NEW YORK (TheStreet) -- Commodity derivatives were first introduced to help farmers manage the price risk related to their crops. I believe that helping end-users - specifically, companies who either produce or consume a physical commodity - manage their business risks should still be the driving force behind these markets. I am not sure that is still the case.
As the implementation of financial regulations such as Dodd-Frank and EMIR (European Market Infrastructure Regulation) continue to cause a reorganization of financial and commodity markets, there has been much talk of systemically important institutions, the need for increased regulatory oversight, and mandatory clearing for certain products. That is before we even consider the countless articles written on high frequency and algorithmic trading and whether it benefits or hurts markets. However, no-one has focused on the most important question: does the current market infrastructure actually serve an underlying economic purpose?
In answering this question, let me take each of the key players in turn.
Historically, banks facilitated business between companies by providing loans for capital projects or trade financing. These days they are heavily involved in trading both physical commodities and commodity derivatives. They tie trade finance and loan terms to a commitment to execute hedging transactions on a bilateral basis with the bank. This leads to hugely uncompetitive prices through wide bid / ask spreads and drives up the cost of food and refined fuels, among other things, for consumers. It also leaves banks with a large amount of counterparty credit risk on their balance sheets.
Moreover, there are significant issues surrounding potential conflicts of interest regarding hedging advice. If a bank is advising a corporate client on a hedging strategy and taking the other side of that trade (as opposed to just facilitating its execution or making a market), is the advice provided in the best interests of the bank's client or its own trading desk? As banks have become owners of physical assets in the commodity industry (refineries, oil tankers etc.) and traded increasingly for their own book, they have in many cases become competitors with the businesses they claim to impartially serve.
The CFTC (Commodity Futures Trading Commission) and the SEC (Securities and Exchange Commission) have oversight for financial and commodity markets and are responsible for ensuring they are fair, functionally robust ,and free from manipulation and abuse. It may surprise you to know that the CFTC is also responsible for ensuring economic utility.
Historically, the CFTC was not responsible for behavior outside of the regulated markets. This all changed after 2007 when the taxpayer had to bail out financial institutions that were close to failing as a result of, among other things, their unregulated over-the-counter trades. Regulators now designate products that must be 'mandatorily cleared', that is, novated to a central clearing house. There is no economic purpose here and no benefit to the end user; the sole reason is to allow regulators to collect more information on the overall level of risk in the system. This is not necessarily a bad thing, in and of itself. However, the byproduct of these regulatory changes is to increase, or in many cases add, significant compliance costs to businesses that are not financial companies and were never a threat to the financial system.
Exchanges were originally member-owned institutions that provided a marketplace for buyers and sellers of commodity derivatives to trade their business risks. At the same time, businesses and traders were protected by the central clearing house that guaranteed their trades. Since the major exchanges became public companies and the subsequent industry consolidation, the exchanges' ultimate goal is to maximize return for their shareholders. It makes sense then that they would focus on areas where there is the potential for the largest fees - from the hedge fund community and large financial institutions - rather than on smaller industry participants such as a regional ferry service or a small shipping pool operator. That is not to say that exchanges are ignoring end-users. The InterContinental Exchange (ICE) has listed numerous products that should be extremely useful risk management tools for businesses and The Cleartrade Exchange (CLTX) has listed smaller-sized contracts that are focused on end-users further downstream.
Unfortunately, it has become more likely that smaller companies who wish to hedge their commodity risks are unable to find a clearing member, or FCM (Futures Commission Merchant).
Hedgers (or anyone wishing to trade on a commodity exchange), require a relationship with a clearing member, registered as an FCM with the CFTC. However, many of the large, well respected FCMs are turning away potential customers, primarily due to the low commissions those companies generate relative to balance sheet capacity they account for. Many of the better-known FCMs have now introduced minimum commission fees for their customers, which are often as much as $10,000 per month.
Let's assume that you are a small fleet operator with 10 Panamax (the largest size of ship permitted to travel through the Panama canal) dry bulk carriers. Based on a few assumptions (see below), the operator would burn approximately 98,550 tonnes of fuel oil per year for his entire fleet at a cost of just over $64 million per year.
Burn 27 tonnes of Intermediate Fuel Oil (IFO)/day (assume in use every day) = 9855 tonnes per year per ship
Yearly burn for the fleet = 98,550 tonnes
Yearly cost (recent average of IFO 180 is around $650/tonne) = $64,057,500
The 180 CST (centistokes, a measurement of viscosity) Singapore Fuel Oil contract that could be used to hedge this (assuming the ship was bunkering in that region) is for 1000 tonnes. To hedge the entire year fuel burn you would only need to trade 99 contracts. To put this in perspective, when I worked at a small trading firm, we would regularly trade 1500-2000 contracts per day. However, clearing fees for the FCM would be pennies per contract and, as a result, it is tremendously difficult to find a clearing member that would accept such a small customer.
For the fleet operator, $64 million is a significant expenditure and one that the company should hedge. However, as they are not going to account for a large volume of contracts on a daily basis like a fund, bank or trading house, the end user may well be turned down by an FCM.
Currently, these companies can participate in bilateral trades directly with a bank or trading house but, in doing so, they take on counterparty credit risk and give up a big spread as there is no competitive process. There is also the possibility I alluded to earlier that regulations will outlaw these bilateral deals.
None of these different cogs in the system are doing anything more than making informed decisions about the risks and rewards of participating in certain activities. They all no doubt believe they are making the best decisions for their shareholders.
However, the combination of the factors outlined above means that large numbers of companies that drive our economy and need commodity derivative contracts to plan their expenditures and allocate resources, cannot access these products today. Instead, the system in place is becoming an arms race between market makers and proprietary trading desks to see who has the best technology and smartest traders.
I remember a conversation I had with a retired mining company CEO in 2006. A burly South African, he had been asking me questions about CDOs (Collateralized Debt Obligations) and other complicated financial products. As I was explaining how they worked he said "That's all well and good, but at the end of the day somebody has to dig a hole". He's right. Our financial system was developed around serving the needs of the business community. The system requires exchanges, clearing houses, FCM's, banks and market makers. However, they should serve an economic function. My fear is, in the commodity world, our institutions and products are becoming too far removed from the constituents they were designed to serve.
Written by Chris Cheetham, founder, Soter Advisors