key commodities exchanges are today the only place where the prices of specific commodities are formed and used as global benchmark prices for bilateral transactions. From small and niche market activities, exchanges today have become global actors with a diversified business that cuts across all services linked to trading of commodities derivatives and other financial instruments (e.g. clearing, settlement, data and technological services). Technological advances are pushing the boundaries of relevant markets at the global level, even though relevant legal and infrastructural issues at the national level impede the rapid development towards fully-fledged market competition among global exchanges.

Futures markets have historically been an essential part of commodities markets, helping commodities users and producers to hedge or transfer risk over their inventories due to seasonality issues (Irwin 1954). Working (1962) concluded that these markets have managed to facilitate contract holding, to build up different types of hedging strategies and to incorporate the convenience yield and thus price of storage in the intertemporal price spread. Futures prices represent the expected spot price on the basis of currently available information, especially for storable commodities (Carter, 2000). A lack of balance in the physical market pushes up futures prices, which ultimately results in additional price discovery when arbitrageurs absorb fairly quickly potential price abnormalities between futures and spot markets (Geman, 2005). Futures markets give a sense of where the spot price is heading, by signalling greater storage opportunities when futures prices are high and lower storage when futures prices drop close or below spot prices. However, this might not be the case for non-storable commodities, for which futures prices may be an unreliable forecast of cash market prices (Kamara, 1982) because no physical link with supply and demand can be established through the management of inventories. In this case, market liquidity is a key indicator of reliability.

1.2.2.2 Contractual characteristics

Despite the fact that futures contracts are a simple tool to transfer risk across time and space, the organisation of futures markets is rather complex, whether it is run through an exchange or bilaterally (over-the-counter) in a customised fashion. The ability to deal with transaction-specific risks is enhanced in a futures market setting, where contracts are standardised in terms of size and other factors. OTC markets are more costly and may require deep pockets that many commodities firms may not have. As Table 9 suggests, commodities transactions can be concluded through cash spot, cash forward, and futures contracts. Temporal and spatial risk transfer in commodities markets can be done through bilateral agreements mainly in the OTC space (forward contracts)¹⁸ or through standardised contracts listed on exchanges (futures contracts).

Table 9. Key characteristics of transactions

Spot contract Forward contract Futures contract Nature of transaction Bilateral

contract size) Customised Customised Standardised

Price FOB FOB/CIF FOB (or in warehouse)

period To delivery To delivery Before delivery

Delivery Spot Customised Selected months

Storage costs No Yes Yes

Transaction costs Medium Medium/High Low

Leverage No No Yes

Forwards are customised contracts (volumes and quantities) and can be either Free-On-Board (FOB) priced or include cost of storage, insurance and freight (CIF) in the final price. Physical and (sometimes) cash settlement is done to maturity, so the holding period is typically to delivery.

Customisation (plus limited exposure to interest rates and collateral requirements), however, comes at higher transaction costs and counterparty risk, which can make transactions less attractive for limited volumes. Futures contracts, on the other hand, are standardised contracts with delivery at a given location at a pre-defined set of dates during the year. The underlying commodity also has a common quality grade, which reduces delivery risks. Prices are typically FOB (or in warehouse; as for industrial metals) and contracts are typically offset with a reversal trade before maturity and marked-to-market on a daily basis through margin calls. By keeping a maintenance margin rather than disbursing the full value of the contract, buyers and sellers are leveraging to increase exposure with a limited amount of cash. These contracts should, in principle, serve commercial firms, which typically do not hold large amounts of cash. In contrast to OTC forwards, which are used for bigger volumes, these standardised contracts are highly liquid, due to the limited amount of cash needed. Small

18 That are not financial agreements (OTC swaps), which result in a pure exchange of cash flows rather than the delivery of a physical commodity. An OTC swap is a pure financial transaction.

investors can also potentially invest in these markets. Through the system of margin calls, then, there is only a very limited exposure to counterparty risk (certainly less than in the case of forward contracts). However, standardised futures contracts may involve expose to other two types of risk:

currency risk and interest rate risk. Since the contract is traded in the currency where the most liquid market is (historically) located, there is a currency risk for players acting in countries with a different currency. The currency for the vast majority of these products is the U.S. dollar. In addition, the open futures contract position requires the maintenance of a margin account where cash is kept away from alternative uses, so the opportunity cost is at least the risk-free interest rate.

Both forward and futures contracts are exposed to price risk, which is affected by opposed to only at maturity for forwards. This key feature attracts liquidity and allows the contract to be closed out with an offset transaction at any time before delivery. The high standardisation of future contracts and daily collateralisation typically permit the closing out of contracts without running the risks of physical delivery (e.g. quality grade, delivery time, receipts, etc.). The transaction can be offset before delivery with an equal offsetting purchase or sale (essentially an exchange of cash; Lerner, 2000). Anecdotal evidence suggests that fewer than 2% of futures contracts are settled through physical delivery.

The physical delivery obligation, when the contract is brought to maturity, essentially aligns the futures contracts to the underlying spot market prices close to maturity (‘no arbitrage clause’, see below). For forwards, the contract is completed with actual delivery of the underlying commodity. In around 98% of futures, there is no actual delivery since traders enter into reversal trades (offsetting).

Another way to terminate futures contracts, without an offsetting transaction or physical delivery, is the liquidation in cash of the difference between the agreed price to delivery and the spot price of the underlying commodity. Finally, parties can also agree a combination of compensation with an offsetting transaction and delivery of the commodity or the exchange of the futures position with a corresponding physical market position of a market participant that wants to switch exposure to current prices with exposure to prices at a future date (exchange for physical).

Actual delivery of the commodity is set a few times a year for futures contracts on exchanges, depending on the type of futures contract that is traded on the exchange for that specific commodity.

Typically, there are no more than four or five delivery dates per year (i.e. every three or four months).

1.2.2.3 Futures market structure

Financial transactions in commodities may take place on organised electronic multilateral platforms, such as exchanges, or in bilateral settings (over-the-counter). Due to lack of comparable data, the size of exchange-traded commodities futures and options markets versus the OTC markets at the end of 2012 can be only estimated. Roughly $1.36 trillion was the total notional value of outstanding global OTC commodity forward and swaps in 2012.¹⁹ The notional value of outstanding contracts (open interest) on futures commodities exchanges, estimated by taking the value of the turnover (as total value of traded contracts) of futures contracts and discounting it by a decompressing factor, is $3.17 trillion.²⁰ As a result, outstanding value of exchange-traded futures contracts was at least 70% of total

19 Forward and swaps can be considered as the OTC market equivalent of futures exchanges contracts.

20 This ‘decompressing factor’, which is equal to 0.0338977, is a ratio between the weighted (by production in tonnes) average of the open interest ratio over physical production (in 2011) for selected liquid futures contracts (natural gas, crude oil, copper, aluminium, cocoa, coffee, corn, soybean oil, wheat, white sugar), and the weighted

OTC and ETD commodities futures markets ($4.53 trillion) at the end of 2012, up from 66% a year before, as OTC commodities derivatives have been shrinking more than $450 billion in one year, mainly due to regulatory pressures on collateral requirements, costs of capital and banks’

deleveraging (see Table 10).

Table 10. Notional value of outstanding commodities futures and options traded OTC and on exchange ($bn) Exchange-traded Over-the-counter Total Note: Exchange-traded data are conservative estimates derived from turnover value of futures and options

contracts. ²² Value of over-the-counter positions is not daily marked-to-market.

Source: Author’s estimates from WFE/IOMA, BIS, CME, LIFFE, LME, ICE, other sources.

Due to its systemic size, the trading environment is also closely regulated and supervised by both exchanges and regulators. The interest of the platform operator is thus in ensuring that trades are done smoothly with no major dysfunctions, because only a stable and standardised trading environment can potentially attract the critical mass of liquidity needed to make the business of the neutral operator sustainable over time. As Figure 9 shows, commodity futures trading on exchanges has grown very fast in the last ten years, despite being already a significant part of commodities futures trading. OTC markets have also grown rapidly (at a slower pace, though), which suggests that more players have accessed these markets gradually over the last decade. After the crisis erupted in 2007, however, OTC transactions have lost ground in favour of more open and transparent trading venues due to increasing cost of funding for bilateral transactions.

Figure 9. Growth of Exchange-traded and over-the-counter commodity derivatives (2002=100-2012)

Source: Author’s calculations from BIS, WFE, ECMI (2012). Note: Exchange-traded data on number of contracts might be underestimated before 2008. Data include futures only for exchange-traded contracts.

average (by production in tonnes) of the value of traded contracts ratio over value of physical production (in 2011 and average spot price from World Bank) for the same liquid contracts (except for copper, aluminium and white sugar; volumes of contracts traded during 2011 with maturity up to 12 months).

21 Forwards and swaps for OTC transactions.

22 The statistics published by the World Federation of Exchanges and the International Options Market Association do not include the turnover value of commodities futures (forwards) and options traded on the London Metal Exchange, NYSE Euronext (US), Australian Securities Exchange SFE Derivatives Trading, Multi Commodity Exchange of India, Singapore Exchange, plus an undefined list of very small commodities exchanges.

The size of commodities futures exchanges has more than tripled since 2004, particularly as a result of the financial crisis, which has reduced dealers’ capital commitment in OTC transactions and increased the role of transparent venues as a cheaper source of liquidity for commodities users. The size of the global commodities futures exchange reached its peak in 2012, with almost 3 billion traded contracts and seven global market infrastructures of which no one is European and four of them are Chinese companies (see Figure 10).

Figure 10. Growth of commodity futures exchanges volumes by number of contracts, 2002-2012

Note: 2012 data for Multi Commodity Exchange of India is from 2011.²³ Source: Author’s calculations from WFE and ECMI (2012).

Figure 11. Global commodity futures exchanges volumes by number of contracts, 2012

Note: Data for Multi Commodity Exchange of India is from end of 2011.

Source: Author’s calculations from WFE and ECMI (2012).

23 ‘Others’ include: MICEX / RTS, NYSE Euronext (Europe), Bursa Malaysia Derivatives, ICE Futures Canada, Thailand Futures Exchange, Johannesburg SE, BM&FBOVESPA, ASX SFE Derivatives Trading, Korea Exchange, Buenos Aires SE, NYSE Euronext (US), Rofex, ASX Derivatives Trading, BSE India, Bursa Malaysia, Japan Exchange Group – Osaka, Tokyo Commodity Exchange (TOCOM), Tokyo Grain Exchange.

US and Chinese exchanges are the leading participants in commodities futures market consumer in the world (Figure 11). Some Chinese exchanges have become points of reference in Asia but, partly due to governance issues and legal uncertainty for these emerging exchanges, most of benchmark futures prices are still formed in US and European venues.

The trading landscape is still on the move, however, and global competition may lead to additional attempts at consolidation. The recent acquisition of NYSE LIFFE by ICE will certainly increase ICE’s global market share and will perhaps create the biggest European commodities exchange. Most importantly, the merger follows the path of consolidation between European and US exchanges striving to increase their market share and market power at the global level. Given the similar underlying macroeconomic conditions and financial systems of the two regions, cross-border merger and acquisition activities may find more solid ground for synergies and economies of scale to develop, as often seen in recent years. Finally, implications of current regulatory reforms on the market power of global infrastructures require further investigation. Commercial interest around new services that are generally considered not profitable (such as trade repositories) points at the market power generated by the economies of scale and scope that providing this service may offer, in combination with several trading, clearing and settlement services that vertically integrated market infrastructures already offer to clients.

1.2.2.4 Market organisation

The most common type of market setting for the trading of commodity futures is an auction system handled by ad hoc organisations (for-profit entities, after demutualisation) called ‘commodities futures exchanges’. This auction system, whether orders are submitted through an open outcry session (via a member of the exchange) or through an electronic trading platform (via a broker that is an exchange member and has pre-trade controls before the submission of the order), is open to anyone who meets the financial requirements needed to trade these standardised contracts (among which is a ‘margin account’). The nature of an auction requires the market to be fully transparent with regards to membership rules, types of orders that users can introduce into the system, and prices of each lot of underlying contracts. Auction markets, in addition, have lower transaction costs and can ensure a more efficient flow of information into prices. However, these standardised markets may be unable to deal with block sizes, which can produce market impact if not properly managed. If price-sensitive information about market operations of a commodity firm is not properly managed by insiders, the market can also break down, ultimately causing a run on liquidity.

Electronic trading

The evolution and growth of commodity futures exchanges has followed the development of new legal and technological tools, which have made the trading process more standardised and suitable for electronic trading. On the legal side, future contracts traded on exchanges have at least four

The evolution and growth of commodity futures exchanges has followed the development of new legal and technological tools, which have made the trading process more standardised and suitable for electronic trading. On the legal side, future contracts traded on exchanges have at least four