Building blocks for a successful commodity exchange

1. Building blocks for a successful commodity exchange Lamon Rutten Officer-in-charge, Finance, Risk Management and Information UNCTAD Seminar on Introducing a Commodity Exchange in Nigeria Abuja, 23 November 2004

2. Overview • The key ingredients for a successful exchange: an overview • Trading platforms: options and cashflow implications • Identifying high-potential contracts: possibilities and procedures • Counterparty risks: a problem but also a source of strength for the exchange • Attracting clients to the exchange • Ensuring that exchange prices are representative of the underlying market conditions: the delivery process • Successful exchange regulation

3. The key ingredients for a successful exchange: an overview A platform • You need a system for people to trade on. It has to be efficient, robust, not too expensive, and fit with clients’ needs & systems. • Major platform-related risks: • chases clients away • creates major cashflow problems.

4. The key ingredients for a successful exchange: an overview A platform • Then you need contracts that your target clients need or are looking for. They need to be well-formulated, and enable users benefits that exceed their costs. • Major risks: • Poorly formulated contracts that do not meet customer requirements • Insufficient likely volumes Contracts

5. The key ingredients for a successful exchange: an overview A platform You will then need to interact with clients. As an exchange, you will take a risk on clients; and clients will take a risk on you, the exchange. Managing both sides of risk is crucial for a successful, sustainable commodity exchange. One of the major incentives for clients to use the exchange is that it reduces their counterparty and price risk compared to other potential arrangements – a large benefit. The costs that the exchange imposes to manage its own counterparty risk should be less than this benefit. Contracts Clients

6. The key ingredients for a successful exchange: an overview A platform The exchange then needs to find a way to enable potential clients to use the platform. While direct access is possible (similar to eBay, or closed procurement platforms), for most contracts the preferable mode of access is through brokers. Brokers will act as marketing agents for the exchange, and they will also support clients in their strategies, advising them on how to use the contracts. Contracts Brokers Clients

7. The key ingredients for a successful exchange: an overview The exchange will only be useful for those active in physical production, processing and trade if exchange prices reflect the underlying market conditions. For this to happen, proper delivery mechanisms need to be written into contract specifications. In practice, a sound delivery process will need good links between the exchange platform, and warehouses/collateral managers. The delivery period is the time of greatest risk for the exchange, and it is essential that the delivery process is well-organized. A platform Contracts Brokers Delivery process Ware- houses Clients

8. The key ingredients for a successful exchange: an overview Regulation TRUST Ultimately, the whole exchange system relies on trust – trust in the exchange (and its clearing house), trust in the brokers to whom clients entrust their money, and trust in the warehouses and collateral managers who will issue the pieces of paper that will actually be delivered on the exchange. A good system of regulation is necessary to ensure such trust. The exchange could provide all this regulation itself, but ideally, there should be regulation at different levels – e.g., self-regulation by the brokers, warehouses and the exchange, covered by an overall government regulatory framework. A platform Regu- lation Contracts Brokers Delivery process Ware- houses Clients Regulation

9. 1. Trading platforms: options, and cashflow implications • An exchange needs a platform that is • Reliable and robust • Easily maintainable • Upgradeable • Affordable • Choices: • Develop the platform yourself • Buy it • Obtain it through a joint-venture • Outsource it (franchising arrangement)

10. The main problem with the “develop the platform yourself” and “buy it” scenarios: In these scenarios, the exchange has to incur massive expenditures before trade starts. And when trade starts, volumes only grow incrementally. Implication: these scenarios carry with them large cash flow risks – it may take a long time for the exchange to reach cash flow break-even.

11. Other problems with these two scenarios: • Can be very costly • Updating can be problematic • Upscaling can be problematic (e.g., to introduce new contracts, or new margining methods) • Compatibility with other platforms may not be assured • In the case of bought software, maintenance can be very expensive. • These scenarios are only advisable if one has deep pockets, and expects to reach cash flow break even soon, so that the necessary cash for updating & upscaling will be generated out of ongoing operations. • Or alternatively, if one wants a relatively simple, non-evolving platform (e.g., a closed procurement platform).

12. Obtaining technology through a joint venture, or outsourcing technology requirements through a franchising arrangements avoid most of these problems. The choice between them is a practical ones: what are the specific possibilities on offer, and what benefits and disadvantages do each offer? Regu- lation Franchising arrangements ensure closer support from the technology partner, not only in keeping the technology up-to-date, but also in developing promotional programmes. Both scenarios would still leave most other elements of the exchange to the local counterparty, although the international franchiser will insist on certain minimum standards. Contracts Brokers Delivery process Ware- houses Clients Regulation

13. The franchising model… The Abuja Commodity Exchange would have its own identity, but it would be part of a wider African exchange network. What is visible to the average user is specific, but some of the resources are centrally provided (e.g., Education), and when trade takes place, this is processed centrally through the systems and back-office provided by the pan-African network. Benefits: among other things, access to common services; international promotion and marketing; low-cost back-office and processing costs (benefits of scale), system maintenance, etc.

14. 2. Identifying high-potential contracts: possibilities and procedures A wide choice, along three dimensions: Commodity Type of contract Type of trading • an “open” trading platform • a dedicated platform for trade within the country • a dedicated platform for a selected group of users • a dedicated auction-type platform for sales or purchases of a single user. • agricultural commodities – for domestic and export marketing. • metals and fuels • processed bulk commodities such as fertilizers or chemicals • electricity • exchange rates • other financial contracts or indices. • spot contracts • forward contracts, for delivery beyond 30 days. • futures contracts, with the majority of contracts not resulting in physical delivery • option contracts • contracts that enable collateralized commodity financing (repos)

15. An exchange is not limited to offering trade in forward or futures contracts. In an inefficient market, there are many other valuable services that a commodity exchange can offer. In particular: • · An exchange could facilitate physical trade by guaranteeing parts of a commodity chain, supervising warehousing or inspection functions. • · It could provide a trading forum where buyers and sellers can meet. • · The latter function can be enhanced by the exchange by, for example, the provision of a guarantee on the logistics of trade; or by the facilitation of financing for the transaction • · The exchange can play a role in the financing of agriculture. It should play this role automatically by its approval of warehouses, but it can also play a more active role, by trading warehouse receipts as underlying elements for financing deals (as part of repo transactions).

16. Some examples1. Using commodity exchanges to enlarge effective marketing areas Farmer Exchange warehouse 1. Deposits products Commodity exchange 3. The highest bidder gets the products, and the farmer is paid 2. The warehouse receipt is (electronically) transferred to the exchange and auctioned off. Conditions: - the exchange either owns warehouses, or approves them - standardization of quality descriptions into specific grades, and - standardization of the documentation used.

17. Some examples 2. The exchange as an auction place (e.g., a sales mechanism for fertilizer, chemical or oil companies) Buyer Bids Exchange-provided bidding floor (physical, electronic) Buyer Seller Offer Buyer Buyer Order-matching Requires significant logistical skills

18. Some examples 3. “Traditional” forward or futures trade Seller Buyer Seller Exchange-provided bidding floor (physical, electronic) Buyer Offers Bids Seller Buyer Seller Buyer Order-matching

19. Some examples 4. The exchange as “underwriter” of the warehouse receipt system Note: farmers can also use the scheme 6. Provides credit 5.Lodges receipts with bank Small traders Banks 3. Deposits products 2.Guarantees warehouse Warehouse company 7a.Sign sales contract 4.Issues receipts Clearing house 1. Approves warehouse 9. Delivers receipt; warehouse makes delivery Large traders Commodity exchange 7b. Delivery through exchange 8a. Reimburses credit; in return, bank transfers receipts

20. Some examples 5. The exchange as financing tool for agriculture – goods in storage Investor/bank 5. Open outcry bids on the interest rate for loans secured by the warrant Recognized warehouse 2. Issuance of warehouse warrants National Agricultural Exchange 6. Credit 1. Deposit of goods 4. Warrant is given in custody of Exchange Agricultural or agro-industrial firm Broker 3. Transfer of warrant, with the agreement to buy it back after a certain period

21. The mechanism to develop successful contracts • In-house research • Formulation of a “business case” – why would anyone be interested in using the contract? • Setting up of product committee with prominent industry representatives, to elaborate contract details • A lot of marketing, both focused efforts for hedgers, and a general campaign for speculators. • Well-timed launch

22. 3. Counterparty risks One of the key reasons for prospective users to trade on the exchange is because the risks of such trade are lower than the risks of alternative trading methods. In order for the exchange to provide such a « safe environment » it needs to impose discipline on its users (rules of trade, arbitration panel, etc.), and to demand financial guarantees (margins) for them. To deal with margin payments, the exchange can either operate an in-house clearing department, or set up an independent clearing house (which may have shareholders different from the exchange itself).

23. 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 therefore helps in boosting the depth of the market.

24. The clearing house, or department, manages its financial risks towards seller and buyer through margining. When the contract is initiated, both seller and buyer pay a margin deposit. The clearing house then dynamically manages the margin accounts. Both buyer and seller need to maintain a certain margin, but this is adjusted as a function of the profitability of their position. E.g., if prices increase: Additional margin payment Payment Clearing house Margin deposit Margin deposit Seller Buyer Sale Sale

25. But the clearing hose is not the only way for the exchange to reduce counterparty risk. There are other methods. For example, 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

26. The exchange can reduce contract default risk by acting as a depository for guarantee payments Seller Buyer Contract 10% deposit 10% deposit Exchange If contract performance is fully satisfactory, the exchange pays back the deposits (the exchange, or an agent bank, can also handle the payment for the ultimate delivery). If there is a problem with contract performance, the exchange would investigate, and pay the security deposit of the “guilty party” to the other party. Problem: given the volatility of commodity prices, is 10% enough? Would 25% be? Given the costs of finance in the country, would this not make use of the exchange too expensive?

27. Indirect ways to reduce counterparty risks Any exchange should help to develop industry standards, arbitration panels, information systems and the like. Being one of the exchange members should be seen as a “mark of quality” by the industry - so, set up rules so that only “quality companies” can become member, agree on good “rules of behaviour”, and set up procedures to punish members who don’t follow these rules. The exchange members can then become an “island of excellence” in an otherwise difficult environment. E.g., banks could find it attractive to finance members because these have to adhere to the exchange bylaws, and in case of problems the bank has recourse to an industry arbitration panel and industry rules, rather than to the legal system. The exchange could even develop and help guarantee a warehouse receipt finance system. Particularly if exchange members can benefit of certain privileges (e.g., information bulletins, extension services, financing services) the risk of contract default is strongly reduced.

28. Arbitration procedures Exchanges also reduce counterpart risks by providing an alternative to courts. Commodity exchanges should spell out their arbitration procedures, and standard exchange contracts should include clauses naming the exchange’s arbitration panel in the event of disputes. The use of this service should not restricted to users of the exchange’s contracts. Anyone should be able to use it, either if there is an arbitration clause in their contract, or even if there is not but both parties agree on it once a dispute has begun. Arbitration is much faster than court procedures, and less vulnerable to improper pressures. The State should recognize this role of the exchange.

29. 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.

30. 4. Attracting clients to the exchange • Elements: • The exchange has to offer useful contracts at a reasonable cost • Potential clients should be aware of the exchange and its potential users • They need to trust the exchange • Such clients should have no difficulty in obtaining access to realtime data on exchange activity • Potential users should have access to brokers that they feel they can trust • They need efficient mechanisms to place orders on the exchange • Margining arrangements need to be reasonable.

31. Elements: • The exchange has to offer useful contracts • Access should be at a reasonable cost • Potential clients should be aware of the exchange and its potential users • They need to trust the exchange • Such clients should have no difficulty in obtaining access to realtime data on exchange activity • Potential users should have access to brokers that they feel they can trust • They need efficient mechanisms to place orders on the exchange • Margining arrangements need to be reasonable. DESIGN PLATFORM MARKETING REGULATIONS PLATFORM OWNERSHIP MARKETING PLATFORM REGULATIONS PLATFORM PLATFORM

32. Three potentially viable models Client Client Client Broker gives client trading limit Client places orders with broker Broker vets potential clients Broker vets potential clients Exchange vets potential clients, and may give them trading limits Client trades directly on exchange Broker Broker Broker informs exchange of client trading limits Client trades directly on exchange Broker places client orders Exchange Exchange Exchange

33. 5. The delivery process Exchange prices will reflect underlying market conditions only if exchange trading is properly linked with physical trading. This is generally done through the delivery mechanism (there are some cases where the link is through the gathering of prices at which physical trade takes place, by a reputable government agency). A good delivery mechanism will ensure that, in the final weeks of the contract, exchange prices reflect physical prices – but this will only be the case if the delivery process does not meet any obstacles. Such obstacles are normally linked to the delivery details of the contract: what are the delivery possibilities (grades and locations). If something goes wrong at this stage, it will undermine the trust of users in the exchange. In an African context, a strong delivery mechanism would have to rely on cooperation with warehouse operators and collateral managers.

34. Such links also provide opportunities to the exchange. For example, an exchange can tie together warehouses. If there is a series of national exchanges that form part of a pan-African network, this would automatically link together these warehouses. This, in turn, can form the basis for intra-regional trade. Warehouses National exchanges tied into a pan-African network

35. 6. Successful exchange regulation • There are at least three sometimes conflicting interests in regulation: • Client interest: they want an exchange that is safe to use, and that generates prices that really represent underlying market conditions. But while they would like the exchange to be well-regulated, they may dislike regulatory intervention in their own operations. • Government interest: a broad interest in avoiding that exchange prices are manipulated by a small group, and in ensuring that the exchange does not collapse; and sometimes, a more narrow interest in ensuring that the exchange does not show prices that are “too high” or “too low” • Exchange interest: enough regulation to create client trust, but not so much that its operations are disrupted. • So, at the end, successful regulation is a matter of balance. • Another issue: who will pay the costs of regulation?

36. What is the international “best practice” regulatory structure for exchanges and brokers? National Brokers’ Association Brokers Customers Complaint procedure Complaint procedure Licensing Regulation Exchange management/ committees Brokers Setting the framework; verification Regulator Capital adequacy controls Regulation Ability to intervene in case of problems Exchange Strong self-regulation is essential. Clearing department