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

1. 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

2. 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.

3. 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.

4. 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?

5. Why manage price risks? TO HAVE A BETTER CASH FLOW MANAGEMENT. In order not to lose opportunities, by having access to the funds you need to undertake the activities that you want to undertake; and not be forced to borrow expensively; and not leave scarce funds lie 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

6. Market-based price risk management is particularly useful for strategic reasons: to make sure one can do what one wishes to do. Prices are basically unpredictable. Price forecasts do not replace proper risk management practices.

7. Confidence intervals for price projections, 70 % probability 263 373 319 286 Coffee (arabica) Cts/kg 185 Cts/kg 158 Cocoa 154 178 98 134 95 103 85 2000 2001 2005 2000 2001 2005 World Bank projections made in July 1999 29 3100 25 23 2400 21 US$/barrel 2100 Crude oil US$/tonne Copper 13 12 1300 11 1300 1200 2000 2001 2005 2000 2001 2005

8. Mexico --> budget USD 15.5 per barrel Price drop from USD 17 to USD 9.69 per barrel Venezuela --> budget USD 15.5 per barrel Drop in price to USD 10.60 per barrel Relying on guessing how prices will develop (“forecasts”) can cause problems…. 1998 Mongolia --> 11% budget from copper, 5% from gold. Actually obtained: 2% copper, 2% gold.

9. Risk management: market intervention, international earnings stabilization, self-insurance, and externalizing risks Sometimes work for some time (OPEC), but mostly failed. Didn’t work. Now discontinued. Virtually never worked, for a series of reasons. Used by + all large companies and some government entities. Mostly successful, but some big losses. Market intervention Earnings stabilization Self-insurance Externalizing risks International commodity agreements, OPEC Compensatory financing funds (IMF, EU) Stabilization funds (dozens of countries) Using risk management markets

10. A commodity exchange of the past

11. A commodity exchange of the 1980s

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

14. Commodity exchanges are taking off around the world.

15. The roots of commodity exchanges Successful commodity exchanges have been set up as tools for physical trade. Notas 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.

16. The difficulty of changing The bricks and mortar of the established exchanges…... …..can be a barrier to seeing existing opportunities.

17. Buyer Seller Order input Order input Computer Computer Verification Verification Check credit risk Check credit risk Electronic trading Confirmation Legitimate orders are transferred Confirmation Legitimate orders are transferred Orders are matched Execution Transfer of positions Clearing house Clearing member Clearing member Position and margin settlement Futures markets are highly organized - whether they are electronic or not. In contrast, OTC markets are rather informal.

18. Futures and Over-the-Counter Market Futures Market OTC Market Some standardization is taking place on some of the more heavily traded over-the-counter markets

19. Futures and Over-the-Counter Market Futures Market OTC Market

20. Actors in futures markets Traders, processors, producers…. Do they hedge, speculate or manipulate… Hedgers Floor traders, individuals managed funds, institutions…. Perhaps they hedge…. How do they behave? Speculators Very little arbitrage is really risk-free… Individuals, specialized entities Arbitrageurs

21. Functions of a commodity exchange Everybody can know at what price is each product sold Transparency in prices Avoid manipulation, provide a benchmark price for transaction Reduces transaction costs Everybody is in the same place, no need to look for buyer or seller What will be the price of onions next month? Sorry, I only deal with love affairs, look at the commodity exchange Provides price discovery

22. What services can a forward exchange provide? Some possibilities The exchange as meeting place Seller Buyer Contract Information on contract price Exchange Information on market prices Price transparency is already a major gain - everyone knows how to use information.

23. What services can a forward exchange provide? Some possibilities The exchange as vetting mechanism (e.g., eBay) Seller Buyer Contract Information on contract price Information on contract performance Information on contract performance Exchange Database on reputable buyers and sellers Information on market prices Blacklist of unreliable counterparties

24. What services can a forward exchange provide? Some possibilities The exchange as regulatory framework, using contract law EXCHANGE Membership requirements Agreed quality standards Seller Buyer Contract Some level of contract standardization Rules and bye-laws 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.

25. What services can a forward exchange provide? Some possibilities The exchange as an auction place Buyer Bids Exchange-provided bidding floor (physical, electronic) Buyer Seller offer Buyer Buyer Order-matching Requires significant logistical skills

26. What services can a forward exchange provide? Some possibilities The exchange as clearing house to all transactions Seller Buyer 1. Agreement on contract 2. Exchange clearing house becomes automatically buyer of commodities 3. Exchange clearing house becomes automatically seller of commodities 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.

27. What services can a forward exchange provide? Some possibilities The exchange as a facilitator of finance BNA (exchange) Selection of the regions, ranches and cattlemen suitable for inclusion in the securitization (security conditions, cattle experience, infrastructure, etc.) Buyers of fattened cattle Sale of animals Marketing agent Fattened cattle Sales proceeds Bank Assigned responsibility, as agents for the trust, for fattening of cattle, for 11 months. Cattlemen US$ 150,000 bank guarantee (only for first issue, June 2000) Transfer of ownership of young cattle and of pasture rights. Trust Extension services Insurance against larceny and terrorism. Insurance value increases in line with price increase of animals. Guarantee in case cattle fails to reach anticipated weight gain. Technical supervisor Issuance of securities up to 75% of value of the cattle Insurance Registration of the securities (which enables public trade) Centralized Securities Deposit Investors

28. The organization of futures trade Different motives: hedging, speculation, arbitrage Different 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. Client Order input “Intermediary” Verification Check credit risk Positions only open during the day. Legitimate orders are transferred Trading Floor traders Orders are matched Execution Order matching systems are on a “first come, first served” basis Transfer of positions Confirmation Clearing house Clearing member Position and margin settlement

29. The functions of the clearinghouse Obligations without a clearinghouse Contract for future delivery of goods BUYER Seller Funds, or credit risk Obligations with a clearinghouse Sale Sale Buyer Clearing house seller 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.