2015 Energy Risk Professional ERP Exam Course Pack REQUIRED ONLINE READINGS In addition to the published readings listed, the Financially Traded Energy Products section of the 2015 ERP Study Guide includes several additional readings from online sources that are freely available on the GARP website. These readings include the following learning objectives that will be tested on the 2015 ERP Exam: 1. Craig Pirrong, The Economics of Commodity Trading Firms (March 2014). Identify and describe the functions of commodity trading firms; explain how commodity trading firms can serve as financial intermediaries. Explain how commodity trading firms facilitate transformation of commodities to add value to producers and consumers. Identify the typical risk exposures that threaten the operation of commodity trading firms; understand how each type of risk arises. Understand the processes by commodity trading firms to manage various categories of risk, including flat price risk, basis risk, credit risk, liquidity risk, freight risk, and other categories of risks. Summarize methods used to measure risk exposure, including the benefits and drawbacks of VaR, the use of historical and Monte Carlo simulation, and the estimation of extreme losses. Describe trends in asset ownership by commodity trading firms and explain why commodity trading firms would own midstream, downstream, and upstream assets. Assess the potential impact of commodity trading firms on systemic market risk, including their potential to be a direct source of systemic risk. 2015 Global Association of Risk Professionals. All rights reserved.
2015 Energy Risk Professional ERP Exam Course Pack REQUIRED ONLINE READINGS In addition to the published readings listed, the Financially Traded Energy Products section of the 2015 ERP Study Guide includes several additional readings from online sources that are freely available on the GARP website. These readings include the following learning objectives that will be tested on the 2015 ERP Exam: 2. IEA, The Mechanics of the Derivatives Markets: What They Are and How They Function (Special Supplement to the Oil Market Report, April 2011). Explain the role of hedgers, speculators, and arbitrageurs in a derivatives market. Compare and contrast forward and futures contracts and understand how they are applied. Understand the mechanics of a futures position; assess the margin requirements and profitability of an open futures contract. Identify circumstances that would require posting of additional margin (a margin call ); quantify the margin requirements for a specified period of time based on incremental MtM valuations. Differentiate and apply market, limit and stop-loss orders. Use a long or short futures position to hedge a commodity exposure or an obligation to buy or sell a commodity. Understand how basis risk can arise in a hedging transaction. Describe the mechanics of swaps and explain the function of the swap counterparty, including swap dealers. Use forward prices and interest rates to calculate a periodic swap settlement for a multiyear commodity swap. Understand how the market value of a swap changes over time and describe factors that affect the market value of a swap. Demonstrate how a swap represents an implicit lending agreement, use forward commodity prices and interest rates to derive a fixed swap rate (swap price). Compare and contrast American, European and Bermudan options. Understand the mechanics and payoff profiles of call and put options; identify when an option contract is in, at, or out of the money. 3. Gordon Goodman. Swaps: Dodd-Frank Memories. Understand the financial limits and other obligations that a counterparty must meet to qualify for the end-user exemption. Explain how the use of swap hedges is affected under Dodd-Frank. Understand and apply the de minimis threshold and major swap participant (MSP) test as they apply to counterparty end-user qualification. Summarize the reporting process under Dodd-Frank, and identify when a counterparty is obligated to report a transaction to a swap data repository (SDR). 2015 Global Association of Risk Professionals. All rights reserved.
2015 Energy Risk Professional ERP Exam Course Pack REQUIRED ONLINE READINGS In addition to the published readings listed, the Financially Traded Energy Products section of the 2015 ERP Study Guide includes several additional readings from online sources that are freely available on the GARP website. These readings include the following learning objectives that will be tested on the 2015 ERP Exam: 4. Gordon Goodman. Dodd-Frank s Impact on Financial Entities, Financial Activities and Treasury Affiliates. Understand and interpret the definition of a financial entity under the Dodd-Frank Act; explain how this designation affects mandatory clearing requirements. Construct or identify scenarios in which the end-user exemption may be applied to organizations deemed financial entities. 2015 Global Association of Risk Professionals. All rights reserved.
THE ECONOMICS OF COMMODITY TRADING FIRMS CRAIG PIRRONG Professor of Finance Bauer College of Business University of Houston
ABOUT THE AUTHOR CRAIG PIRRONG is a professor of finance and the Energy Markets Director for the Global Energy Management Institute at the Bauer College of Business at the University of Houston. Pirrong previously was the Watson Family Professor of Commodity and Financial Risk Management and associate professor of finance at Oklahoma State University. He has also served on the faculty of the University of Michigan Business School, Graduate School of Business of the University of Chicago, and Olin School of Business of Washington University in St. Louis. He holds a Ph.D. in business economics from the University of Chicago. Pirrong s research focuses on the economics of commodity markets, the relation between market fundamentals and commodity price dynamics, and the implications of this relation for the pricing of commodity derivatives. He has also published substantial research on the economics, law, and public policy of market manipulation. Pirrong also has written extensively on the economics of financial exchanges and the organization of financial markets, and most recently on the economics of central counterparty clearing of derivatives. He has published over thirty articles in professional publications and is the author of four books. Pirrong has consulted widely, and his clients have included electric utilities, major commodity traders, processors, and consumers, and commodity exchanges around the world. CRAIG PIRRONG Professor of Finance Trafigura provided financial support for this research. I also benefited substantially from discussions with Trafigura management, traders, and staff. All opinions and conclusions expressed are exclusively mine, and I am responsible for all errors and omissions. Throughout this document $ refers to USD. Craig Pirrong, March 2014. All rights reserved. 2
TABLE OF CONTENTS INTRODUCTION 4 I THE BASICS OF COMMODITY TRADING 6 A Commodity Transformations 6 B Value Creation in Commodity Trading 7 C Commodity Trading Firms 9 II THE RISKS OF COMMODITY TRADING 12 A Risk Categories 12 B Risk Management 17 III RISK MANAGEMENT BY COMMODITY TRADING FIRMS 21 A Introduction 21 B The Risk Management Process 22 C Managing Flat Price Risk and Basis Risk 22 D Risk Measurement 24 E Managing Credit Risk 27 F Managing Liquidity Risk 28 G Managing Freight Risk 28 H Managing Other Risks 28 I Paper Trading 29 IV V VI COMMODITY FIRM FINANCING, CAPITAL STRUCTURE, AND OWNERSHIP 31 A The Financing of Commodity Trading Firms 31 B The Liability Structures of Commodity Trading Firms 33 C The Ownership of Commodity Trading Firms: Public vs. Private 34 D Commodity Trading Firms as Financial Intermediaries 36 COMMODITY FIRM ASSET OWNERSHIP AND VERTICAL INTEGRATION 40 A The Physical Asset Intensity of Commodity Trading Firms 40 B Asset Ownership by Commodity Trading Firms 42 SYSTEMIC RISK AND COMMODITY TRADING: ARE COMMODITY TRADING FIRMS TOO BIG TO FAIL? 49 A Introduction 49 B Analysis of the Systemic Risk of Commodity Trading Firms 50 AFTERWORD 58 APPENDIX A 60 Source Data For International Trade Flow in Commodities APPENDIX B 62 Trading Activity and Physical Asset Ownership for Leading Commodity Trading Firms 3
INTRODUCTION The trading of the basic commodities that are transformed into the foods we eat, the energy that fuels our transportation and heats and lights our homes, and the metals that are present in the myriad objects we employ in our daily lives is one of the oldest forms of economic activity. Yet, even though this activity traces its origins into prehistory, commodity trading is often widely misunderstood, and, as a consequence, it is often the subject of controversy. So too This whitepaper is intended to help demystify the commodity trading business. It presents a combination of description and analysis: in it, I describe some salient features of the commodity trading business and commodity trading firms, and utilize a variety of economic concepts to analyze and explain them. SUMMARY CONCLUSIONS Several fundamental conclusions flow from the analysis: Commodity trading firms are all essentially in the business of transforming commodities in space (logistics), in time (storage), and in form (processing). Their basic function is to perform physical arbitrages which enhance value through these various transformations. Although all commodity traders engage in transformation activities, they are tremendously diverse. They vary in size, the commodities they trade and transform, the types of transformations they undertake, their financing, and their form of ownership. In engaging in these transformation activities, commodity traders face a wide array of risks, some of which can be managed by hedging, insurance, or diversification, but face others that must be borne by the firms owners. Crucially, most commodity trading firms do not speculate on movements in the levels of commodity prices. Instead, as a rule they hedge these flat price risks, and bear risks related to price differences and spreads basis risks. Risk management is an integral part of the operations of commodity trading firms. Some major risks are transferred to the financial markets, through hedging in derivatives or the purchase of insurance. Other risks are mitigated by diversification across commodities traded, and across the kinds of transformations that firms undertake. Remaining risks are borne by equity holders, and controlled by policies, procedures, and managerial oversight. Commodity trading firms utilize a variety of means to fund their transformation activities. Different commodity traders use different funding strategies involving different mixes of types of debt and debt maturities, and these funding strategies are aligned with the types of transformations firms undertake, and the types of assets they use to undertake them. Short-term assets like inventories are funded with short-term debt, and long-term assets are funded with longer-term debt. Commodity trading firms provide various forms of financing and risk management services to their customers. Sometimes commodity marketing, financing, and risk management services are bundled in structured transactions with commodity trading firms customers. Offering these services to customers exploits trading firms expertise in merchandising and risk management, utilizes the information commodity trading firms have, and provides better incentives to customers. Some commodity trading firms are public companies, whereas some are private. The private ownership model is well-adapted to traditional, asset light transformation activities, but as economic forces are leading to increasing investments in physical assets by all types of trading firms, the private ownership model is coming under pressure. Some major traders have already gone public; others are considering it; and still others are implementing hybrid strategies that allow them to retain some of the benefits of private ownership while tapping the public capital markets (sometimes including the equity markets) to fund some investments. 4
INTRODUCTION Commodity trading firms exhibit considerable diversity in their investments in physical assets, with some firms being relatively asset intensive, and others being very asset light. These firms also exhibit diverse trends in asset intensity. Within both categories (asset heavy and asset light), some firms are becoming more asset intensive, and others less (or remaining relatively constant). What economists refer to as transactions costs economics provides considerable insight on what kinds of assets commodity traders own, and why these ownership and investment patterns have changed over time. Most notably, these transactions costs economics considerations imply that commodity traders have strong reasons to own midstream assets including storage facilities and terminals. Changes in commodity trading patterns in the last decade have created needs for increased investments in such midstream assets, and commodity trading firms have responded by building them. Although it has been suggested that commodity trading firms are potential sources of systemic risk, as are banks, and hence should be regulated in ways similar to banks, they are in fact unlikely to be a source of systemic risk. That is, commodity trading firms are not too big to fail. Not only are they substantially smaller than truly systemically risky financial institutions, they do not engage in the kinds of maturity transformations that make banks vulnerable to runs; nor are they highly leveraged; nor are they major sources of credit; and the assets of a firm that experiences financial distress can be transferred to others. THE REMAINDER OF THIS PAPER IS ORGANIZED AS FOLLOWS: Section I discusses the basics of commodity trading, focusing on the three major transformations that commodity traders undertake. Section II summarizes the various risks that commodity trading firms face. Section III describes the risk management process at Trafigura. Section IV examines the financing of commodity trading firms, their ownership structure, and their provision of funding to their customers. Section V analyzes asset ownership by commodity firms. Section VI examines the question of whether commodity trading firms pose systemic risks. The paper concludes with a brief afterword. 5
I. THE BASICS OF COMMODITY TRADING SUMMARY Agricultural, energy and industrial commodities undergo a variety of processes to transform them into things we can consume. These can be categorized as transformations in space, time, and form. Commodity trading firms (CTFs) add value by identifying and optimizing transformations in commodities that reconcile mismatches between supply and demand: in space - using logistics in time - through storage in form - with processing. Physical and regulatory bottlenecks may act as constraints on these transformations. CTFs undertake physical arbitrage activities, which involve the simultaneous purchase and sale of a commodity in different forms. CTFs do not speculate on outright commodity price risk, but aim to profit on the differential between the untransformed and transformed commodity. CTFs specialize in the production and analysis of information that identifies optimal transformations. They respond to price signals and invest in physical and human capital to perform these transformations. There are many different types of CTF. They vary by size and by product specialization. Some are independent entities; others are subsidiaries of oil majors or banks. They may be privately owned or publicly listed. Commodities undergo transformations... in space through logistics and transportation... in time... through storage... A. COMMODITY TRANSFORMATIONS Virtually all agricultural, energy, and industrial commodities must undergo a variety of processes to transform them into things that we can actually consume. These transformations can be roughly grouped into three categories: transformations in space, transformations in time, and transformations in form. Spatial transformations involve the transportation of commodities from regions where they are produced (supply regions) to the places they are consumed. The resources where commodities can be efficiently produced, such as fertile land or mineral deposits, are almost always located away from, and often far away from, the locations where those who desire to consume them reside. Transportation transformation in space is necessary to bring commodities from where they are produced to where they are consumed. Just as the locations of commodity production and consumption typically do not align, the timing of commodity production and consumption is often disjoint as well. This is most readily seen for agricultural commodities, which are often produced periodically (with a crop being harvested once a year for some commodities) but which are consumed continuously throughout the year. But temporal mismatches in production and consumption are not limited to seasonally produced agricultural products. Many commodities are produced at a relatively constant rate through time, but are subject to random fluctuations in demand due to a variety of factors. For instance, wells produce natural gas at a relatively steady rate over time, but there can be extreme fluctuations in the demand to consume gas due to random changes in the weather, with demand spiking during cold snaps and falling when winter weather turns unseasonably warm. Commodity demand can also fluctuate due to macroeconomic events, such as a financial crisis that causes economic activity to slow. Supply can also experience random changes, due to, for instance, a strike at a copper mine, or a hurricane that disrupts oil and gas production in the Gulf of Mexico. These mismatches in the timing of production and consumption create a need to engage in temporal transformations, namely, the storage of commodities. Inventories can be accumulated when supply is unusually high or demand is unusually low, and can be drawn down upon when supply is unusually low or demand is unusually high. Storage is a way 6
SECTION I of smoothing out the effects of these shocks on prices, consumption, and production. Furthermore, the other transformations (in space and form) require time to complete. Thus, commodity trading inevitably involves a financing element. Moreover, commodities often must undergo transformations in form to be suitable for final consumption, or for use as an input in a process further down the value chain. Soybeans must be crushed to produce oil and meal that can be consumed, or serves as the input for yet additional transformations, as when the meal is fed to livestock or the oil is used as an ingredient in a snack. Crude oil must be refined into gasoline, diesel, and other products that can be used as fuels. Though often overlooked, blending and mixing are important transformations in form. Consumers of a commodity (e.g., a copper smelter that uses copper concentrates as an input) frequently desire that it possess a particular combination of characteristics that may require the mixing or blending of different streams or lots of the commodity. in form...through processing Most commodities undergo multiple transformations of all three types between the farm, plantation, mine or well, and the final consumer. Commodity trading firms are vital agents in this transformation process. B. VALUE CREATION IN COMMODITY TRADING Commodity trading is, in essence, the process of transforming commodities in space, time, and form. Firms that engage in commodities trading attempt to identify the most valuable transformations, undertake the transactions necessary to make these transformations, and engage in the physical and operational actions necessary to carry them out. The creation of value in commodities trading involves optimizing these transformations. Commodity traders aim to optimize transformations This is an inherently dynamic process because the values of the myriad possible transformations vary over time due to shocks to supply and demand. For instance, a good harvest of a commodity in one region will typically make it optimal to store additional quantities of that commodity, and to transport the additional output to consumption locations. Developments in oil markets in North America illustrate how dynamic transformation opportunities can be. Prior to the dramatic increases in oil production in places like the Bakken, the Permian Basin, and the Eagle Ford, the Midcontinent of the United States was a deficit production region where the marginal barrel was imported to the Gulf Coast and transported to the Midcontinent via pipeline to supply refineries in the region. The unprecedented rise in oil output turned this situation on its head. Soon the Midconcontinent became an area of supply surplus. This necessitated an increase in storage in the region, and a reversal of transportation patterns. There have also been knock-on effects, including the virtual elimination of light sweet crude imports into the United States and the redirection of Nigerian crude (for instance) to other markets. That is, a supply shock led to a complete change in the optimal pattern of transformation not just in the US, but around the world. The process of making transformations is constrained by technology and available infrastructure. For instance, transportation technology and resources ocean freight, rail, barge, truck, pipelines determine the set of possible spatial transformations. Similarly, storage capacity determines the feasible intertemporal transformations. Constraints on transformation possibilities can vary in severity over time. Severe constraints represent bottlenecks. One important function of commodity traders is to identify these bottlenecks, and to find ways to circumvent them. This can be achieved by finding alternative ways to make the transformation, and/or investing in additional infrastructure that alleviates the constraints. Developments in the North American oil market also illustrate these processes. The lack of pipelines capable of transporting oil from the Midcontinent and other regions in which production had spiked to refineries on the Gulf was a bottleneck that severely constrained the ability to move oil from where it was abundant to where it was scarce. In the short run, traders identified and utilized alternative means of transportation, including truck, barge and rail. Over a slightly longer time frame some existing pipelines were reversed and new pipelines were built. Within a period of roughly two years, the bottleneck had largely been eliminated. They overcome bottlenecks... Sometimes bottlenecks are not physical, but are instead the consequence of regulatory or legal restrictions. At present, the primary bottleneck that is impeding the movement of newly abundant North American crude to markets where it is scarcer is the US law that largely prohibits the export of crude oil. Even there, traders are finding ways to alleviate the constraint. For instance, market participants are investing in splitters ( mini-refineries ) that transform crude oil that cannot be exported, into refined products that can be sold abroad. 7
and incur transportation, storage, and processing costs......to realize physical arbitrage The primary role of commodity trading firms is to identify and optimize those transformations. An important determinant of the optimization process is the cost of making the transformations. These costs include transportation costs (for making spatial transformations), storage costs (including the cost of financing inventory), and processing/refining costs. These costs depend, in part, on constraints/bottlenecks in the transformation processes. All else equal, the tighter the constraints affecting a particular transformation process, the more expensive that transformation is. Commodity traders characterize their role as finding and exploiting arbitrages. An arbitrage is said to exist when the value of a transformation, as indicated by the difference between the prices of the transformed and untransformed commodity, exceeds the cost of making the transformation. 1 Consider a spatial transformation in grain. A firm can buy corn in Iowa for $5.00/bushel (bu) and finds a buyer in Taiwan willing to pay $6.25/bu. Making this transaction requires a trader to pay for elevations to load the corn on a barge, and from a barge to an oceangoing ship; to pay barge and ocean freight; to finance the cargo during its time in transit; and to insure the cargo against loss. The trader determines that these costs total $1.15/bu, leaving a margin of $0.10/bu. If this is sufficient to compensate for the risks and administrative costs incidental to the trade, the trader will make it. They trade face-to-face with buyers and sellers They invest in information systems and in human and physical resources This description of a typical commodity trade illustrates that the commodity traders are primarily concerned with price differentials, rather than the absolute level of commodity prices. Traders buy and sell physical commodities. The profitability of these activities depends on the difference between the prices of the transformed and untransformed commodities, rather than their level. As will be discussed in more detail subsequently, price levels affect the profitability of commodity trading primarily through their effect on the cost of financing transactions, and their association with the volume of transactions that are undertaken. Although commodity trading firms use centralized auction markets (e.g., futures markets) primarily to manage price risks, their core activities of buying, selling, and transforming physical commodities takes place in what economists call bilateral search markets. Commodity trading firms search to identify potential sellers and potential buyers, and engage in bilateral face-to-face transactions with them. This reflects the facts that auction trading on central markets is an efficient way to transact highly standardized instruments in large quantity, but is not well-adapted to trading things as diverse as physical commodities. Even a particular commodity say corn, or crude oil is extraordinarily diverse, in terms of location (of both producers and consumers) and physical characteristics. Moreover, consumers and producers often have highly idiosyncratic preferences. For instance, oil refineries are optimized to process particular types of crude oil, and different refineries are optimized differently. The trade of diverse physical commodities requires matching numerous producers and consumers with heterogeneous preferences. Centralized markets are not suited to this matching process. Instead, since time immemorial, traders have searched both sides of the market to find sellers and buyers, and matched them by buying from the former and selling to the latter in bilateral transactions, and added value by engaging in transformations. To operate in these markets, commodity trading firms specialize in (1) the production and analysis of information buyers and sellers active in the market, supply and demand patterns, price structures (over space, time, and form), and transformation technologies, and (2) the utilization of this information to optimize transformations. In essence, commodity traders are the visible manifestation of the invisible hand, directing resources to their highest value uses in response to price signals. Given the complexity of the possible transformations, and the ever-changing conditions that affect the efficient set of transformations, this is an inherently dynamic, complex, and highly information-intensive task. Trading firms also invest in the physical and human capital necessary to transform commodities. Commodity trading therefore involves the combination of the complementary activities of information gathering and analysis and the operational capabilities necessary to respond efficiently to this information by transforming commodities to maximize their value. 1 This use of the term arbitrage is contrary to the strict academic usage in finance, i.e., a transaction that earns a positive profit with positive probability, but entails no risk of loss. Virtually all of the commodity trades referred to as arbitrages involve some risk of loss. The use of the term is therefore aspirational. It indicates that traders are attempting to identify and implement very low risk trades, and in particular, trades that are not at risk to changes in the general level of a commodity s price. 8
SECTION I Value creation opportunities in commodity trading depend on the economic environment. Volatile economic conditions increase value creation opportunities. Supply and demand shocks can cause geographic imbalances that create spatial arbitrage opportunities for traders. Greater volatility also makes storage more valuable, thereby creating intertemporal arbitrage opportunities. Greater economic volatility is also associated with greater volatility in relative prices, and in particular in temporary mispricings that create trading opportunities. Moreover, major secular economic shifts can create imbalances that drive trade and increase arbitrage opportunities. The dramatic growth of China in the past 20 years, and particularly in the last decade, is an example of this. These factors explain why the profitability of commodity trading has tended to be greatest during periods of economic volatility, such as the Iranian Revolution, the Gulf War, and the collapse of the Soviet Union, and during periods of rapid growth concentrated in a particular country or region. They are more periods of upheaval In summary, commodity trading firms are in the business of making transformations. In doing so, they respond to price signals to move commodities to their highest value uses. This improves the efficiency of resource allocation. Indeed, as Adam Smith noted centuries ago, making these transformations more efficiently can be a matter of life and death. 2 C. COMMODITY TRADING FIRMS A large and diverse set of firms engages in commodity trading. 3 Indeed, the diversity is so extensive, and occurs along so many dimensions, that it is difficult to make generalizations. Some commodity trading firms are stand-alone entities that specialize in that activity. For instance, well-known trading firms such as Trafigura and Vitol are independent and engage almost exclusively in commodity transformation activities. Other commodity traders are subsidiaries or affiliates of other kinds of firms. For instance, many banks have (or had) commodity trading operations. Prominent examples include J. Aron (part of Goldman Sachs since 1981), Phibro (once part of Citigroup and before that Salomon Brothers, though it is now not affiliated with a bank), and the commodity trading divisions of Morgan Stanley, J. P. Morgan Chase, and Barclays (to name some of the most prominent). Other commodity trading entities are affiliated with larger industrial enterprises. Most notably, many supermajor oil companies (such as Shell, BP, and Total) have large energy trading operations (though some, notably Exxon, do not). Pipeline and storage operators ( midstream firms such as Kinder Morgan and ETP in the United States) in energy often engage in trading as well. Commodity trading firms also differ by the breadth of the commodities they trade. Some are relatively specialized, trading one or a few commodities. Others trade a broader set of commodities but within a particular sector. For instance, the traditional ABCD firms-adm, Bunge, Cargill, and Louis Dreyfus-concentrate in agricultural commodities, with lesser or no involvement in the other major commodity segments (although Cargill does have a sizable energy trading operation). As another example, some of the largest trading firms such as Vitol, and Mercuria, and the energy trading-affiliates of the oil supermajors, focus on energy commodities, with smaller or no presence in other commodity segments. One major trading firm, Glencore, participates in all major commodity segments, but has a stronger presence in non-ferrous metals, coal, and oil. Another, Trafigura, is a major energy and non-ferrous metals trader. Commodity trading scope and scale... Firms with a presence in a particular sector (e.g., agriculture) also vary in the diversity of commodities they trade. For instance, whereas Olam participates in 18 distinct agricultural segments, Bunge focuses on two and other major firms are active in between three and seven different segments. 2 Adam Smith, The Wealth of Nations (1776). In Chapter V of Book IV, titled Digression Concerning the Corn Trade and Corn Laws, Smith describes how by engaging in transformations in space and transformations in time grain traders ( corn dealers ) were invaluable in preventing local shortages from causing famines. He further noted that even though traders perform their most valuable service precisely when supplies are short and prices high, this is also when they are subject to the heaviest criticism. 3 I will use the term commodity trading to mean the process of purchasing, selling, and transforming physical commodities. 9
they may own assets upstream, midstream or downstream......they can be privately owned or publicly listed Furthermore, firms in a particular segment differ in their involvement along the marketing chain. Some firms participate upstream (e.g., mineral production or land/farm ownership), midstream (e.g., transportation and storage), and downstream (e.g., processing into final products or even retailing). Others concentrate on a subset of links in the marketing chain. (This is discussed in more detail in Section V.) Commodity trading firms also vary substantially in size. There are large numbers of small firms that tend to trade a single commodity and have revenues in the millions of dollars. At the other end of the spectrum, the largest traders participate in many markets and have revenues well over $100 billion. Firms that engage in commodity trading also exhibit diverse organizational forms. Some, including many of the most prominent (Cargill, Louis Dreyfus, Koch Industries) are privately owned. Some of these non-public traders are funded by private equity investors: TrailStone (Riverstone Holdings) and Freepoint Commodities (Stone Point Capital) are well-known examples. Others (e.g., ADM and Bunge) are publicly traded corporations. Some are affiliates or subsidiaries of publicly traded firms. Yet others are organized as master limited partnerships with interests traded on stock exchanges: Kinder Morgan, ETP, and Plains All American are examples of this. 10
SECTION I 11
II. THE RISKS OF COMMODITY TRADING SUMMARY CTFs face several overlapping categories of risk. They have little exposure to commodity prices (flat price risk). They normally hedge physical commodity transactions with derivatives. Hedging exchanges flat price risk for basis risk. The basis is the differential between the price of a physical commodity and its hedging instrument. Basis risk is the risk of a change in this differential. CTFs accept and manage basis risk in financial markets. They may also take on spread risk, which arises out of timing mismatches between a commodity and a hedging instrument. Margin and volume risk. CTFs have limited exposure to commodity price risk. Their profit is largely based on volumes traded and the margin between purchase and sale prices. Margins and volumes are positively correlated. CTFs have various kinds of liquidity risk: Hedging liquidity. CTFs use futures exchanges to hedge commodities. Loss-making hedges incur costs daily before offsetting profits on physical commodities are realized. Market liquidity. In some commodities markets it may be difficult to realize value from a trading position at short notice. Funding liquidity. With high commodity prices, CTFs need substantial capital to trade effectively. CTFs are exposed to a wide range of operational risks. They manage these through a combination of approaches, including insurance, IT, and health and safety audits. Other risks include political risk, legal/reputational risk, contract performance risk, and currency risk. CTFs can reduce risk: Through diversification. There is little correlation between basis risks in different commodity markets. A CTF can reduce its overall exposure by trading in multiple commodity markets. Most large CTFs are widely diversified and are therefore less susceptible to market shocks. Through integration. Owning assets across the value chain provides opportunities to self-hedge. When there is a market shock, cushioning effects generally occur elsewhere along the value chain. physical commodities with derivatives... A. RISK CATEGORIES Commodity trading involves myriad risks. What follows is a relatively high level overview of these risks. Note that some risks could fall into more than one category. As will be seen, a crucial function of commodity traders is to manage these risks. This risk management essentially involves transferring risks that commodity traders do not have a comparative advantage in bearing to entities that do: this allows them to generate value by concentrating on their core transformation activities. Flat price risk. Traditional commodity trading involves little exposure to flat price risk. 1 In the traditional commodity trading model, a firm purchases (or sells) a commodity to be transformed (e.g., transported or stored), and hedges the resulting commodity position via a derivatives transaction (e.g., the sale of futures contracts to hedge inventory in transit) until the physical position is unwound by the sale (or purchase) of the original position. The hedge 1 The flat price is the absolute price level of the commodity. For instance, when oil is selling for $100/barrel, $100 is the flat price. Flat price is to be distinguished between various price differences (relative prices), such as a time spread (e.g., the difference between the price of Brent for delivery in July and the price of Brent for delivery the following December), or a quality spread (e.g., the difference between the price of a light and a heavy crude). 12
SECTION II transforms the exposure to the commodity s flat price into an exposure to the basis between the price of the commodity and the price of the hedging instrument. (I discuss basis risk in more detail below). Of course, hedging is a discretionary activity, and a firm may choose not to hedge, or hedge incompletely, in order to profit from an anticipated move in the flat price, or because the cost of hedging is prohibitively high. Moreover, particularly as some commodity firms have moved upstream into mining, or into commodities with less developed derivatives markets (e.g., iron ore or coal), they typically must accept higher exposure to flat price risks. to exchange basis risk Commodity prices can be very volatile, and indeed, can be subject to bouts of extreme volatility. Therefore, firms with flat price exposure can suffer large losses. This does not mean that flat price exposure is a necessary condition for a firm to suffer large losses: as an example, trading firm Cook Industries was forced to downsize dramatically as a result of large losses incurred on soybean calendar spreads in 1977. Indeed, many (and arguably most) of the instances in which commodity trading firms went into distress were the not the result of flat price risk exposures, but basis or other spread risks: a spread or basis position that is big enough relative to a firm s capital can create a material risk of financial distress. Basis Risk. Hedging involves the exchange of flat price risk for basis risk, i.e., the risk of changes in the difference of the price between the commodity being hedged and the hedging instrument. Such price differences exist because the characteristics of the hedging instrument are seldom identical to the characteristics of the physical commodity being hedged. For instance, a firm may hedge a cargo of heavy Middle Eastern crude with a Brent futures contract. Although the prices of these tend to move broadly together, changes in the demand for refined products or outages at refineries or changes in tanker rates or myriad other factors can cause changes in the differential between the two. Liquidity considerations lead firms to accept basis risk. In theory, it is possible to find a counterparty who would be willing, at some price, to enter into a contract that more closely matches the exposure a firm wants to hedge. However, it can be time consuming and expensive to find such a counterparty: the firm has to accept flat price risk until a counterparty has been found. Moreover, it can be time consuming and expensive to exit such a contract once the hedge is no longer needed (as when a firm hedging a cargo of crude oil finds a buyer for it), in part because the time and expense of finding a new counterparty gives the original counterparty considerable bargaining power. By trading in standardized liquid derivatives contracts (e.g., Brent oil futures, CBOT corn futures), a hedger must accept basis risk (because the standardized contract almost never matches the characteristics of the exposure being hedged), but can enter and exit a position rapidly and at low cost because there are many other traders (other hedgers, speculators, market makers) continuously present in a heavily traded, liquid market. The speed, flexibility, and liquidity of trading in a market for a heavily traded standardized instrument reduce the transactions costs and execution risks of hedging, and for most hedgers the savings in transactions costs and execution risks more than offset the costs associated with basis risk. Indeed, there is a positive feedback mechanism that creates a virtuous cycle that leads to the dominance of a small number often just one of standardized hedging instruments for a commodity, and induces market participants to trade these standardized contracts rather than customized contracts with less basis risk but higher transactions costs. The more firms that trade a particular standardized contract, the cheaper it is to trade that contract. Thus, more trading activity in a standardized contract reduces transactions costs, which attracts more trading activity to that contract. This commonly results in trading activity tipping to one contract (or at most two) for a given commodity. For instance, there is only one heavily traded corn futures contract. Oil is exceptional in that two liquid contracts exist side-by-side. Thus, basis risk is ubiquitous because firms prefer to accept such risk in order to achieve the transactions cost savings of trading in liquid markets for standardized instruments. Although the basis tends to be less variable than the flat price (which is why firms hedge in the first place), the basis can be volatile and subject to large movements, thereby potentially imposing large losses on hedging firms. And as noted above, it is possible to take a position in the basis (or spreads generally) that is sufficiently risky relative to a firm s capital that an adverse basis (spread) change can threaten the firm with financial distress. Basis risks generally arise from changes in the economics of transformation during the life of a hedge. Changes in transportation, storage, and processing costs affect relative prices across locations, time, and form. Sometimes these basis changes can be extreme when The basis is less volatile but there is still a risk of large losses 13
Basis risks arise when the economics of transformation change there are large shocks to the economics of transformation: for example, the explosion of a natural gas pipeline that dramatically reduced transportation capacity into California in late-2000 caused a massive change in the basis between the price of gas at the California border and at the Henry Hub in Louisiana (the delivery point for the most liquid hedging instrument). As another example, in the past three to four years, the basis between West Texas Intermediate crude oil and internationally traded crude oils has become larger, and substantially more variable, due to the dramatic increase in US oil production and to infrastructure constraints. Basis risk can also vary by commodity. The basis for refined industrial metals tends to be less volatile than the basis for metal concentrates hedged using futures contracts on refined metals....or when traders corner or squeeze a commodity in derivatives markets Local, idiosyncratic demand and supply shocks are ubiquitous in commodity markets. A drought in one region, or an unexpected refinery outage, or a strike at a port affect supply and/or demand, and cause changes in price relationships changes in the basis that should induce changes in transformation patterns; commodity trading firms play an essential role in identifying and responding to these shocks. Basis risks can also arise from the opportunistic behavior of market participants. In particular, the exercise of market power in a derivatives market a corner or a squeeze tends to cause distortions in the basis that can inflict harm on hedgers. 2 For instance, it was reported that Glencore lost approximately $300 million in the cotton market in May-July, 2011 due to extreme movements in the basis that were likely caused by a corner of the ICE cotton futures contract. 3 Basis and calendar spread movements are consistent with another squeeze occurring in cotton in July, 2012. Squeezes and corners have occurred with some regularity in virtually all commodity markets. In the last three years alone, there have been reports (credibly supported by the data) of squeezes/corners in cocoa, coffee, copper, and oil. Spread risk. From time to time commodity trading firms engage in other kinds of spread transactions that expose them to risk of loss. A common trade is a calendar (or time) spread trade in which the same commodity is bought and sold simultaneously, for different delivery dates. Many commodity hedges involve a mismatch in timing that gives rise to spread risk. For instance, a firm may hedge inventory of corn in October using a futures contract that expires in December. Margins and volumes tend to rise and fall together Calendar spreads are volatile, and move in response to changes in fundamental market conditions. 4 The volatility of spreads also depends on fundamental conditions. For instance, time spreads tend to be more volatile when inventories are low than when they are high. Spreads can also change due to manipulative trading of the type that distorts the basis. Margin and Volume Risk. The profitability of traditional commodity merchandising depends primarily on margins between purchase and sale prices, and the volume of transactions. These variables tend to be positively correlated: margins tend to be high when volumes are high, because both are increasing in the (derived) demand for the transformation services that commodity merchants provide. The demand for merchandising is derived from the demand and supply of the underlying commodity. For instance, the derived demand for commodity transportation and logistics services provided by trading firms depends on the demand for the commodity in importing regions and the supply of the commodity in exporting regions. This derived demand changes in response to changes in the demand and the supply for the commodity. A decline in demand for the commodity in the importing region will reduce the derived demand for logistical services. The magnitude of the derived demand decline depends on the elasticity of supply in the exporting region. The less elastic the supply, the less the 14 2 The subject of cornering (a form of manipulative conduct) is obviously hugely sensitive and controversial, but it is has been a matter of contention since modern commodity trading began in the mid-19th century. Rigorous economic analysis can be used to distinguish unusual price movements and price relationships resulting from unusual fundamental conditions, and those caused by the exercise of market power. Craig Pirrong, Detecting Manipulation in Futures Markets: The Ferruzzi Soybean Episode, 6 American Law and Economics Review (2004) 72. Stephen Craig Pirrong, Manipulation of the Commodity Futures Market Delivery Process, 66 Journal of Business (1993) 335. Stephen Craig Pirrong, The Economics, Law, and Public Policy of Market Power Manipulation (1996). Craig Pirrong, Energy Market Manipulation: Definition, Diagnosis, and Deterrence, 31 Energy Law Journal (2010) 1. Using the rigorous theoretical and empirical methods set out in these publications it is possible to identify several recent episodes in which it was extremely highly likely that prices and basis relationships were distorted by the exercise of market power. It is important to emphasize that these methods can be used-and have been-to reject allegations of manipulation. 3 Jack Farchy, Cotton trading costs Glencore $330m, Financial Times, 7 February, 2012. 4 For instance, an unexpected increase in demand or decrease in supply tends to lead to a rise in prices for delivery near in the future, relative to the rise in prices for later delivery dates.
SECTION II underlying demand shock reduces the derived demand for logistical services. This occurs because the bulk of the impact of the demand decline is borne by the price in the exporting region rather than the quantity traded, leaving the margin between purchase and sales prices and the quantity of the commodity shipped only slightly affected. This means that variations in the quantity of commodity shipments, as opposed to variations in commodity flat prices, are better measures of the riskiness of traditional commodity merchandising operations. (Similar analyses apply to the effects of supply shocks, or shocks to different kinds of transformation such as storage or processing.) The amount of financial risk incurred by a commodity trading firm due to variations in margins and volumes depends on the kinds of transformations it undertakes, and the assets it utilizes in those transformations. Transformations involving large investments in fixed assets (notably many processing and refining activities) entail high fixed costs and operational leverage. The financial performance of a firm with higher operational leverage will vary more due to fluctuations in margins. It should be noted further that many commodity firms benefit from self-hedges. For instance, a decline in the demand for a commodity (e.g., the decline in the demand for oil and copper during the 2008-2009 financial crisis) reduces the demand for logistical services provided by commodity trading firms, but simultaneously increases the demand for storage services. A firm that supplies logistical services and operates storage facilities therefore benefits from an internal hedge between its storage and logistics businesses; the decline in demand in one is offset by a rise in demand in the other. Commodity trading volumes not prices Vertically integrated self-hedges These considerations highlight the danger of confusing the riskiness of commodity prices with the riskiness of commodity trading, i.e., the provision of commodity transformation services. Although changes to underlying supply and demand for commodities affect demand for transformation services, the latter tend to be less volatile (especially when underlying demand and supply are highly inelastic), and because there are frequently negative correlations (and hence self-hedges) between the demands for different types of transformations. Operational Risk. Commodity firms are subject to a variety of risks that are best characterized as operational, in the sense that they result from the failure of some operational process, rather than from variations in prices or quantities. The list of potential operational risks is large, but a few examples should suffice to illustrate. A firm that transports a commodity by sea is at risk to a breakdown of a ship or a storm that delays completion of a shipment, which often results in financial penalties. A particularly serious operational risk is rogue trader risk, in which a trader enters into positions in excess of risk limits, without the knowledge or approval of his firm. The firm can suffer large losses if prices move against these positions. A rogue trader caused the demise of one commodity trading company, Andre & Cie. The copper trading operation of Sumitomo suffered a loss in excess of $2 billion due to rogue trading that lasted nearly a decade. Contract Performance Risk. A firm that enters into contracts to purchase or sell a commodity is at risk to the failure of its counterparty to perform. For instance, a firm that has entered into contracts to buy a commodity from suppliers and contracts to sell the commodity to consumers can suffer losses when the sellers default. In particular, sellers have an incentive to default when prices rise subsequent to their contracting for a sales price, leaving the commodity trading firm to obtain the supplies necessary to meet its contractual commitments at the now higher price, even though they are obligated to deliver at the (lower) previously contracted price. This is a chronic problem in the cotton market, and this problem became particularly acute beginning in late-2010. Initially, many cotton producers reneged on contracts to sell cotton when prices rose dramatically. Subsequently, cotton consumers reneged on contracts when prices fell substantially. As a result, several commodity trading firms suffered large losses in cotton that had materially adverse effects on their overall financial performance. Contract performance has also been an issue in sales of iron ore and coal to Chinese and Indian buyers: this has tended to result in traders dealing with such buyers only on a spot basis. Market Liquidity Risk. Commodity trading (including specifically hedging) frequently requires firms to enter and exit positions quickly. Trading risks are lower, to the extent that it is possible to enter and exit without having a large, adverse impact on prices. That is, trading is less risky, and cheaper, in liquid markets. 15
Liquidity can vary across commodities; e.g., oil derivative markets are substantially more liquid than coal or power derivatives markets. Moreover, liquidity can vary randomly and substantially over time. Liquidity can decline precipitously, particularly during stressed market periods. Since market stresses can also necessitate firms to change positions (e.g., to sell off inventory and liquidate the associated hedges), firms can suffer large losses in attempting to implement these changes when markets are illiquid and hence their purchases tend to drive prices up and their sales tend to drive prices down. There are liquidity risks for funding, in markets, and when hedging As frequent traders, commodity trading firms are highly sensitive to variations in market liquidity. Declines in liquidity are particularly costly to trading firms. Moreover, firms that engage in dynamic trading strategies (such as strategies to hedge financial or real options positions) are especially vulnerable to declines in market liquidity. Furthermore, to the extent that declines in liquidity are associated with (or caused by) market developments that can threaten commodity traders with financial distress, as can occur during financial crises, for instance, liquidity is a form of wrong way risk: under these conditions, firms may have to adjust trading positions substantially precisely when the costs of doing so are high. Funding Liquidity Risk. Traditional commodity merchandising is highly dependent on access to financing. Many transformations (e.g., shipping a cargo of oil on a very large cruise carrier are heavily leveraged (often 100%) against the security of the value of the commodity. A commodity trading firm deprived of the ability to finance the acquisition of commodities to transport, store, or process cannot continue to operate. Risk management activities can also require access to funding liquidity. A firm that hedges a cargo of oil it has purchased by selling oil futures experiences fluctuating needs for (and availability) of cash due to the margining process in futures. If prices rise, the cargo rises in value but that additional value is not immediately realized in cash. 5 The short futures position suffers a loss as a result of that price increase, and the firm must immediately cover that loss of value by making a variation margin payment. Thus, even if the mark-to-market values of the hedge and the cargo move together in lockstep, the cash flows on the positions are mismatched. Maintaining the hedge requires the firm to have access to funding to bridge this gap. Firms can suffer funding liquidity problems due to idiosyncratic factors or market-wide developments. As an example of the first, a firm that suffers an adverse shock to its balance sheet (due to a speculative loss, for instance) may lose access to funding due to fears that it may be insolvent. As an example of the second, a shock to the balance sheets of traditional sources of funding (e.g., a financial crisis that impairs the ability of banks to extend credit) can reduce the financing available to commodity firms. Funding liquidity is often correlated with market liquidity, and these types of liquidity can interact. Stressed conditions in financial markets typically result in declines of both market liquidity and funding liquidity. Relatedly, stresses in funding markets are often associated with large price movements that lead to greater variation margin payments that increase financing needs. Moreover, declines in market liquidity make it more costly for firms to exit positions, leading them to hold positions longer; this increases funding needs, or requires the termination of other positions (perhaps in more liquid markets) to reduce funding demands. Commodity trading in territories with a weak rule of law Currency Risk. Most commodity trading takes place in US dollars, but traders buy and/or sell some commodities in local currency. This exposes them to exchange rate fluctuations. Political Risk. Commodities are produced, and to some degree consumed, in countries with political and legal systems characterized by a weak rule of law. Commodity trading firms that operate in these jurisdictions are exposed to various risks not present in OECD countries. These include, inter alia, the risk of expropriation of assets; the risk of arbitrary changes in contract terms at which the firms have agreed to purchase or sell commodities; and outright bans on exports. Such risks exist in OECD economies as well, though to a lesser degree. For instance, OECD countries sometimes intervene in commodity markets in attempts to influence prices. Thus, there is a continuum of political risks, and although some countries pose very high levels of such risk, it is not absent in any jurisdiction. 5 Inventories financed with traditional transactional bank credit are typically marked to market on a weekly basis. If the price rises over a week, the funding bank increases the amount loaned, whereas if the price falls, the inventory owner/borrower pays down some of the loan. 16
SECTION II Legal/Reputational Risk. Various aspects of commodity trading give rise to legal and reputational risks for commodity trading firms. Many commodities are potential environmental hazards, and firms are subject to legal sanctions (including criminal ones) if their mishandling of a commodity leads to environmental damage. These risks can be very large, particularly in oil transportation. Note the 200 million euro fine imposed on Total arising from the Erika incident, or Exxon s massive liability in the Exxon Valdez spill; although these are not commodity trading firms, firms that engage in oil transportation are exposed to such risks. One commodity trading firm, Trafigura, paid a large monetary settlement and suffered substantial reputational damage when slops produced when cleaning a tanker that it had chartered, the Probo Koala, were disposed of improperly by an independent contractor, causing some people exposed to the slops to fall ill. Many commodities pose potential environmental hazards Legal sanctions and reputational damage can be substantial Furthermore, commodity trading firms frequently operate in countries in which corruption is rife, making the firms vulnerable to running afoul of anti-corruption laws in the United States, Europe, and elsewhere. 6 Moreover, commodities are sometimes the subject of trade sanctions. Since these sanctions create price disparities of the type that commodity firms routinely profit from they create an enticement for trading firms to attempt to evade the sanctions. As a final example, commodity trading firms may have opportunities to exercise market power in commodity markets; indeed, their expertise regarding the economic frictions in transformation processes that make such kinds of activities profitable and their size make them almost uniquely positioned to do so. The exercise of market power in this way is sometimes referred to as manipulation, or cornering: such actions cause prices to diverge from their fundamental values and leads to distortions in commodity flows. There are recent examples in which commodity traders have been accused of each of the foregoing legal transgressions. This has exposed these firms to legal sanctions and reputational damage. These risks can be substantial. For instance in late-june, 2012 a class action was filed in the United States accusing one major commodity merchant, Louis Dreyfus (and its Allenberg subsidiary), with cornering cotton futures contracts in May and June 2011. 7 Although the accused firm has vigorously denied the allegation, the potential exposure is large (in the hundreds of million dollars) and is therefore a material risk that illustrates the potential for contingent liabilities arising from manipulation claims. Given the current environment in which manipulation generally, and commodity manipulation specifically, is the subject of considerable political and regulatory attention, this is a real risk attendant to commodity trading, and likely a growing one. 8 Note specifically recent allegations of manipulation involving LME metal warehousing and Brent crude oil. 9 Even though manipulation is difficult to prove in legal proceedings, allegations are increasingly common, costly for the accused to defend, and can result in serious reputational damage even if the allegations are not proven in court. B. RISK MANAGEMENT Commodity trading firms universally emphasize their expertise in risk management, and the importance that they place on managing risks (price risks in particular). They utilize a variety of tools to achieve risk control objectives. Most notable among these are hedging using derivatives (e.g., selling crude oil futures or a crude oil swap to hedge a cargo of crude oil) and diversification across commodities and integration of different links in the value chain. As noted above, hedging transforms the nature of a firm s risk exposure from flat price risk to basis risk. These basis risks can be material, also as noted above. Diversification across commodities makes firm financial performance less dependent on idiosyncratic events in any particular commodity. Given the nature of commodities, particular markets or submarkets are prone to large shocks that can seriously impair the profitability of operating in those markets. Diversification is a way of reducing the overall riskiness of a commodity trading firm. This is particularly important for privately-held firms that have limited ability to pass idiosyncratic risks onto diversified shareholders. 6 For instance, ADM recently agreed to pay a fine of $54 million to settle charges that it bribed Ukrainian government officials. Gregory Meyer, ADM to pay $54 million to settle bribery charges, Financial Times, 20 December, 2013. 7 In re Term Commodities Cotton Futures Litigation 12-cv-5126 (ALC) (KNF) (SDNY). Term Commodities is a subsidiary of Louis Dreyfus. Louis Dreyfus BV and Allenberg Cotton (another Louis Dreyfus subsidiary) are also named defendants. 8 There are examples of commodity trading firms paying large sums to settle claims of market manipulation. These include Ferruzzi (in soybeans) and Sumitomo (in copper). 9 Morgan Stanley, Phibro, Trafigura and Vitol are also defendants in the Brent lawsuit. Kevin McDonnel et al v. Royal Dutch Shell PLC et al, 1;13-cv-07089-UA (SDNY). 17
reduce risk by Most large trading firms are widely diversified. Many smaller firms are more specialized, and less diversified. The latter are obviously more vulnerable to adverse developments in a particular market. To quantify the potential benefits of diversification, I have evaluated data on world trade flows by commodity code. Specifically, I have collected data on world imports and exports of 28 major commodities for the 2001-2011 period from the International Trade Centre UNCTAD/WTO. 10 Using this data, I calculate correlations in annual world imports and exports across these 28 commodities. I calculate two sets of correlations between percentage changes in trade flows across commodities. The first set is based on nominal trade flows, measured in US dollars. The second set is based on deflated trade flows. To calculate deflated traded flows, I divide the nominal trade flow in a given year by the nominal price of the commodity in question, scaled so that the 2001 value is 1.00. 11 The deflated trade flow is a measure of the quantity (e.g., barrels of oil or tons of coal) of each commodity traded in a given year. Correlations of nominal trade flows across commodities are generally positive. The median nominal import and export correlation is close to 50%. However, deflated trade flow percentage changes exhibit much lower correlations. The median correlation for deflated import percentage changes is.065, and the median correlation for deflated export percentage changes is.031. Approximately 40% of the correlations based on the deflated flows are negative. As noted elsewhere, the derived demand for the services of commodity trading firms, and their profitability, is dependent on the quantities of commodities traded, rather than prices. Therefore, the correlations based on deflated data are more relevant for evaluating the potential benefits to the firms of diversification across commodities. The lack of correlation generally, and the prevalence of negative correlations indicate the potential benefits of diversification across commodities in reducing the variability of trading firm risk. Integration in the value chain can reduce overall risk Diversification can also reduce a trading firm s exposure to basis risk. Dealing in multiple commodities diversifies away basis risk to the extent that basis movements exhibit little correlation across commodities. Integration in the value chain also tends to reduce risk. As noted earlier, there can be self-hedges in the value chain, as in the case of storage on the one hand and throughput-driven segments on the other. Moreover, shocks at one level of the value chain often have offsetting effects (or at least, cushioning effects) at others. For instance, a supply shock upstream that raises prices of raw materials tends to depress processing margins. Integrating upstream and processing assets can stabilize overall margins, thereby reducing risk. Again, this is particularly useful for privately held firms that cannot readily pass on risks through the equity market, or for firms subject to other financing frictions. Moreover, it is more valuable across segments of the marketing chain where markets are not available to manage price risk at these stages of the chain, or these markets are relatively illiquid (e.g., iron ore, alumina and bauxite, or coal). Diversification and integration are primarily useful in managing risks idiosyncratic to particular commodities or commodity submarkets, e.g., a drought that affects wheat production and hence prices. They are less effective at mitigating systematic shocks that affect all commodity markets, e.g., a global financial crisis, or a decline in Chinese growth (because China is a major importer of all important commodities). 12 Although commodity trading firms emphasize their risk management orientation and prowess, they have considerable discretion in their ability to manage and assume risks. Risk measurement is a crucial component of risk management. Most commodity trading firms utilize Value-at-Risk as a risk measurement tool. The limitations of this measure are well known. In particular, commodity trading firms incur model risk (including risks 10 The commodities included are listed in Appendix A. The data was accessed using the ITC s Trade Map system. 11 The nominal price for each commodity is based on data provided in the World Bank Commodity Price Data (Pink Sheet) annual average commodity prices. For commodities (such as oil, coal, or wheat) where there are multiple varieties or grades reported (e.g., Brent and WTI; Australian, Columbian, and South African coal), I utilize the simple average of the 2001=1.00 deflators. 12 There are some exceptions. As noted previously, some commodity trading activities like storage are profitable when commodity demand is low even though such demand shocks tend to reduce the profitability of other trading company operations. 18
SECTION II associated with the estimation of parameter inputs). Such model risks have been implicated in large losses in virtually every market and type of trading firm (e.g., banks, hedge funds), and they must be considered a serious concern for trading firms as well, especially given the fact that these firms have extensive involvement in commodities and markets for which pricing, volatility, and correlation information is particularly scarce (especially in comparison to financial markets). Given the importance of the subject, I now turn from this more general discussion of risk management to a more detailed analysis that focuses on risk management at Trafigura. 19
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SECTION III III. RISK MANAGEMENT BY COMMODITY TRADING FIRMS SUMMARY This section examines risk management systems and processes in one company to develop a more granular picture. Risk management at Trafigura is highly centralized. A Chief Risk Officer has overall responsibility. A Risk Committee and a Derivatives Trading Committee assess risk concentrations and set limits. Trading desks operate within centrally determined parameters. Outright market price risks are almost always hedged via futures or swaps. Basis risks are managed in financial markets. Hedges are executed through an internal broker and overall risk is consolidated at Group level. Trafigura has invested $550 million over the last three years in risk management and measurement systems. are usually less highly leveraged The company s Value-at-Risk (VaR) model combines 5,000 risk factors to assess net exposure. It uses Monte-Carlo simulations to predict P&L outcomes in multiple scenarios. Its VaR target is 95% confidence that its maximum one-day loss is less than 1% of Group equity. Trafigura augments its VaR data with stress tests and analysis that estimate P&L outcomes in extreme scenarios. Trafigura s enhanced VaR analysis addresses many, but not all, of VaR s deficiencies. The company therefore supplements this analysis with qualitative assessment. Trafigura has experienced a low rate of credit losses in its history. A formal process assigns a credit limit for each counterparty. It typically bears less than 20% of trading counterparty credit risk and transfers the remainder to financial institutions. The company manages liquidity risk by diversifying types of funding and providers of funding. Trafigura manages freight risk using Forward Freight Agreements and fuel swaps. It manages operational risks through a combination of liability insurance, best practice procedures, and Group-wide quality controls. It has a comprehensive framework for health, safety, environmental, and community (HSEC) performance. The company and its subsidiary Galena Asset Management also engage in speculative paper trading. This takes advantage of Trafigura s industry knowledge. Traders deal in calendar and intra-market spreads; they have very little exposure to flat price risk. A. INTRODUCTION Trading firms have always been at the forefront of the management of commodity price risk. This fact was recognized by one of the first great scholars of futures markets, Holbrook Working. Working noted that open interest in futures markets (the number of outstanding contracts) varied with the amount of a crop that was in the hands of merchandisers. Open interest was bigger for commodities like wheat that was largely marketed, rather than held by farmers to feed livestock, than it was for corn, which was held by farmers as a feed grain in far larger proportion. Similarly, Working noted that the seasonal patterns in open interest matched crop marketing patterns, with open interest reaching its maximum some time after the harvest, and hence after farmers had sold the crop to merchandisers. From these facts, Working concluded that commodity merchants who transformed wheat, corn, and cotton in space and time were the primary users of futures contracts, and that they used these contracts to hedge their risk. Commodity trading firms remain major users of futures contracts, and other derivatives contracts, as a centerpiece of their risk management programs. Viewing logistics, storage, and other transformations as their core businesses, they do not have a comparative advantage in bearing flat price risks. As a result, they hedge most price risks using exchange traded ( listed ) or over-the-counter derivatives. 21
management is representative of the industry Risk management is highly centralized Quantitative data is critical Qualitative information is also important Market price risks are always hedged where possible Although as a general rule commodity trading firms are hedgers, firms have different risk management policies, pursue different risk management strategies, and have different risk management procedures in place. Moreover, although commodity price risk is arguably the largest risk for most trading firms, other risks, notably credit and operational risks, are also material and involve their own company-specific policies, procedures, and strategies. Therefore, it is impractical to characterize in detail risk management by commodity traders generally, and I focus on Trafigura as a representative example of how commodity traders manage risk. A review of the disclosures of some publicly traded commodity trading firms suggests that Trafigura s approach to risk management is broadly representative of major commodity firms generally. B. THE RISK MANAGEMENT PROCESS Risk management in Trafigura is highly centralized. The company has a Chief Risk Officer ( CRO ) who reports directly to the Chief Operating Officer ( COO ) and the Management Board. The CRO is a member of the Risk Committee, which also includes company directors and senior traders. The Committee meets regularly to assess and manage risk exposures, and to adjust strategies in light of prevailing market conditions. The CRO performs functions such as overseeing the refinement of risk models, the review and testing of model performance, and reviewing exposures across businesses. The CRO is independent of the front office revenue generating operations of the company. Trafigura also has a Derivatives Trading Committee that is responsible for implementing the company s risk management policies. It evaluates risk limits and concentrations, and monitors markets to identify emerging risks and opportunities. This process is highly dependent on the collection, analysis, and distribution of information regarding risks. Some of this information is hard data on positions in both physical commodities and derivatives contracts. Other hard information includes data on current and historical prices of the commodities that Trafigura trades, and models to analyze this data: I discuss risk measurement and risk modeling in more detail below. Using these data and analytics, the firm produces quantitative measures of overall risk exposure, and the risks of individual trading books. The company establishes limits on these quantitative risk measures, both on a firm-wide basis and for each individual trading team. A team is notified when its measured risk approaches its assigned limit. Given the number of commodities that Trafigura trades, and the large number of prices (e.g., spot prices of various varieties of oil at various locations, futures prices for different maturities) collecting, storing, distributing, and analyzing this hard information is an extremely computationally and information technology intensive process. Largely as a result of the computational demands of the risk management process, Trafigura has spent $550 million on information technology hardware and software in the past three years. This is an overhead expense, and from the perspective of the industry overall, expenditures on risk management information technology creates a scale and scope economy that tends to favor consolidation of the industry into a smaller group of large firms, and which makes it more difficult for smaller and more specialized firms to compete. The increasing data and analytical intensity of trading and risk measurement modeling is tending to increase the degree of these scale and scope economies. Other information is softer, more qualitative information about market conditions and market dynamics. Trading desks constantly active in the market obtain this information, and provide it to the CRO, the Risk Committee and the Derivatives Trading Committee. The CRO, the Risk Committee, the Derivatives Trading Committee and the Trading Desks collaborate to integrate, interpret, and analyze this information. They then utilize this analysis to assess and manage risks. C. MANAGING FLAT PRICE RISK AND BASIS RISK It is standard practice at Trafigura to hedge market price risks where possible. Indeed, hedging is required under the terms of some transactional financing arrangements. In the past (prior to 2007) the bank providing funding for a transaction controlled the hedge through a tripartite agreement (TPA) between it, the brokerage firm, and the client; this arrangement is still utilized for smaller and medium sized-traders. In this arrangement the bank has a security interest in the portfolio of derivatives and the product being hedged (e.g., a cargo of crude oil), and finances the margin calls on the futures. At present, however, Trafigura (and other larger traders) do not utilize this TPA mechanism, as it is operationally and administratively cumbersome. Instead, although the bank lending against a physical position has a security interest against that inventory, and adjusts the 22
SECTION III financing on a weekly basis (or perhaps more frequently under volatile conditions), it has no interest in, or even view of, the futures or swap position used to hedge. Instead, Trafigura and other traders operating in this way endeavor to hedge all the risk via futures or swaps, self-finance the initial margins (mainly out of corporate lines), and also finance any mismatches in variation margin payments: mismatches arise because futures (and some swaps) are marked to market daily, which results in daily variation margin payments, but as just noted normally the bank lending against inventory only marks its value to market on a weekly basis. In addition to hedging inventories, Trafigura also routinely hedges future physical transactions. For instance, it may enter into an agreement to purchase crude from West Africa for delivery in two months at the Brent price plus/minus a differential, and enter into another contract to sell that cargo to a US refiner at the West Texas Intermediate price plus/ minus a differential. This set of transactions exposes the company to fluctuations in the Brent-WTI differential, which it can, and routinely does, hedge by buying Brent futures and selling WTI futures. This type of transaction receives different accounting treatment than a hedge of a physical inventory. Whereas the derivatives position associated with the physical inventory is accounted for as a hedge, the derivatives used to hedge the forward floating price transactions are put in the trading book. These positions can represent a substantial fraction of Trafigura s total net notional derivatives positions. For instance, as of September 30, 2011, the notional value of derivatives held for trading purposes represented approximately 45% of the total notional amount of Trafigura s derivatives. 1 Although as discussed later some of the derivatives held for trading purposes are fairly characterized as speculative (though mainly involving speculation on price differentials rather than flat prices), most are entered for the purpose of managing price risks. The hedging process is rather mechanical and centralized. When the price on a physical trade (e.g., the purchase of a physical oil cargo) is fixed, the Deals Desk initiates a hedge. The hedge is executed through a broker by the central execution desk of Trafigura Derivatives Limited (TDL): all hedges are also centrally booked through TDL, which acts as an internal broker for the group. There is thus a separation of the execution of physical trades from the management of the market price risk associated with those trades, and the risk management function is centralized. Trafigura primarily utilizes futures and swaps to manage its risks. For instance, it typically hedges the purchase of a cargo of crude oil by selling oil futures or an oil swap. Options can be used to manage risk as well, but Trafigura does not use them extensively in its hedging program. 2 Due to differences between the characteristics of the commodity being hedged, and the hedging instruments, no hedge is perfect, and Trafigura bears some residual risk. For instance, hedging a cargo of Nigerian crude with Brent crude futures or WTI crude futures involves a mismatch in quality, location, and timing. Since these factors influence price, mismatches cause the prices of the hedge instrument and the commodity being hedged not to move in lockstep. Trafigura is at risk to changes in the difference between the price of the hedged commodity and the hedge instrument. This difference the basis is variable, due to this differential movement in prices arising from the mismatches. Thus, a hedger like Trafigura is exposed to basis risk, and hedging involves the substitution of basis risk for flat price risk. Since the prices of hedging instruments and the commodities hedged are correlated, however, basis risk is typically substantially less than flat price risk. Future physical transactions are routinely hedged Hedges are executed centrally through an internal broker futures and swaps to manage risk The amount of basis risk differs by commodity. For instance, whereas copper cathodes stored in an LME warehouse can be hedged quite effectively using LME copper futures, copper concentrates can be hedged less effectively. The copper content in the concentrate can be hedged, because many contracts for the sale of concentrates specify that one component of the price will be based on copper content and the LME price: the LME price risk can be hedged. But the other components of the price, notably treatment and refining charges, cannot be hedged, and are a source of basis risk. Basis risk can also vary over time. For instance, the basis tends to be more volatile when inventories are low. Changes in the severity of constraints can also affect the variability 1 Base Prospectus, Trafigura Funding S.A. (14 November, 2013) F-31-F-33. 2 This illustrates that the firm aims to eliminate flat price exposure, because an option hedge leaves a (one-sided) exposure. For instance, a firm can hedge a cargo of crude against price declines by buying an oil put. This protects the firm against price declines, but allows it to profit from price increases. Thus, an option hedge retains a price exposure, and due to its one-sided nature this hedge is costly: the firm must pay a premium to purchase the put. If the firm s objective is to eliminate price exposure, it can avoid this cost by merely selling futures as a hedge. 23
It uses its market knowledge to manage basis relationships overall risk is reduced through It monitors Value-at-Risk of the basis. For instance, the basis tends to be more variable when transportation capacity is tightly constrained than when it is not. As an extreme example, the basis between WTI at Cushing, Oklahoma and the prices of crude oil at the Gulf of Mexico exhibited relatively little variability when the main flow of oil was from the Gulf to the Midcontinent and there was abundant pipeline transport capacity. When oil went into surplus at Cushing, and there was no pipeline capacity to ship it to the Gulf, the basis became more variable. Trafigura manages basis risk using its knowledge of the relationships between prices of related but different commodities. Moreover, just as Holbrook Working described in his writing on hedging by commodity traders in the 1950s, the traders use their marketplace knowledge to try to predict future basis movements, and place their hedges to earn a profit from a favorable movements in the basis. Thus, to the extent that Trafigura speculates, most of its speculation is on basis relationships. The underlying physical transactions and the hedges associated therewith are included in the company s centralized risk measurement system (described below). The basis risk on a trading book s position contributes to the overall risk of the firm. Moreover, the risk measurement system calculates the risk associated with a trading desk s positions, and the trading desk is subject to risk limits: its measured risk cannot exceed the assigned limit. Furthermore, trades are marked to market on a daily basis based on proprietary forward curves produced by the Risk Control Group, and exception reports are generated when a position incurs a change in value in excess of $50,000. Traders have to explain the reason for the exception to senior management. Although traders attempt to manage basis risk through judicious design of hedges, this risk cannot be eliminated. However, to the extent that basis movements are uncorrelated across different transactions, this risk can be reduced through diversification. In particular, given that basis movements in different commodities (e.g., oil and copper) are driven by different fundamentals, they are likely to exhibit little correlation, and hence a firm that trades a diversified portfolio of commodities can reduce risk exposure. This provides an advantage to larger firms that participate in a variety of different commodities, engage in a variety of transformations, and trade in many geographic markets. D. RISK MEASUREMENT With respect to market price risks, a trading company such as Trafigura can be viewed as a portfolio of positions in a myriad of physical commodities and financial derivatives contracts (including futures contracts and swaps). Given information about the variability of the prices associated with individual positions, and the covariation between these prices, it is possible to compute various measures of the risk of the overall portfolio. Consistent with standard industry practice for trading generally (not just commodity trading), Trafigura employs Value-at-Risk ( VaR ) as its measure of the overall price risk of its portfolio of physical and derivatives trading positions. Value-at-Risk is defined as the amount of money, or more, that can be lost over a given time horizon with a given probability. Implementation of VaR requires the user to choose a probability level, and a time horizon. Consistent with standard industry practice, Trafigura uses a one-day time horizon, and a 95% probability ( confidence ) level. As of 30 September, 2013, Trafigura reported its VaR as $11.3 million. This means that on 95% of trading days, the company would be expected to suffer losses of less than $11.3 million. Put differently, on 5% of trading days, the firm could expect to lose more than $11.3 million. Its risk analysis examines extreme scenarios As noted above, the company has established a VaR target. Specifically, the firm attempts to maintain VaR at less than 1% of group equity. Using equity to set the target reflects the fact that capital represents loss bearing capacity. Thus, the company compares the risk of loss, as measured by VaR, to its risk bearing capacity. Again consistent with standard industry practice, Trafigura uses a simulation ( Monte Carlo ) method to calculate VaR. In particular, it uses a variant on the industry standard historical simulation VaR method. That is, it randomly draws changes in the prices of instruments in its portfolio from historical data. The company s VaR system currently takes into account over 5,000 risk factors. These include the forward prices for the commodities the firm trades, interest rates, foreign exchange rates, and equity prices. Based on these simulated price movements, the profits/losses on each position in the portfolio are calculated and then added to determine the simulated profit/loss on the entire portfolio. It makes many such random draws: there is one portfolio profit per simulation. 24
SECTION III The standard approach in the industry is to rank the many simulated profit/loss outcomes, and to set and the 5% VaR equal to the level of loss such that 95% of the simulations have a smaller loss (bigger profit), and 5% of the simulations have a bigger loss: the approach can be applied to other confidence levels. This is acceptable for calculating VaR, but as will be discussed in more detail below, it is important for trading companies to understand the likelihood of outcomes that are more extreme than the VaR. That is, it is important to understand what happens in the left tail of the probability distribution of possible outcomes. Due to the relative rarity of such extreme outcomes, historical simulations will produce few observations, making it difficult to achieve such an understanding based on historical simulation alone. Therefore, Trafigura adds another step. It uses the simulated profit-and-loss outcomes to fit heavy-tailed probability distributions for portfolio P&L. Heavy-tailed distributions (such as Generalized Hyperbolic Distributions) take into account that extreme outcomes which are of central importance to determining the risk of a trading operation occur more frequently than under the Gaussian (Normal) distribution (the standard bell-curve widely used in statistics, and which is the basis of standard derivatives pricing models such as the Black-Scholes equation). Trafigura uses the heavy-tailed distribution fitted to the portfolio profit and loss simulation outcomes to calculate VaR, and to calculate other measures of risk that focus on extreme losses (i.e., losses in excess of VaR): these measures are discussed below. This historical methodology has decided advantages over alternative methods, most notably parametric methods that require the choice of particular probability distributions (like the normal distribution) that may fail to capture salient features of price behavior. If large price moves are more common in the data than the standard probability distributions would imply, the historical method will capture that behavior, especially if the method is augmented by using the simulated outcomes to fit heavy-tailed probability distributions. Moreover, the historical simulation captures dependencies between the changes in different prices (of which there are many: recall that Trafigura s VaR is based on 5,000 different risk factors) that are not well-characterized by standard probability distributions, and which would be daunting to estimate parametrically in any event. 3 The company regularly re-calibrates and back-tests its VaR model. Risks that perform poorly in back-tests are subjected to thorough review involving extensive discussions with traders operating that market. The most problematic feature of historical VaR simulations is that the user is a prisoner of the historical data: current conditions may not be well characterized by past conditions. Moreover, since conditions change over time, not all historical data is equally informative about current risk conditions, and it is a non-trivial problem to determine which data is most representative of current circumstances. This is particularly true inasmuch as Trafigura trades so many markets, and it is likely that current conditions in market A may match time period X well, but conditions in market B may match another period Y better. Trafigura has devoted considerable resources to developing analytic techniques to choose the historical data that is most representative of current conditions, but even the best techniques are imperfect, and what s more, major economic shocks can render current circumstances completely different than anything in the historical record. For example, price movements during the 2007-2008 Financial Crisis were far outside anything experienced in the historical data used by firms to calculate VaR at that time. In part for this reason, VaR is increasingly being augmented by stress tests that estimate possible losses under extreme scenarios that may not be present in the historical data. Stress tests are useful in identifying vulnerabilities, and stress scenarios can be constructed that match current conditions and current risks. Pursuant to US regulatory requirements, Trafigura does perform stress tests on the funds of its subsidiary, Galena Asset Management. It does not perform stress tests on the entire Trafigura portfolio due to its diversity and complexity, and due to the difficulty of establishing realistic stress scenarios. Instead, to achieve a better understanding of its downside risk exposure under extreme outcomes, Trafigura and many other companies in commodity and financial trading augment VaR with other methods: in particular, methods that quantify how large might be the losses 3 Parametric methods face two difficult problems. The first is the sheer number of correlations that need to be estimated. For a large portfolio with 5,000 risk factors, it is necessary to estimate almost 12.5 million correlations, or find a way of reducing the dimensionality of the problem, knowing that any such reduction inherently suppresses information. The second is estimating these parameters accurately, especially since they can change dramatically over time. Historical simulation has advantages over theoretical models but the future may be different from the past Conditional Value-at-Risk losses 25
a firm could incur, if the loss is bigger than its VaR. An increasingly common measure is Conditional VaR ( CVaR, also referred to as excess loss, expected shortfall, and tail VaR ). This measure takes the average of losses in excess of VaR. It therefore takes into account all large losses, and presents a more complete measure of downside risks in a trading book. Trafigura estimates CVaR using the heavy-tailed probability distributions fitted to the profits and losses generated by the historical simulations. The cost of implementing risk measurement gives economies of scale Another approach to measuring extreme risks that is employed by Trafigura is Extreme Value Analysis. 4 This permits the company to estimate the probability of more extreme outcomes with losses substantially greater than VaR. Although these methods represent a substantial improvement on VaR, they are still dependent on the historical data used to calculate these additional risk measures. Risk relates to the future, but every known measure of risk relies on what happened in the past. As a consequence, any and all risk metrics are themselves a source of risk. 5 All of these methods are very computationally and data intensive, especially for a large trading firm such as Trafigura that operates in many markets. The cost of implementing a state-of-the-art risk measurement system is another source of scale economies that tend to favor the survival of large firms, and it undermines undermine the economic viability of small-to-medium sized firms. VaR is by far the most widely employed measure of market price risk, but years of experience and research (much undertaken by academics) have identified various deficiencies in VaR as a risk measure over and above the problem inherent in relying on historical data: some of these deficiencies also plague other measures such as CVaR. Liquidity risk is not well captured by Value-at-Risk use similar models it reinforces trends Quantitative risk modeling has to be supplemented One problem is that the short-time horizon conventionally employed (e.g., the one-day horizon that Trafigura and many others utilize) does not permit the estimation of losses over longer time horizons. This is especially relevant because of another factor not well captured by VaR: the liquidity of positions in the trading book, where by liquidity I mean the ease and cost of exiting positions, with illiquid positions being more costly and time-consuming to offset. The fact that a firm like Trafigura may hold positions in illiquid instruments that may take some time to reduce or eliminate means that such longer time periods are relevant in assessing overall risk, and the adequacy of capital to absorb these risks: simple time scaling rules are typically subject to considerable inaccuracy. One other issue relating to the use of VaR deserves comment. Specifically, when many firms in a sector utilize VaR and weight recent data more heavily, another problem arises: Procyclicality. 6 This is best illustrated by an example. If oil prices become more volatile, firms using VaR to measure risk will calculate that their risk exposures have increased. This is likely to induce some, and perhaps all, of these firms to try to reduce their risk exposures by offsetting positions. The attempt of a large number of firms to do this simultaneously can cause prices to move yet more, increasing measured volatility, increasing VaR, causing further reductions in position, and so on. Such feedback loops can be destabilizing, and are often observed during periods of market turbulence: working through the VaR channel, turbulence begets position changes that beget more turbulence. In sum, Trafigura uses a heavily augmented version of the Value-at-Risk approach that is the standard way to measure risk in commodity and financial trading. The enhancements implemented by Trafigura address many of the well-known deficiencies of VaR, but some deficiencies remain, and there are no readily available remedies for them, despite concerted efforts in industry and academia to develop them. It will likely never be possible to quantify future risk exactly, especially since risk quantification inherently relies on historical data. Thus, quantitative risk modeling must be supplemented by more qualitative judgments about risk, and model risk should be backed by capital just like price or credit risks. 4 See, for instance, Rolf-Dieter Reiss and Michael Thomas, Statistical Analysis of Extreme Values (2007). 5 Risk measurement is also substantially more complicated for portfolios that include a large number of non-linear exposures, such as those that arise from options. Non-linear exposures are more difficult and computationally expensive to value accurately. Moreover, non-linear exposures depend on risk factors such as volatilities, so the number of risk factors in portfolios with options is substantially greater than is the case with portfolios that do not have options. Since Trafigura trades relatively few options, this is not a major consideration for the firm. 6 Tobias Adrian and Hyun Song Shin, Procyclical Leverage and Value-at-Risk, 27 Review of Financial Studies (2014) 373. Jon Danielsson and Hyun Song Shin, Endogenous Risk, Working Paper (2002). 26
SECTION III E. MANAGING CREDIT RISK Trafigura is at risk of loss resulting from the failure of a trading counterparty (either in a physical trade or a trade in a financial contract) to perform on its contract with the firm. Counterparties include those to whom Trafigura sells physical commodities, and firms from which it buys them. Counterparties also include hedge counterparties, which are typically prime financial institutions or large physical participants (e.g., a multinational oil company). Finally, counterparties include those providing payment guarantees or other credit risk mitigants that are used to manage counterparty risks. Trafigura uses a variety of methods to manage the credit risk that arises from transacting with these diverse counterparties. Specifically, it implements a formal credit process. Based on financial information, it establishes credit limits for each counterparty. This information includes historic payment performance information and creditor financial statements, as well as soft information about the creditor s business. Tafigura also uses a system (based on the well-known Moody s KMV methodology) that creates a credit risk rating for its counterparties. This system takes into account country and industry factors as well as counterparty-specific financial information. formal credit process Credit evaluations are made by teams that specialize based on commodity and geographic region. The firm has credit officers located in crucial markets throughout the world; these individuals can utilize local knowledge and contacts to make more accurate evaluations of counterparty credit risk. Trafigura historically has experienced a very low rate of credit losses. The firm has suffered ten final credit losses since its inception in 1993. If a transaction or transactions with a counterparty would result in a credit exposure to that counterparty in excess of the credit limit assigned to it, Trafigura purchases payment guarantees or insurance from prime financial institutions (or declines to make the trade). The purchase of a guarantee transfers the credit risk associated with the counterparty to the financial institution that provides the guarantee. Trafigura typically bears between 10 and 20% of the credit risk associated with its trade counterparties, and transfers the remainder to financial institutions. Moreover, the company purchases political risk cover for any transaction in a country with a Dunn & Bradstreet rating below DB3d, and purchases such cover on a discretionary basis for exposures in countries rated between DB3a and DB3d. This transfer creates another counterparty risk: the risk that the provider of the guarantee will not perform. Trafigura manages this risk exposure through a credit review process employing a variety of types of information about the guarantee counterparties, and the establishment of exposure limits with them based on this review process. Trafigura is also concerned about credit risk concentration by individual counterparty, industry, and geographic region. It monitors these concentrations on a continuous basis. With respect to derivatives counterparties, approximately 70% of the company s trading is in listed exchange-traded products that are centrally cleared. Another 15% are centrally cleared over-the-counter transactions: these deals are cleared through the CME Group s Clearport system. Central clearing dramatically reduces counterparty credit risk. Therefore, hedge counterparty credit risk primarily arises from the 15% of its transactions that are uncleared OTC trades. These trades are executed with a large number of counterparties, consisting primarily of prime financial institutions and large physical market participants. Based on a credit review process, Trafigura assigns credit limits to each counterparty, and requires the counterparty to post collateral when the limit is exceeded. Credit limits and collateral control credit exposure to an individual counterparty, and by trading with a large number of counterparties Trafigura can obtain the hedge transactions it needs without taking on a large exposure to any counterparty, or counterparties from any region. The use of standardized contracts (ISDA Master Agreements or long-form Confirmation Agreements) with derivatives counterparties also facilitates the management of credit risk, most importantly by establishing procedures to address a credit event (such as a default or downgrade) suffered by a counterparty. The use of cleared instruments requires Trafigura to post initial margins: margins (a form of collateral) mitigate credit risk, and just as the use of cleared transactions reduces the credit risk faces from derivatives counterparties, clearing also reduces the losses that its counterparties would suffer in the event of a Trafigura default. The use of margins which It insures itself by buying payment guarantees It monitors credit risk concentrations centrally Commodity requirements 27
must be posted in cash or liquid securities to control credit risk means that achieving this objective creates demands on the liquidity of the company, and creates liquidity risk. In an important sense, margining substitutes liquidity risk for credit risk. The company s initial margins routinely total in the $700 million-$1 billion range. Trafigura funds these out of its corporate lines. Moreover, cleared derivatives positions (and some uncleared positions) are marked to market regularly (usually on a daily basis), and Trafigura must make variation margin payments on positions that suffer a mark-to-market loss. These derivatives trades are often hedges of inventory positions that are also marked to market under financing arrangements, but on a weekly (rather than daily) frequency. This mismatch in timing of marks and associated cash flows can create an additional funding need: a hedge position may suffer a loss that requires an immediate posting of margin, and although the inventory has likely realized a gain, the firm will not receive the cash payment from the bank for a period as long as a week. The firm uses its corporate lines to manage these mismatches in cash flows. F. MANAGING LIQUIDITY RISK A trading company like Trafigura is acutely dependent on access to liquidity to fund its activities. Loss of funding, or even a substantial contraction thereof, would seriously constrain the ability of the company to implement the arbitrage activities through which it generates value and earns a profit. The primary means of managing this risk include: (a) a substantial cash balance, with the cash balance varying directly with market volatility; (b) bilateral credit lines with a large number of banks to fund commodity purchases, with the volume of lines comfortably in excess of anticipated needs, to ensure that the company can finance its trading activities in the event that prices move sharply higher; (c) committed, unsecured credit lines that can be tapped to meet liquidity needs; (d) a securitization program that accelerates the receipt of cash upon delivery of commodities to buyers, thereby reducing reliance on credit lines; and (e) significant retention of earnings and subordination of equity repurchased from employees. In essence, the company manages liquidity risk by diversifying the types of funding, and diversifying the providers of each type of funding. Liquidity risks tend to be positively related to the prices of the commodities that Trafigura trades. (This is true generally for commodity trading firms.) In low price environments, funding needs are reduced. Moreover, since commodity prices often drop precipitously during financial crises (e.g., the Asian Financial Crisis of 1997-1998, or the recent 2008-2009 Financial Crisis), the secured, low-risk, and self-liquidating nature of transactional financing means that banks are willing to enter into bilateral financing arrangements even when they are sharply reducing their supply of other forms of credit. Conversely, in high-price environments, credit lines can be insufficient to fund potentially profitable trades. This is a reason to maintain credit facilities substantially in excess of current or anticipated needs. G. MANAGING FREIGHT RISK As a major charterer of ships to perform its logistical functions, Trafigura is subject to freight charter rate risks, and to fuel price risks. Once a ship is chartered and the rate fixed, the firm sells a Forward Freight Agreement to hedge against declines in charter rates. It also purchases fuel swaps to manage the risk of fuel price changes. Operational risks are managed through insurance, best practice, and compliance H. MANAGING OTHER RISKS As noted earlier in Section II, commodity traders are subject to many other risks other than price and credit risks. These include operational, logistic, environmental, and volumetric risks. The financial consequences of some risks can be transferred via insurance. The company purchases marine cargo open cover, charterers legal liability oil, charterers legal liability metals, and general liability insurance policies. These policies insure against product liability, bodily injury, and pollution. Other risks cannot be insured. Some of these must be controlled through the establishment of policies and procedures, training employees in these policies and procedures, and the close monitoring of compliance with them. Trafigura has such procedures for, inter alia, contracts, charterparties and clauses, environmental policies and legislation, insurance declarations, claims, and demurrage handling. Since environmental risks associated with transportation and storage are a particularly acute concern (due to the potentially large liability costs that a spill or other accident can cause) 28
SECTION III the firm mitigates risks by restricting its chartering of ships, railcars, trucks, and barges based on the conveyance age and design (e.g., using only double-hull tankers). Similarly, the firm inspects all storage locations. To control the risk of theft and contamination, the company routinely inspects the stocks of commodities it holds. In 2012, the company implemented a Group-wide initiative to manage health, safety, environment, and community ( HSEC ) risks. This creates a set of policies regarding these issues. Managers are accountable for implementing these policies, by, inter alia, providing resources, training employees, and measuring and reporting HSEC performance. Moreover, even prior to the formal launch of the framework, Trafigura s Management Board established an HSEC Steering Group with a mandate to: oversee HSEC compliance; revise the HSEC policies and principles based on changes in the company s operations and the market environment; analyze and measure HSEC performance; develop and oversee reporting and assurance processes; report to the Management Board on HSEC performance; and coordinate external reporting of the company s HSEC performance. The Steering Group meets bi-monthly. I. PAPER TRADING Although Trafigura primarily uses derivatives contracts to hedge the price risks, it also engages in limited speculative trading using these instruments. For instance, the crude oil team has 21 traders, four of whom engage in proprietary paper trading. This trading is subject to risk limits established by the Risk Committee. Moreover, this trading exploits the information advantages that Trafigura has as the result of its physical trading. That is, rather than taking positions that expose the firm to flat price risk, the paper trading focuses on calendar spreads (e.g., buying January Brent crude and selling March Brent crude) and inter-market spreads (e.g., Brent vs. WTI). Spreads are driven by the economics of transformations that commodity trading firms specialize in understanding and implementing. Knowledge of the economics of transformation can be employed to trade spreads profitably. There is a Group-wide framework for HSEC speculates on intra-market and calendar spreads Trafigura also engages in speculative paper trading through its Galena Asset Management arm. Galena traders have access to Trafigura s physical traders, and their information, which they can use to devise trading strategies. The information flow is one way: information flows from Trafigura traders to Galena, but Trafigura traders do not obtain information on Galena trades and positions. Nor do Galena traders know Trafigura trades and positions. Galena uses this information primarily to trade calendar and inter-market spreads, and for the same reason that Trafigura s proprietary traders do: this information is most relevant to the economics of transformations that drive spreads. 29
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SECTION IV IV. COMMODITY FIRM FINANCING, CAPITAL STRUCTURE, AND OWNERSHIP SUMMARY A CTF s capital structure depends on the scale of its operations and the size of its asset base. Leverage for the largest, most asset-heavy CTFs is similar to non-financial US corporations. Other CTFs are more highly leveraged but much less leveraged than banks. CTFs balance sheets are structured differently from banks. In general, short-term assets are funded with short-term debt and long-term assets with long-term funding. Historically, banks have been major suppliers of credit to CTFs. Fears that reduced bank funding would destabilize markets appear unfounded so far. However, bank funding may be more restricted in future. This may increase concentration in commodity trading, but the impact on trading volumes will be limited. Smaller firms are all privately owned. Private ownership aligns incentives between managers and equity owners. Some larger, more asset-heavy CTFs are publicly listed. They may require large-scale equity investments that exceed the capacity of a small group of owner-managers. Public listing allows firms to transfer risks to diversified investors. Broader market developments, including the wider availability of information, are causing some firms to become more asset-intensive. This will put increasing pressure on the private ownership model. CTFs also act as financial intermediaries for their customers through complex transactions that bundle financing, risk management and marketing services. Common structures include trade credit agreements, prefinancing, commodity prepays and tolling arrangements. Banks and other financial institutions remain, overwhelmingly, the ultimate source of credit. CTFs act as conduits between these financial institutions and their customers. A. THE FINANCING OF COMMODITY TRADING FIRMS Like all firms, commodity traders need to finance their operations. Their choices of funding strategies their capital structures influence the efficiency of their operations, and are crucial determinants of their ability to withstand economic shocks. Moreover, since the debt and equity issued by commodity trading firms connects them to the broader financial system, capital structure also determines the vulnerability of trading firms to financial market conditions including financial crises and the influence of commodity trading firms (and hence commodity market conditions) on the stability of the broader financial markets. An examination of the available information on the financing of commodity trading firms indicates that the diversity of commodity trading firm business strategies is mirrored in the diversity of their financing strategies. Firms differ in their gearing/leverage; the forms of leverage that they employ; and their ownership of their equity. Moreover, these differences in financing strategies co-vary with the kinds of transformations that firms undertake: firms that are more physical asset intensive finance themselves differently than firms that are engaged in more traditional pure trading activities. Relatedly, as the business strategies of trading firms are evolving, their financing strategies are evolving as well. differ from pure trading operations Financial statement information available for some of the largest trading firms illustrates these points. I start by looking at the leverage of trading firms. One measure of total leverage is total assets divided by book value of equity. Table 1 presents this measure for 2012 for 18 trading firms for which data are available. This ratio ranges from 2.38 (ADM) to 111 (E.On Global). The average (which is somewhat misleading, due to the presence of the outlier E.On) is 18, and the median is 4. This measure of overall leverage of commodity trading firms is somewhat higher than non-financial corporations in the United States. As of the end of the third quarter, 2013, 31
the ratio of assets to equity for such corporations was 2.06. 1 The more asset-heavy firms (e.g., Cargill, ADM, Bunge) have leverage ratios that are similar to those for the US non-financial corporations as a whole: the more asset-light firms are more heavily leveraged. Moreover, as will be discussed in more detail below, the heavier leverage of the more traditional trading firms is somewhat misleading. Much of this debt is short-term and associated with liquid, short-term assets. The net debt of these firms (total debt minus current assets, which is a better measure of their true leverage) is quite low. TABLE 1 TOTAL ASSETS/EQUITY (2012) Arcadia Energy Pte 17.51 Louis Dreyfus B.V. 3.74 Archer Daniels Midland 2.39 Mercuria Energy Trading 5.06 BP International Ltd 5.32 Noble Group 3.80 Bunge Ltd 2.51 Olam 4.02 Cargill 2.37 Shell Trading International 12.09 E.On Global 111.07 Trafigura 7.94 EDF Trading 4.56 Vitol 4.00 Eni Trading & Shipping 35.09 Wilmar 2.76 Glencore 3.08 Data from Bureau van Dijk are usually less highly leveraged Notably, trading firms are much less highly leveraged than banks, to which they are sometimes compared: some have argued that commodity trading firms should be subject to regulations similar to banks. Specifically, for US banks that have been designated Systemically Important Financial Institutions ( SIFIs ), the mean leverage is 10.4 and the median is 10. For European SIFI banks, the mean is 20.6 and the median is 22.5. There is a relationship between the leverage of commodity trading firms and characteristics of the asset side of their balance sheets. In particular, there is a strong correlation between the fixed asset intensity of commodity trading firms, and their leverage: more fixed asset (long term asset) heavy firms tend to be less leveraged. For 2012, the correlation between the ratio of fixed assets to total assets and the ratio of total assets to book value of equity (leverage) is -.55. Thus, trading firms that are asset heavy tend to be less heavily leveraged than those that are asset light. Put differently, pure trading firms that own relatively few fixed assets tend to be more highly leveraged than firms that also engage in processing or refining transformations that require investments in fixed assets. The structure of the liabilities of commodity trading firms is somewhat distinctive, and also co-varies with the structure of the asset side of their balance sheets. Specifically, short-term liabilities dominate the balance sheets of trading firms. For the 17 firms in the sample, the average of the ratio of current liabilities to total liabilities is.75: the median is.70. There is considerable variation in this ratio across firms: the minimum is.36 and the maximum is 1.00. Furthermore, there is a strong correlation between this ratio and firms fixed asset intensity. Specifically, the correlation between the ratio of current to total liabilities and the ratio of fixed (or long term) assets to total assets is -.51. Thus, firms engaged in more fixed asset intensive transformations (such as processing) have a greater proportion of long-term liabilities. There is therefore an alignment between the asset and liability structures of commodity trading firms balance sheets. Commodity trading liquidity risk than intermediaries Available balance sheet information also indicates that commodity trading firms do not engage in maturity transformation as do banks. Indeed, to the extent that commodity trading firms engage in maturity transformation, it is the reverse of the borrow short-lend long transformation that makes bank balance sheets fragile, and which makes banks (and other financial intermediaries) subject to runs and rollover risk. Specifically, for all 17 of the commodity trading firms studied, current assets exceed current liabilities. The median ratio of current assets to current liabilities is 1.26. Consequently, one measure of net debt (total liabilities minus current assets) is negative for 8 of the 17 firms. Furthermore, the median 1 Board of Governors, Federal Reserve Board, Financial Accounts of the United States, Table B.102. 9 December, 2013. This calculation is based on historical cost data, which makes it more comparable to the accounting data used to determine leverage for trading firms. Based on market values/replacement costs of non-financial assets, the ratio is somewhat smaller: 1.75. Since market values or replacement costs of trading firm assets are not available, I cannot calculate an analogous figure for them. 32
SECTION IV ratio of net debt to shareholder equity is very small, taking the value of.014. Since commodity trading firm current assets (primarily hedged inventories and trade receivables) tend to be highly liquid and/or of high credit quality (as is documented below) these figures strongly suggest that as a whole, commodity trading firms run far less liquidity risk than do financial intermediaries like banks or shadow banks. In sum, the data show an alignment between the nature of the transformation activities firms engage in, and their funding strategies. Short-term assets are funded with short-term debt, and long-term assets are funded with long-term debt. The data also show that commodity trading firms are not heavily leveraged overall, and that their balance sheets are not fragile (i.e., subject to liquidity or rollover risk). B. THE LIABILITY STRUCTURES OF COMMODITY TRADING FIRMS The foregoing conclusions are reinforced when one evaluates the specifics of commodity trading firm financing. In particular, there is a close connection between the nature of transformation activities, and how they are financed. Consider, for instance, the financing of most short-term arbitrages involving spatial transformation, storage, and blending. Firms rely extensively on bank borrowings to finance these transformation activities. In particular, they engage in large amounts of relatively short-term borrowings, including borrowings through unsecured credit lines arranged with banks, frequently through syndication arrangements. Moreover, they typically maintain bilateral credit lines with banks that can be drawn upon to fund the purchase of commodities and the issuance of credit instruments, such as letters of credit, utilized in the merchandising of commodities. These are generally used to finance each transaction at 100% of collateral values, and are marked to market periodically (e.g., weekly, or more often during periods of large price movements). They are referred to as self-liquidating because they are repaid upon the receipt of payments from the purchasers of the commodity. Given that these borrowings are secured by commodities that are often saleable in liquid markets, marked to market, and hedged, and that these exposures have relatively short maturities, they present less credit risk to the lending banks than unsecured credit, or credit secured by less liquid collateral. In the past decade, some commodity trading firms have also arranged non-traditional short-term financings that could be characterized as shadow bank transactions. 2 These include the securitization of inventories and receivables, and inventory repurchase transactions. Borrowings secured by inventories pose limited credit risk to the lender, especially to the extent that these inventories are in relatively liquid commodities (e.g., deliverable aluminum held in an LME warehouse) and are located in jurisdictions where there is little risk of perfecting legal title; borrowings secured by less liquid commodities, and in some jurisdictions, pose greater risks. Commodity receivables that back some securitization structures historically have exhibited very low rates of default, and rates of default did not rise appreciably even during the 2008-2009 crisis period. 3 Moreover, these structures do not generally exhibit the maturity mismatches that contributed to runs on the liabilities of some securitization vehicles during the financial crisis. Indeed, in some of these structures, the liabilities have longer maturities than the underlying assets, meaning that the challenge they face is replenishing the assets, rather than rolling over the liabilities. These non-bank financing vehicles may become increasingly important because broader financial trends may constrain the availability of, and raise the cost of, traditional sources of transactional financing. Historically, banks, and especially French banks, have been major suppliers of credit to commodity trading firms; five banks, three of them French, are reported to provide 75% of the commodity trade finance for Swiss-based trading firms. Deleveraging post-crisis and dollar funding constraints on European/French banks have led to a reduction in bank extensions of commodity credit. This has led to increases in funding costs and reductions in the flexibility of credit arrangements. The impending Basel III rules impose greater capital charges on commodity lending and trade finance generally, which could further reduce bank supply of commodity credit. is becoming more important 2 The earliest such transactions that I am aware of is a securitization of base metals inventories undertaken by Glencore and a securitization of receivables by Vitol in 2003. The term shadow banking is used in many different ways. Here is used to mean financial intermediation through the issuance of debt outside the insured banking system. 3 An International Chamber of Commerce study of data from 2005-2009 found that for trade credit generally (which includes not just commodity trade finance), default rates averaged.02%, and that the rate of defaults did not rise appreciably during the period of the crisis. The Offering Circular from a securitization of Trafigura receivables from 2012 reports default rates on the trading firm receivables from November, 2004-February, 2012. Default rates are less than 0.1%, and delinquency rates never exceed 2.4% and are typically less than 0.1%. 33
Fears of a large reduction in financing available from traditional sources were particularly acute in early-2012, but have abated somewhat. Moreover, according to statements by industry participants, the impact has been minimal for larger, more creditworthy trading firms. 4 Nonetheless, the seismic changes in bank regulation, and the potential for further changes going forward, mean that the traditional commodity trading funding models may not be sustainable. Thus, it is advisable to consider how commodity firms could replace reduced transactional bank funding. Reductions in traditional sources a bigger impact on A scaling back of lending by traditional suppliers of commodity finance would create opportunities for new suppliers less severely constrained (e.g., US banks with that can obtain dollar financing more readily, and non-european regional banks looking to invest export-driven dollar flows), but given the relationship-specific nature of bank lending these new suppliers would likely be less efficient than the incumbents. Moreover, global rules like Basel III will impact banks internationally. The reduction in traditional sources of credit would also encourage greater reliance on shadow bank-type funding arrangements. Any future reductions in traditional forms and sources of commodity finance would be likely to have greater impacts on smaller commodity trading firms than on the larger ones. This would tend to increase concentration in commodity trading activities. Moreover, it should be noted that some of the higher funding costs would be shifted to commodity suppliers (in the form of lower prices) and commodity consumers (in the form of higher prices): that is, higher costs will be associated with higher margins. Given the relative inelasticity of commodity supply and demand, a large fraction of these higher costs will be shifted via prices in this fashion, and the impact on commodity trading volumes will be modest. One area that deserves further study is the possibility that the reduction in traditional sources of funding for commodity trading could lead to funding squeezes during times of market stress. Traditional commodity finance has been quite flexible and responsive to market conditions. Sharp reductions in the supply of commodity financing from traditional sources would likely result in a decline in the responsiveness of the funding of commodity trading activities to extraordinary conditions in the commodity or financial markets. This could lead to funding squeezes during periods of such conditions that could lead to disruptions in commodity trading; that is, the contraction of traditional sources of commodity finance will likely increase future funding liquidity risk. Private ownership aligns incentives between owners and managers C. THE OWNERSHIP OF COMMODITY TRADING FIRMS: PUBLIC VS. PRIVATE One important aspect of the capital structure of commodity trading firms is the ownership of equity. As noted before, some commodity trading firms are listed firms with publicly traded equity, but others are private firms. Although all small commodity trading firms are private, the relationship between size and equity ownership is complex. Some very large commodity trading firms are private, while other firms that are similar in terms of size and market participation are listed, public firms. The ABCD firms provide an interesting illustration. Although these firms are broadly comparable in terms of size and breadth and depth of market segment participation, ADM and Bunge are publicly traded, but Cargill and Louis Dreyfus are private. There is thus evidently an element of indeterminacy in the choice of public or private ownership. This indeterminacy reflects fundamental trade-offs that are particularly challenging for commodity trading firms. A primary advantage of private ownership is the superior alignment of incentives between managers and equity owners. Managers who own small (or no) stake in an enterprise have an incentive to act in ways that benefit themselves, but are harmful to equity holders. For instance, they may consume excessive perquisites, invest in low-returning prestige or empire-building projects, or run ill-advised risks: the managers enjoy the benefits of these activities, but the outside investors bear the costs. In contrast, manager-owners have lower (and perhaps no) incentive to engage in these wasteful behaviors. Moreover, ownermanagers have a stronger incentive to monitor their peers, and do so more effectively, than do diffuse outside-equity owners. More generally, since owner-managers more completely internalize the costs and benefits of their decisions than do the managers of public firms, they have a stronger incentive to exert effort, control costs, manage risks, and make value-enhancing investments. 4 See, for instance, Mercuria CFO Interview: We Have Seen a Flight to Quality, Euromoney, 29 October 2013. Mercuria CFO Guillaume Vermersch said, We have seen a flight to quality. Basically, the good and strong tier 1 credits, such as Mercuria, have had the benefit of additional support and credit lines brought by the same banks that reduced their balance sheets during the crisis. My only explanation for that is that banks have probably ended tier 2 and 3 credit relationships to refocus on tier 1 companies like us. In interviews with me, Trafigura financial executives expressed similar views. 34
SECTION IV These benefits do not come for free, however. The main cost of private ownership is inefficient risk bearing. Whereas shareholders of a listed firm can diversify away the idiosyncratic (i.e., firm specific) risks of commodity trading, the owner-managers of a private firm hold a large fraction of their wealth in their enterprise, and hence cannot diversify away these idiosyncratic risks. Thus, idiosyncratic risks are more costly to bear with private ownership than public ownership. The scale and scope of a commodity trading firm s operations, and the availability of markets to transfer risk, influence the optimal trade-off between public and private ownership. Private ownership is more viable for a commodity firm that engages in activities where many of the risks outside of management control can be transferred to others via financial contracts. For instance, a firm that engages in activities that primarily involve flat price risks that can be hedged in derivatives markets (e.g., an oil trading firm) or credit risks that can be assumed by banks or insurers or casualty risks that can be insured can transfer these primary risks through financial contracts, leaving the managers to bear only risks that they can more readily control (e.g., operational risks that can be mitigated through close management oversight). Private ownership offers substantial advantages under these circumstances, because the risk bearing benefits of public equity are modest and the incentive alignment benefits of private ownership are large....and makes most sense when risks can be transferred In contrast, if a firm is engaged in an activity that involves risks that cannot be transferred by (non-equity) financial contracts, the benefits of public ownership are larger. For instance, the risks of investing in and operating a large mining or energy production project (e.g., the risks of increases in labor costs or construction costs, variability in well depletion rates) cannot be transferred (or are extremely expensive to transfer) using non-equity financial contracts. Private equity can bear these risks at modest cost if the scale of the activity is sufficiently small. However, large-scale investments (e.g., in a mine or energy exploration and production) require equity investments that are beyond the capacity of a small group of managers to finance. Thus, despite its superior incentive effects, private ownership is incompatible with the operation of large-scale assets with large exposures to risks that cannot be transferred to others by non-equity financial contracts. This suggests that more traditional asset light pure trading activities are efficiently undertaken by private firms, but that more asset heavy transformation activities (e.g., mining, crude oil production, refining and processing) must be financed in large part with public equity. This is broadly consistent with observed patterns. For instance, most small, specialized commodity trading firms are privately owned. Even the far larger, but asset light, trading firms, such as Trafigura and Vitol, are privately owned. This reflects the fact that many of the largest risks incidental to these businesses can be hedged in derivatives, credit, or insurance markets. A company that was, in many ways, similar to Trafigura and Vitol, but which integrated into more asset-intensive transformation activities (notably mining) Glencore shifted from private to public ownership in parallel with this increasing asset intensity. Notable potential exceptions include large, relatively asset-heavy firms such as Cargill and Louis Dreyfus. 5 Their choice to remain private is likely a consequence of path-dependence. These companies are old (both dating from the mid-19 th century), and have accumulated substantial retained earnings during their long history. This historical success has made internal equity finance viable: the companies can finance large projects internally, and diversify risks internally by participating in a wide variety of market segments, thereby reducing the benefits of selling equity to diversified investors. The increasing asset intensity of commodity trading firms a trend discussed in Section V is forcing some of them to evaluate their ownership structure. Trafigura is a case in point. It is transitioning from a pure trading model to a more fixed asset intensive model, and this is forcing it to adjust its financing accordingly. Heretofore it has decided to remain private, and explicitly invokes the incentive benefits of private ownership to explain its choice. The Trafigura Annual Report states: We believe [an employee owned private company] is the best ownership model for our core trading business. Other firms most notably Louis Dreyfus are actively considering going public. Public ownership works better for large, Increasing asset intensity may change ownership structures Creative financing methods (e.g., the issuance of perpetual debt) that offer some of the advantages of outside equity (e.g., no rollover risk) but which do not require the firm to go public permit can permit a firm to continue to realize the incentive benefits of private 5 I provide data on the asset-heaviness of some important commodity trading firms in Section V below. 35
There are alternatives to public listings ownership: Trafigura and Louis Dreyfus have issued perpetual bonds. 6 Moreover, Trafigura is using hybrid strategies that tap equity financing, but allow it to retain the benefits of private ownership for its core activities. Specifically, the firm has sold off equity in its Puma Energy affiliate, and may pursue a similar strategy with its Impala subsidiary in the future. Private equity stakes sold to outside groups is another way of transferring risks to nonmanagers while maintaining the incentive benefits of private ownership. As noted earlier, in recent years a variety of private equity firms have invested in commodity trading ventures. However, these alternative financing methods are inherently limited (because firm debt capacities are inherently limited due to what economists refer to as agency problems ). 7 Thus, private ownership for companies not blessed with more than a century of good fortune constrains their future strategic choices. Retention of private ownership necessarily limits the fixed asset intensity of a firm s transformation activities, and the types of risks it can run. EU-registered private companies have greater disclosure requirements This further implies that broader market developments that undermine the viability of the pure trading model (such as the greater availability of public information about prices) and that are causing some firms to become more asset intensive will put pressure on the traditional private ownership model. 8 Ownership structure and the nature of firm activities are complementary, and determined jointly. These things cannot be chosen independently. 9 The form of organization (public vs. private ownership) also has implications for public disclosure, and the amount of information that firms must reveal. In all jurisdictions, private firms like Cargill, Louis Dreyfus, and Trafigura are obligated to keep accounts and records, which must be kept according to accepted accounting principles and standards. Laws regarding what information must be disclosed vary by jurisdiction. In the United States, private companies are not obligated to disclose publicly accounts or other financial information. In the European Union, in contrast, every limited liability company (even private ones) must disclose its balance sheet, income statement, notes to its financial statements, an annual report, and an auditor s opinion: this information is available from the central register of the country where the firm is incorporated. 10 Therefore, standard financial information about companies registered in EU countries (e.g., Louis Dreyfus, Trafigura) is available, whereas the same is not true for firms incorporated in the US. Thus, although the ability to limit disclosure of financial information may influence the choice between private and public ownership in the United States, it is likely a far less important consideration in Europe. One final point on disclosure and transparency is warranted. Even privately owned firms in the United States have to provide financial information to their lenders and derivatives counterparties, and private firms anywhere can at their discretion distribute their financial information in ways similar to those used by public companies: Trafigura s recent publication of an annual report, available on its website, is an example of this. With respect to disclosures to government regulators, trading firm positions in listed derivatives are available to exchange staff and government regulators. Moreover, with new reporting regulations under Dodd-Frank in the United States and EMIR in Europe, regulators also have, or will have, access to commodity traders positions in OTC derivatives. Commodity trade credit... D. COMMODITY TRADING FIRMS AS FINANCIAL INTERMEDIARIES Not only is the funding of commodity firms an important aspect of the trading business: so is the fact that trading firms also play a role in financing the commodity trade. Specifically, firms involved in commodity trading often provide various forms of funding to their customers. Thus, these firms supply financial intermediation services to their customers. This intermediation takes the forms of traditional trade credit, and more complex structured transactions that bundle financing, risk management, and marketing services. The practice of commodity trading firms extending trade credit to those they sell to is a venerable one. These receivables (along with inventories) represent the bulk of the current assets on the balance sheets of trading firms. An established economics literature provides an explanation for the prevalence of such 6 Javier Blas, Louis Dreyfus taps bond markets for $350m, Financial Times, 6 September, 2012. Javier Blas and Jack Farchy, Trafigura raises $500m with perpetual bond, Financial Times, 10 April, 2013. 7 Jean Tirole, The Theory of Corporate Finance (2005). 8 Trends in asset intensity, and the reasons for it, are discussed in Section V. 9 Paul Milgrom and John Roberts, Economic Organization and Management (1990). 10 Jones Day, Public Disclosure Requirements for Private Companies: U.S. vs. Europe (2012). 36
SECTION IV trade financing. 11 A firm selling a commodity to a customer frequently has better information on this buyer than would a bank, due to the trading firm s intimate knowledge of the buyer s operations, how it will employ the commodity, market conditions in the buyer s region, etc. This permits the trading firm to evaluate creditworthiness better than the bank, and to monitor the creditor more effectively than the bank. Furthermore, trade credit is often less subject to opportunistic behavior by the borrower. One concern about any credit transaction is that the funds lent are diverted for other than their intended purpose. Cash is more fungible, and hence more easily diverted, than a commodity used as an input: converting the input to cash would require the buyer to incur transactions costs, transportation costs, and other expenses. Moreover, such activity is subject to risk of detection by the commodity trading firm that sold the input on credit, due to its information on commodity transactions and movements in the markets it serves. The lower susceptibility to diversion means that trade credit expands the borrowing capacity of commodity buyers. 12 Commodities are cheaper, and credit to obtain them more abundant, when commodity trading firms provide trade credit to their customers. In addition to traditional trade credit, firms involved in commodity trading (including, notably, some banks that have physical commodity trading operations) increasingly provide structured financing to their suppliers and their buyers. A common element of these structures is an off-take agreement, whereby a trading firm agrees to purchase a contractually specified quantity of a commodity (e.g., copper concentrate or gasoline) from a producer (e.g., a miner or refiner) usually at a floating price (benchmarked to some market price, plus or minus a differential). These contracts can vary in duration (e.g., a year, or multiple years) and quantity (e.g., the fraction of a mine s output, or its entire production). One common structure that utilizes an off-take is a prefinancing. Three parties are involved: a borrower (a producer), a trading company, and a bank. The producer and the trading company enter into a prepay agreement, and the bank lends money to the producer. Upon delivery of the commodity from the producer to the trading firm, the trading firm pays (some or all of) the amounts it owes under the off-take agreement to the bank to repay the loan. In this arrangement, the bank has no recourse to the trading firm (as long as it performs under the off-take agreement), and bears all the credit risk associated with the loan to the producer. Another structure is a commodity prepay. There are two major variants of this structure, but under each the trading firm and a commodity seller enter into an off-take agreement, funding is provided to the producer (the prepayment), and the terms of the off-take arrangement are set to repay the prepaid amount. and provide...that bundles and marketing activities In the first variant, the bank provides limited recourse financing to the trading firm, and the trader assigns the rights under the off-take agreement to the bank as a security. The trading firm provides funds to the producer, but the bank absorbs the credit risk on the loan, although in some instances the trading firm may keep a risk participation (e.g.,10%). In the second variant, the bank provides full recourse financing to the trading firm, which makes a loan to the producer. In this variant, the trading firm, rather than the bank, bears the risk that the producer will not repay the prepaid amount. It is common for the trading firm to offload all or some of this credit risk by entering into an insurance policy. Depending on the terms of the financing provided by the bank to the trading firm, the bank may be the loss payee on this insurance policy. Another common structure offered by commodity trading firms is a tolling arrangement, whereby a firm supplies a commodity processor (e.g., an oil refiner) with an input (e.g., oil) and takes ownership of the processed commodity (e.g., heating oil, jet fuel, and gasoline). The trading firm pays a fixed fee to the processor, pays the market price to acquire the input, and receives the market price for the refined products. These structures bundle together multiple goods and services. For instance, in a simple off-take agreement, the trading firm provides marketing services and hedging (because the seller is guaranteed a price, and the commodity firm is at risk to price changes over the life of the contract). A prepay incorporates these elements and a financing element as well. The seller receives cash upfront, in exchange for a lower stream of payments in the future: the discount on the sales price is effectively the interest on the prepay amount. 11 See, for instance, Bruno Biais and Christian Gollier, Trade Credit and Trade Rationing, 10 Review of Financial Studies (1997) 903, and Mitchell Petersen and Raghuram Rajan, Trade Credit: Theory and Evidence, 10 Review of Financial Studies (1997). 12 Mike Burkart and Tore Ellingsen, In Kind Finance: A Theory of Trade Credit, American Economic Review (2004) 569. 37
A tolling agreement bundles input sourcing, output marketing, price risk management, and working capital financing. The working capital element exists because the commodity trading firm has to finance the input from the time it is purchased until it can realize revenue from the sale of the refined good after processing is complete. Bundling services can reduce transaction costs The various elements of these bundles could be provided separately. Instead of entering a tolling arrangement, for instance, a refinery could source its own input and market its own output, hedge its input purchases and product sales in the futures markets, and finance its working capital needs by borrowing from a bank. Instead of engaging in a prepay, a miner could market its own output, hedge its price risk on the derivatives markets, and borrow from a financial institution or the capital markets. However, there are frequently efficiencies that can be captured by bundling these transactional elements into a single structure. By exploiting these efficiencies, firms trading commodities (which, notably, can include banks as well as non-bank trading firms) reduce transactions costs and allocate risks more efficiently, thereby benefiting commodity producers and consumers. To understand these benefits consider a tolling transaction (which is the structure with the largest number of elements in the bundle). Refineries, power plants, and the like typically need to pay for the inputs they process before they receive payment for their outputs. This creates a need for working capital to finance the timing gap between cash outflows and inflows. Providing funding for working capital is clearly a traditional banking activity. One way to do this is for a lender to provide a loan or credit facility, and leave the refiner or power plant to acquire inputs and market outputs, and bear and perhaps manage the price and operational risks associated with those activities. This exposes the lender of the funds to risk: adverse movements in prices could put the refiner or generator into financial distress, and perhaps cause a default. The lender could require the borrower to hedge, but there is a moral hazard: if it does not hedge, or does not do it effectively, the lender bears risk. This undermines the incentive of the borrower to hedge, and hedge well. The lender can monitor, but this is costly, and often imperfect....and improve economies of scale The moral hazard problem can be eliminated by passing the risk on to the lender. A prepay agreement or tolling deal does this. These types of deal implicitly provide funding to bridge the outflow-inflow gap, and pass the price risks back to the lender. The lender can manage these risks, and the agency cost in this arrangement is lower: because the lender bears the price risk, there is no moral hazard; it has the incentive to manage the risk; and there is thus no need to monitor. Therefore, bundling price risk management and funding can reduce the cost of funding working capital needs. This is presumably more valuable for lower credit quality refiners and generators. There are other potential benefits. The lender may have a comparative advantage in managing risk due to specialization and expertise in this function: commodity trading firms and banks have a comparative advantage in risk management. Moreover, they may able to be able to manage risk more cheaply because they run large books: there are economies of scope in risk management. For instance, a lender doing an off-take deal with a refinery is short crude and long products, but it might have a long crude position based on a trade it executed with producer, and might have a short products position as the result of a swap with an airline or heating oil dealer. These natural hedges reduce the amount of trading necessary to manage the risks. Moreover, trading firms specialize in marketing and logistics, and there are scale economies and scope economies in these activities. It may be cheaper for a big trading firm to provide marketing and logistical services, thereby eliminating the need for the refiner or the power plant to pay the overhead associated with such activities. Smaller, or less sophisticated firms (e.g., a refiner in an emerging market) are likely to benefit most from delegating marketing, logistics, and risk management services to specialist firms that can exploit scale and scope economies. Thus, there are strong complementarities that make it beneficial to bundle financing, logistical, and marketing activities for some firms that process commodities. 38
SECTION IV 39
V. COMMODITY FIRM ASSET OWNERSHIP AND VERTICAL INTEGRATION SUMMARY Many CTFs are investing more heavily in physical assets as the profitability of pure physical arbitrage comes under pressure. The complexity and diversity of CTFs makes it difficult to generalize. The data suggest that: There are two categories of firm: asset-intensive and asset-light. There is a trend towards increased vertical integration for some firms, but this is not uniform. Midstream All major CTFs own midstream assets such as storage and terminals. There are strong economic arguments for this. CTFs that control their own storage and processing are not subject to the risk of a third party creating an artificial bottleneck to extract excess profit. As arbitrage opportunities become more fleeting there is a greater incentive to integrate. In oil trading, increased price transparency has restricted arbitrage opportunities and made access to storage and logistics more valuable. Recent acquisitions of physical assets by Trafigura highlight the economic factors propelling midstream investment. Downstream Downstream activities are mainly concentrated in emerging markets or developing regions of advanced economies. These are usually small markets requiring investment. Sometimes governance is poor. These conditions favor vertical integration. Integrated midstream and downstream operations are replacing retreating oil majors in emerging markets. Upstream Owning production has transactions cost benefits, but these can be achieved in other ways, for instance with off-take agreements. There are cases of upstream integration in agricultural products, but the trend is more common in energy and industrial metals. Vertical Disintegration Commodity trading firms have also contributed to vertical disintegration by developing liquid, competitive markets that reduce transactions costs and increase sector efficiencies. Patterns of asset ownership are very diverse A. THE PHYSICAL ASSET INTENSITY OF COMMODITY TRADING FIRMS In the past few years, there have been numerous stories and consulting reports claiming that commodity trading firms are evolving from pure intermediaries that own very few physical assets, to more vertically integrated firms that invest more heavily in physical assets, in order to profit from the real optionality inherent in these assets. 1 There is a kernel of truth in this characterization, but reality is more complicated. Many well-known firms commonly identified as commodity traders (notably the ABCD firms) have always been vertically integrated to some degree, and have substantial investments in durable physical assets including refining/processing plants. Other trading firms are affiliates of asset-heavy firms including most notably vertically integrated oil and gas producers. It is the case that some energy and metals trading firms that historically have been very asset light are becoming more fixed asset intensive through the strategically targeted purchase of or investment in physical assets at various stages of the value chain. But the patterns of asset ownership among commodity traders are extremely diverse, complex, and dynamic, making generalizations impossible. Given this complexity and diversity, a detailed analysis of the integration and structure of commodity trading firms is well outside the scope of this study. I therefore set my sights on more modest objectives. First, I will present data that quantifies asset intensity and 1 Deloitte, Trading up: A look at some current issues facing energy and commodity traders (2013). Jan Ascher, Paul Laszlo, Guillaume Quiviger, Commodity trading at a strategic crossroad, McKinsey Working Papers on Risk (2012). Steven Meersman, Roland Rechtsteiner, Graham Sharp, The Dawn of a New Order in Commodity Trading, Oliver Wyman Risk Journal (2012). 40
SECTION V integration by some commodity trading firms. This data shows the diversity of commodity trading firm integration strategies. This data also illustrates some trends. Second, I will draw on the economics literature relating to vertical integration and asset ownership to identify some of the factors that influence the integration of some commodity transformation activities. Third, I will focus on the evolution of integration patterns among oil and energy trading firms, focusing on the experience of Trafigura. The information on individual companies, and integration within particular sectors, is useful in conveying the diversity of commodity trading firms, and in illustrating the fact that commodity firm presence in multiple stages of the commodity value chain is and has been quite common. This information is less useful in illustrating broad patterns. For commodity trading firms for which financial data is available, however, it is possible to construct measures of asset intensity that proxy for integration along the value chain. Fixed assets/total assets measures asset intensity Specifically, the assets held on the balance sheets of traditional pure intermediary trading firms tend to be predominately current assets, consisting of commodity inventories and receivables (trade credit granted to customers). A traditional trading firm can operate with an office, phones and computers, and rent, lease, or charter the physical assets needed to transform goods in space or time. Thus, current assets tend to represent a large fraction of the total assets of pure trading firms, and fixed (or long-term) assets tend to represent a small portion. Conversely, firms engaged in other commodity transformations, notably processing, invest in and own long-term fixed physical assets, such as refineries. Similarly, firms engaged in primary commodity production (e.g., mining or oil production) own assets like mines and wells. I therefore use fixed assets (or long term assets) as a fraction of total assets as a measure of whether a firm is primarily a pure trader, or is instead more extensively integrated into asset-intensive transformation activities. 2 This data is available for 17 firms for years going back as far as 2007. Table 2 presents this information in tabular form: Figure 1 presents it graphically. TABLE 2 FIXED ASSETS DIVIDED BY TOTAL ASSETS AT COMMODITY TRADING FIRMS 2007 2008 2009 2010 2011 2012 Archer Daniels Midland 0.31 0.39 0.42 0.35 0.35 0.34 BP International Ltd 0.20 0.14 0.16 0.29 0.33 0.31 Bunge 0.34 0.35 0.45 0.39 0.44 0.37 Cargill 0.45 0.44 0.43 0.43 0.29 0.35 E.On Global 0.02 0.12 0.06 0.02 0.02 0.02 EDF Trading 0.02 0.02 0.02 0.03 0.02 0.08 Eni Trading & Shipping 0.00 0.01 0.02 0.04 0.06 0.03 Glencore 0.39 0.40 0.42 0.44 0.47 0.49 Louis Dreyfus B.V. 0.18 0.26 0.33 0.29 0.29 0.33 Mercuria Energy Trading 0.00 0.00 0.00 0.03 0.03 0.04 Noble Group 0.19 0.20 0.20 0.29 0.23 0.29 Olam 0.10 0.21 0.27 0.24 0.32 0.36 Shell Trading International 0.00 0.00 0.00 0.06 0.06 0.07 Trafigura 0.06 0.07 0.08 0.08 0.10 0.13 Vitol 0.05 0.05 0.08 0.07 0.08 0.05 Wilmar 0.54 0.54 0.45 0.41 0.40 0.43 Two things stand out. First, firms fall into two basic categories. One set of firms, consisting of companies including the ABCD firms, is relatively asset intensive. The other set, consisting primarily of oil traders (and oil and metals traders) are much less asset intensive. The disparities can be extreme, with some trading firms having virtually no fixed or long-term assets, and some other firms commonly categorized as traders having nearly 50% long-term physical assets. Second, there is an upward trend for some firms, but not uniformly across all the firms in the sample. Among the ABCD firms, ADM and Bunge have exhibited relatively stable ratios, Cargill s ratio has actually fallen, but Louis Dreyfus s has increased. For Asia-based firms, 2 Fixed assets divided by revenues is another measure of asset intensity. Traditional trading firms tend to have large revenues, because their business consists of continuous buying and selling of commodity inventories, but involves little investment in fixed assets. The data on this measure exhibit similar patterns to those for fixed assets relative to total assets, so I do not separately report them. 41
FIGURE 1 FIXED ASSETS DIVIDED BY TOTAL ASSETS AT COMMODITY TRADING FIRMS 0.60 0.50 FIXED ASSETS/TOTAL ASSETS 0.40 0.30 0.20 0.10 0.00 2007 2008 2009 2010 2011 2012 YEAR ADM Glencore BP Bunge Cargill Dreyfus E.On EDF Eni Mercuria Noble Olam Shell Trafigura Vitol Wilmar Wilmar has become less asset-intensive, but Olam and Noble have become more assetintensive. Glencore was becoming more asset intensive even before its acquisition of Xstrata. Some (but not all) more asset intensive There is a similar diversity in trends among the traditional traders who are less asset-intensive. Mercuria has increased its intensity somewhat, though that level remains relatively small, while Vitol s intensity increased, then in 2012 decreased back to its 2007 level. 3 In contrast, Trafigura s asset intensity more than doubled between 2007 and 2012 (and has more than tripled since 2006). Thus, it is incorrect to say that commodity trading firms have uniformly become more asset-intensive. Some have, but some have not. In this, as in so many other things examined herein, there is considerable diversity among trading firms. B. ASSET OWNERSHIP BY COMMODITY TRADING FIRMS As the data on fixed assets suggests, there is substantial variation in asset ownership across commodity trading firms. This is further demonstrated by a more detailed examination of specific trading firms. Some firms own assets at all stages of the value chain upstream, midstream, and downstream. Some have investments at all stages for some of the commodities they trade, but in only one or two of the stages for others. This finding is documented in graphical form in Appendix B for a selection of major companies. There is a chart for each company that indicates its activities in 13 major commodities. Four types of activity are considered: pure trading (with no asset ownership); upstream (which includes ownership of mines, oil wells, and agricultural land); midstream (which includes storage and terminals); and downstream (which includes processing and refining). A solid dark blue box for a particular commodity and activity indicates that the company owns physical assets for that commodity-activity pair. 4 One generalization is that all major commodity trading firms own midstream assets, such as storage facilities and terminals, although some firms participate in some commodity markets purely as traders, with no asset ownership. Moreover, some of the increased asset 3 Data on Vitol is available going back to 2003. Its asset intensity decreased by almost 60% (from.11 to 0.5) from 2003 to 2007, before increasing in 2008-2011 and then turning down. 4 I made determinations as to whether a company owned assets in a particular activity-commodity pair based on an examination of the websites of private companies (e.g., Cargill, Louis Dreyfus, Vitol) and an examination of annual reports and websites for public companies (e.g., ADM, Glencore). 42
SECTION V intensity documented above is driven by increasing investments in midstream assets. As will be discussed in more detail below, there are strong economic reasons for trading firms to invest in such assets: by doing so, they reduce transactions costs. Moreover, the increasing availability of information about prices and flows has increased the transaction cost reduction-related benefits of midstream asset ownership. Generalizations are more difficult to make about upstream and downstream assets. Hence, the analysis is inherently more case-by-case. Given the complexity of the markets, I will focus on a few representative cases to illustrate some of the factors at work. Another generalization is that trading firm asset ownership cannot be viewed in isolation. Especially in energy, commodity firms are acquiring assets that other firms are divesting for strategic reasons. Thus, understanding patterns and trends in commodity trading firms requires an understanding of patterns and trends in other companies, such as large oil companies. midstream assets ownership cannot be seen in isolation I now consider trading firm investments in midstream, downstream, and upstream assets. Midstream Investments. Commodity merchandisers have long invested in midstream assets such as storage facilities and terminals. Historical data and systematic statistics are lacking, but some documentation dating back to the early-20th century illustrates this point. The Federal Trade Commission s (FTC) Report on the Grain Trade analyzed terminal and country grain marketing around 1920. With some alarm, the FTC documented that merchandisers tended to control terminal grain elevators, country elevators, and grain export facilities. It noted that 80% of terminal elevator capacity was owned by private dealers in grain. 5 Even ostensibly public elevators that stored grain for third-parties were largely owned by grain dealers, and they utilized this capacity in their merchandising activities. With respect to country elevators and warehouses, the FTC found that 35% were line elevators owned and operated by large grain merchants. 6 As noted above, this continues to be the case in the grain and cotton trades today. The major agricultural trading firms own storage and logistical facilities. Transactions costs economics sheds considerable light on the need for trading firms to control storage facilities and terminals. Specifically, the concept of temporal specificity is of particular relevance for midstream assets. 7 A temporal specificity exists when even a short delay in obtaining (or selling) a good imposes a large loss on the buyer (or seller). Under these circumstances, the seller (or buyer) has considerable bargaining power that he can exploit. Moreover, the wide bargaining range induces wasteful haggling, that sometimes results in a failure to complete what would have been a mutually beneficial transaction. to control delivery and reduce transactions costs This is perhaps best illustrated by a commodity trading example, namely, storage. One of the main functions of commodity storage is to smooth out supply and demand shocks: the amount of a commodity in store should go down (or up) when demand is unexpectedly high (or low), or supply is unexpectedly low (or high). 8 These shocks occur continuously, and particular in volatile market conditions can be large in magnitude. Optimal utilization of storage capacity requires timely response to these shocks. Consider a firm that has put a commodity in store in a facility that it does not own, or control under some contract or lease. There is an increase in demand, making it optimal for the firm to take the commodity from storage and sell it (or consume it itself). The operator of the storage facility realizes that the value of the commodity to the customer is maximized if the customer can access it quickly to respond to the demand shock, and is worth less if access is delayed. This gives the storage facility operator the ability to extract some of this value by threatening to delay performance. Although the terms of the storage contract may attempt to preclude such conduct, contracts are incomplete (i.e., all contingencies cannot be set out in the contract, leaving room to attempt to evade performance by taking advantage of one of these contractual gaps), and are costly to enforce (meaning that the storer might prefer to capitulate to the storage operator s demand rather than go to court). Moreover, since timely access to the stored good is essential and getting the contract 5 Federal Trade Commission, Report on the Grain Trade, Volume III: Terminal Grain Marketing (1921) at 7. 6 Federal Trade Commission, Report on the Grain Trade, Volume I: Country Grain Marketing (1921) at 41. 7 For a discussion of temporal specificity, and an application of the concept to the study of a particular market, see Stephen Craig Pirrong, Contracting Practices in Bulk Shipping Markets: A Transactions Cost Explanation, 36 Journal of Law and Economics (2003) 937. 8 Craig Pirrong, Commodity Price Dynamics: A Structural Approach (2011). 43
enforced is likely to be time consuming, capitulation becomes a more reasonable alternative. 9 These problems can be avoided if the firm that stores the commodity controls the storage facility, either by owning it, or obtaining control via a long-term contract or lease arrangement that is not subject to opportunistic conduct by the asset owner or user. This logic can explain the phenomenon noted by the FTC almost a century ago: the decline in public warehousing and merchandiser ownership (or control) of storage facilities. It can also explain the ownership (or control by lease/contract) of storage facilities across major commodities by trading firms. 10 Similar arguments obtain for other fixed logistic assets, such as terminals. Executing an arbitrage transaction frequently requires unpredictable, rapid and timely access to such an asset, and this creates a temporal specificity that the asset operator can exploit to extract a supercompetitive price from the firm attempting to execute the arbitrage. If the firm executing the arbitrages owns the asset, however, such a holdup cannot occur. It should be noted further that the possibility for such holdups reduces the incentive to seek out arbitrage opportunities, because the operator of the logistics facility can extract some of the value that the arbitrageur s efforts create. If the arbitrageur owns the asset, however, it can capture fully the value of the arbitrage, and therefore has a stronger incentive to seek out and exploit such value-enhancing transactions. Not all logistic assets are equally susceptible to temporal specificity-related holdups. Standardized bulk ships (or tankers) operating on heavily-trafficked routes are relatively immune, for instance. If a carrier attempts to hold up a shipper, the shipper can readily find another carrier: competition sharply mitigates the potential for a holdup. 11 However, fixed logistic assets for which there are few alternatives are more susceptible to this problem. Thus, one expects that commodity traders need not own standardized bulk carriers or tankers, but have a far stronger incentive to own terminals or storage facilities. This prediction is largely borne out in practice. There are strong economic reasons for traders to own midstream infrastructure The analysis also has implications for the factors that cause changes in the incentive for trading firms to integrate into ownership of logistic assets. The more fleeting are arbitrage opportunities, the more acute are temporal specificities and the greater incentive to integrate. Recent developments in some commodity markets, notably the oil market, are consistent with this prediction. Due to information technology, greater ability to monitor the activities of competing traders (e.g., by tracking vessel movements in real time), and the substantial increase in price transparency in the energy markets, 12 the duration of arbitrage opportunities has declined substantially. Immediate access to logistic assets and storage facilities is therefore more valuable for firms that are primarily engaged in executing arbitrages. This helps explain increased investment of traditional trading houses in midstream logistic assets and storage facilities, which is a major driver of the increased asset intensity of some of these firms. Supply and demand shocks in the commodity markets can increase the demand for midstream infrastructure that is needed to facilitate commodity flows. Moreover, the needed new infrastructure often exhibits characteristics that makes it economical for those that are going to utilize it, build it and own it, at least for some period. In particular, the infrastructure often exhibits substantial scale economies at efficient scale, and due to these scale economies infrastructure assets may be geographically dispersed, with only a small number of facilities serving a particular tributary territory. Moreover, it is often specialized to optimize its efficiency. Furthermore, it is fixed to a specific location: in the language of transactions cost economics, it is site specific. Finally, some traders control flows of the commodity sufficient to utilize a large fraction of the asset s capacity. All of these factors create the potential for serious opportunism problems if the major users of the new assets (traders controlling commodity flows) do not own them. 13 Specialization of the asset, site specificity and scale economies that make it efficient for a single piece of infrastructure to serve a substantial portion of the commodity flows for a large region, and the fact that large traders control flows of the commodity that can utilize a substantial fraction of the asset s capacity mean that bargaining and contracting hazards arise if the 44 9 The ongoing controversies about long load-out times and alleged opportunistic behavior by industrial metals, coffee, and cocoa warehouse operators that offer public storage (usually as warehouses regular for delivery under futures contracts) illustrates the potential for conflicts between those who store commodities in warehouses they do not own and the owners of these facilities. 10 It also sheds light on current controversies in LME warehousing. 11 My article on contracting practices in bulk shipping markets goes through this argument in detail. 12 Jan Ascher, Paul Laszlo, Guillaume Quiviger, Commodity trading at a strategic crossroad, McKinsey Working Papers on Risk, No. 39 (2012). 13 For a detailed analysis of these issues, see Oliver Williamson, The Economic Institutions of Capitalism (1985).
SECTION V trader that controls the commodity flows does not control the asset. If the parties attempted to deal through a long term contract, the asset owner could attempt to evade performance under the contract to extract a better deal from the trader: the trader may find it better to agree because alternative ways of moving the commodity are substantially more costly (because they are out of position relative to the trader s commodity flows, or not optimized to meet the trader s needs). Similarly, the trader could threaten to evade performance by diverting its flows elsewhere, unless the asset owner makes concessions. If the trader controls a substantial fraction of the flows that use the asset, if it carries through on the threat the asset will operate well below capacity, meaning that the asset owner may feel compelled to make concessions in order to avoid idling the bulk of the facility. Thus, the combination of traders that control large commodity flows, with assets that are specialized to facilitate those flows and which must operate at scale, creates the conditions for ongoing and wasteful disputes between the trader and the asset owner. This problem can be eliminated if the trader owns the asset. These considerations are an important driver of the increased asset intensity of some trading firms that was documented above. Trafigura provides several examples. Consider the Burnside Terminal on the Mississippi River in Louisiana. The shale gas boom in the United States, and the resulting decline in natural gas prices, has substantially reduced the demand for coal for electricity generation in the United States. This freed substantial quantities of coal for export, but there is inadequate infrastructure to accommodate an increase in export flows. Trafigura determined that the Burnside Terminal is ideally placed to alleviate this bottleneck, but that this required a substantial investment to upgrade the facility and optimize it for use as a coal (and also alumina and bauxite) terminal. The asset is specialized, of large scale, site specific, and there are few nearby facilities capable of handling its volumes. Moreover, Trafigura, as a major trading firm, efficiently markets coal internationally in sufficient quantity to utilize a substantial fraction of the capacity of the facility. The transactions cost economics considerations discussed above make it efficient for Trafigura to own the asset. Owning midstream assets creates transactions cost Similar considerations pertain in Corpus Christi, where the shale oil boom in Texas created the need for substantial amounts of new, specialized terminal capacity; in Colombia, where existing infrastructure is inadequate to handle increased oil and coal output, and the needed infrastructure exhibits scale economies and is site specific, and where Trafigura controls large flows of coal and oil; and Peru, where large-scale, specialized storage, blending and terminal facilities are required to handle large flows of concentrates marketed by Trafigura. Thus, Trafigura s increased physical asset intensity is concentrated in logistics assets needed to handle large volumes of new commodity flows caused by large changes in supply and demand patterns. Transaction costs considerations make it efficient for the firm, which handles large flows of the commodities, to own the infrastructure assets scaled and specialized to handle these flows. Although Trafigura provides an excellent illustration of the economic factors that can drive increased investment in midstream assets by trading firms, it is by no means the only one. Another example is Brazil, where existing infrastructure on the Amazon is insufficient to handle the increased production of soybeans in tributary regions that can be exported to China. Trading firms, including all of the ABCD firms, are making large investments in handling and storage facilities on the river, and will own and operate these assets (in some cases in joint ventures with Brazilian firms). In sum, commodity trading firms have always owned and operated midstream assets, like terminals, blending facilities, and storage facilities. The nature of these assets makes it efficient for firms merchandising large commodity flows to own them: this reduces transactions costs. Moreover, major changes in supply and demand patterns have led to the need for new infrastructure, which large commodity trading firms have accommodated through investment and ownership, thus increasing their fixed asset intensity. This increased intensity is sometimes explained as the result of commodity trading firms investing in assets that offer optionality. This explanation is incomplete. Optionality (defined as adjusting the use of the asset in response to unexpected supply and demand shocks and the associated relative price changes) is a necessary condition for ownership of an asset, but not a sufficient one. Bulk cargo ships and tankers offer substantial optionality (in terms of routes and sometimes cargoes), but a trading company does not need to own a bulk carrier or tanker to exploit that optionality because ships are mobile, and because there are competitive charter markets with large numbers of buyers and sellers: a trader can exploit a ship s flexibility and optionality by chartering it when needed. Many infrastructure assets, in contrast, are sufficiently unique (in terms of location, configuration, size, etc.) that 45
something analogous to a ship chartering market is not feasible. For these assets, ownership is necessary to exploit their optionality efficiently. downstream in emerging economies and developing markets Downstream Assets. One of the notable developments in energy markets in recent years is the integration of some large trading firms into the fuel and lubricants retail, distribution, and downstream distribution businesses. Puma Energy, originally a wholly-owned subsidiary of Trafigura, owns and operates fuel storage and marketing businesses (involving distribution, retailing and wholesaling) in 40 countries in Africa, Latin-America, North-East Europe, the Middle East, Australia, and Asia. As another example, Vitol s Vivo joint venture (with Helios Investment Partners and Shell) distributes and markets fuel in Africa. The downstream activities of trading firms are primarily concentrated in emerging markets, or rapidly developing regions of advanced countries. 14 These markets tend to be relatively small, and have underdeveloped infrastructures and therefore require additional investment. Moreover, local capital markets are relatively undeveloped. The market sizes are insufficient to support a large number of efficiently-scaled retailers, wholesalers, and distributors (as is the case in far larger markets, such as the United States). If these businesses were operated separately, it is likely that firms at each segment of the marketing chain would have market power, leading to potential for multiple monopoly markups and the potential for opportunistic behavior if firms in the different segments attempted to use long term contracts to mitigate the markup problem. These factors tend to make vertical integration more efficient than separate ownership of retail, wholesale, and distribution segments. Further, markets in these countries tend to be highly regulated, and often adopt price controls. In some, the quality of governance is poor. It is well known that such conditions tend to favor vertical integration. 15 Economic considerations therefore strongly favor the integration of midstream and downstream functions in fuel markets in emerging economies, and these activities have historically been integrated in these markets. The previous owners were the oil majors, and the integration of trading firms into this sector is the flip side of the exit of the majors. Majors have been becoming less integrated generally because returns in downstream businesses do not compare favorably with those that can be earned in the very capital-intensive upstream exploration and production activities. Trading firms that can efficiently supply inputs into the downstream markets in emerging economies are the natural buyers for these businesses. So the tale of vertical integration by commodity traders is also very much a story of disintegration by oil majors. Recently some traditional trading houses (including Gunvor and Vitol) have acquired oil refineries. These acquisitions are again to a considerable degree a reflection of developments in the broader oil industry, in particular the serious erosion in refining economics in Europe. One major refiner, Petroplus, went bankrupt, and the financial performance of European refineries generally has led refiners to shed capacity. Some of this capacity has been idled: from 2006 to 2013, European refining capacity (crude distillation units) declined 7.5%. Trading firms have found it economical to purchase and operate some of the capacity that was no longer sufficiently profitable for traditional refiners to retain. The major agricultural trading firms that merchandise grains and oilseeds also process these commodities. For instance, Cargill and ADM process wheat, corn, and soybeans. Bunge processes soybeans. Processed agricultural products are typically marketed to a large, diverse, and geographically dispersed group of customers. Efficient performance of this marketing function requires the same skills and resources required to merchandise unprocessed agricultural products, including most notably expertise in logistics. Further, expertise in sourcing, storing, and transporting unprocessed agricultural products can be utilized to acquire efficiently inputs for processing operations. Thus, there are complementarities between merchandising of unprocessed and processed agricultural products, providing an incentive for trading firms to engage in processing. Moreover, there can be benefits of centralizing risk management across processing and merchandising activities (for both processed and unprocessed products). This provides an additional reason for firms to engage in both marketing and processing. Upstream investments. There are some instances of upstream integration in agricultural products. Olam and Wilmar own palm oil plantations, and Cargill recently announced an investment in a major Ukrainian agricultural producer, UkrLandFarming. Again, transactions 46 14 For a detailed analysis of these issues, see Oliver Williamson, The Economic Institutions of Capitalism (1985). 15 George Stigler, The Organization of Industry (1968).
SECTION V costs economics explains how these decisions can increase value. The plantations are large (due to scale economies), and obviously site-specific, and Olam and Wilmar market large quantities of oil: ownership avoids the inefficiencies that arise from bilateral monopoly. 16 It should also be noted that the companies own and operate processing facilities on the plantations. Again, this makes sense from a transactions costs economics perspective. Similar considerations obtain in the case of Cargill and UkrLandFarming. The inefficiencies of having a large buyer and a large seller dealing at arms length can be mitigated if the buyer has an ownership stake in the seller (or vice versa). Integration upstream has been more common in energy and industrial metals. For instance, Glencore (especially with its merger with Xstrata) has become in effect an integrated mining company. Mercuria has upstream oil and coal assets, and Vitol owns upstream oil assets as well. Trafigura owns mines in Spain and Peru, and recently sold off another in Peru that it had owned since 1997. Energy and metals traders integrate upstream Transactions costs considerations again explain some of the benefits of integrating processing and marketing operations. Repeated negotiation of short term agreements between the operator of a mine, say, and a trading firm that is capable of marketing all (or a large fraction) of its output is likely to be costly because of the small numbers bargaining problem inherent in this situation. Integration can avoid that problem. That said, there are means other than ownership to achieve similar economies. For instance, a trading firm can enter into a long-term off-take agreement that avoids the costs associated with repeated negotiations between a mine owner and a trading firm. Although such long-term contracts are potentially vulnerable to opportunistic behavior by both the producer and the trading firm/buyer, the ubiquity of these off-take arrangements demonstrates that these contractual hazards can be surmounted economically. Indeed, off-take agreements are a more common way than ownership for commodity firms to acquire commodity flows on a long-term basis from producers. The case of Trafigura provides some insight into factors that can make ownership of an upstream asset like a mine efficient. Trafigura has acquired considerable technical expertise in mining and extraction industries. By purchasing a mine in need of additional investment, Trafigura can utilize that expertise: the well-known difficulties of selling information or expertise often make it more efficient for the party with the expertise to make the investment, rather than provide that information at arms length to a mining company. Trafigura s investment in the Aguas Teñidas Mine (MATSA) in southern Spain is an illustration of this. Further, its purchase of, investment in, and subsequent sale of Compania Minera Condestable SA in Peru suggests that it is the transfer of expertise, rather than synergies between operation and marketing that can be decisive in making ownership of an upstream asset optimal for a trading firm. Trafigura purchased the firm in 1997, and utilized its expertise to improve its efficiency and extend its life. After 16 years of ownership, the mine had achieved such a level of efficiency that Trafigura s expertise was no longer as necessary, so the company sold its 99% stake to a private mine operator. Importantly, as part of the sale, Trafigura entered into a life-of-mine off-take agreement for 100% of the mine s production. This strongly suggests that the reason for ownership was that this was the efficient way to transfer technical expertise and management investment in capacity expansion, and that ownership was not necessary to secure and market the mine s output efficiently. Commodity Trading Firms and Vertical Disintegration in Commodity Markets. Although much public discussion of commodity trading firms focuses on their increasing integration, it is important to note that commodity trading has also contributed to vertical disintegration. As pointed out by Coase long ago, markets and firms are different ways of carrying out transactions. 17 When markets become cheaper to use, some transactions that used to take place within vertically integrated firms (e.g., the supply of crude oil to a refinery) can be undertaken in markets instead, and the upstream and downstream parts of the firm can be separated. By facilitating liquid, competitive markets in crude oil and refined products, commodity trading firms made it more economical to carry out many transactions that had taken place within integrated firms on markets instead. The rise of refining independents and the retreat of oil majors from refining reflects in large part the efficiencies created by commodity trading firms. Commodity trading generates market 16 Note that upstream integration into agricultural production is most common in crops that are produced at scale on large plantations (e.g., palm oil), and virtually unknown in crops (e.g., corn) that are grown by large numbers of relatively small producers. 17 Ronald Coase, The Nature of the Firm, 4 Economica (1937) 386. 47
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SECTION VI VI. SYSTEMIC RISK AND COMMODITY TRADING: ARE COMMODITY TRADING FIRMS TOO BIG TO FAIL? SUMMARY For CTFs to pose a systemic risk three factors must be present: 1. There must be a risk of a large triggering shock. 2. There must be a risk that the shock propagates through the financial system via contagion or chain reaction. 3. The financial disruption must affect the broader economy. CTFs are unlikely to be a source of systemic risk for several reasons: Even the largest commodity firm is significantly smaller than the major banks. Commodity firms balance sheets are far more robust. Commodity firms are not an important source of credit. There is relatively low market concentration among commodity firms. The assets used in commodity trading can be redeployed relatively easily. The economics of commodity trading help to insulate the industry from the effects of a large economic downturn. Trading firms provide logistical services. Recent history demonstrates that even large disruptions to logistical networks have limited economic impact. There have been numerous recent failures in trading firms, which have had no impact on the broader financial system. A. INTRODUCTION After decades of operating in relative obscurity and out of the glare of publicity, in recent years commodity trading firms have received much more public scrutiny. Since the Financial Crisis in particular, some (including some regulators) have questioned whether commodity trading firms pose risks to the financial system analogous to banks, and hence should be regulated similarly to banks. 1 Most notably, in 2013 the Financial Stability Board (FSB) requested national and regional regulators to establish whether commodity trading firms required additional regulation, including initially additional regulatory reporting and financial disclosures. 2 In 2012, the FSB s Timothy Lane opined that trading firms might be systemically important. 3 In public discussion, including many articles in the media, the issue has been framed as are commodity firms too big to fail? An evaluation of this issue first requires a definition of systemic risk and an understanding of what kinds of financial institutions are likely to be systemically important ( systemically important financial institutions or SIFIs ). These terms are widely used, but not always consistently so. Therefore, it is essential to define the terms. I will use a definition provided by then Federal Reserve Chairman Ben Bernanke in a letter to Senator Bob Corker in 2009: Systemic risks are developments that threaten the stability of the financial system as a whole and consequently the broader economy, not just that of one or two institutions. Stanford Professor John Taylor advances a three-part test to determine whether systemic risk exists, and the analysis that follows adheres to this test. Taylor says for a risk to be systemic, (1) there must be a risk of a large triggering shock (such as a natural disaster or the failure of a firm or firms,) (2) there must be a risk of the shock propagating through the financial system via contagion or chain reaction, and (3) the financial disruption must affect the broader macroeconomy. 4 Systemic risks system and the broader economy 1 Alexander Osipovich, Commodity trading firms face questions over systemic risk, Energy Risk, 20 September 2013, 2 Emma Farge, Commodity traders could face regulation for role as lenders, Reuters 1 May 2013. 3 Timothy Lane, Financing Commodity Markets: Remarks Presented to the CFA Society of Calgary, 25 September, 2012. 4 John B. Taylor, Defining Systemic Risk Operationally, in George Schultz, Kenneth Scott, and John B. Taylor (eds.) Ending Government Bailouts as We Know Them (2009). 49
Commodity trading of systemic risk The FSB has a similar definition. 5 It identifies three crucial criteria for assessing systemic risk: size, substitutability (i.e., the ability of other firms or entities to provide the services previously supplied by a failed firm), and interconnectedness. B. ANALYSIS OF THE SYSTEMIC RISK OF COMMODITY TRADING FIRMS Given these definitions, and the broader economic literature on systemic risk (especially the literature that has developed in the aftermath of the recent Crisis), an analysis of commodity trading firms indicates that they are not a potential source of systemic risk, and hence do not warrant being regulated in ways similar to SIFIs. Several considerations support this conclusion. Commodity firms are not really that big, especially in comparison to major banks. The assets of Glencore, the largest commodity trading firm, (which has evolved into a very asset heavy mining firm, more comparable to a Rio Tinto or BHP than a Vitol or Trafigura, or even an ADM) total slightly more than $100 billion, which ranks it approximately 240 th of world publicly traded corporations in terms of assets. If Cargill, the second largest trading company in terms of assets, were publicly traded it would rank approximately 450 th in terms of assets. Comparing just to major banks, Glenore s assets are approximately equal to the 60 th largest bank (by assets) in the world. The banks of similar size include Bank Leumi and Bank Hapoalim, hardly household names outside their home countries. Cargill is comparable in size to the 65 th largest bank in the world. Their balance sheets are much more robust than banks Focusing on SIFIs, the median European SIFI bank has assets of $1.3 trillion, and the median US SIFI bank has assets of $1.18 trillion. Thus, most banks that have been designated as SIFIs have assets that are an order of magnitude larger than the largest commodity trading firms, and two orders of magnitude larger than most commodity trading firms. Thus, the financial distress of even the largest commodity trading firm, or even several of them, would be unlikely to have the same disruptive impact on the financial system as the collapse of a middling-size major bank, let alone a behemoth like Deutsche Bank or JP Morgan. 6 The balance sheets of trading firms are not fragile in the same way that banks balance sheets are. The analysis of commodity trading firm financing in Section IV demonstrates several salient features that bear on the potential systemic risk arising from the financial distress of a trading firm. First, in comparison to banks in particular, commodity trading firms are not heavily leveraged. Whereas large bank leverage ratios (measured by book value of assets divided by book value of equity) range between 9 and 14 for US SIFI banks (with a median of 10), and between 9.6 and 37 for European SIFI banks (with a median of 22), the median leverage for commodity trading firms I have examined is 4. Moreover, focusing on net debt, many commodity trading firms are not leveraged at all because current assets exceed total liabilities: since most of these current assets are highly liquid (e.g., hedged commodity inventories) net debt is better indication of leverage because commodity firms can sell the current assets to raise cash to pay off liabilities. Second, the most important factor contributing to financial crises throughout history is the fact that banks engage in maturity transformation, but commodity trading firms do not. Maturity transformation occurs when banks (or shadow banks) issue short-term liabilities to fund long-term assets. This requires the banks to rollover debts almost continuously in order to fund their assets. When lenders suspect that a bank, or the banking system in general is financially unsound, they may not agree to rollover the bank s (or banks ) short-term debts as they come due. This renders the bank (or banks) unable to fund their operations, and they collapse. Indeed, balance sheet data indicates that major banks do engage in such maturity transformation. In stark contrast, as noted in Section IV, commodity trading firms do not engage in maturity transformation. Indeed, the short-term assets of all commodity trading firms analyzed (which includes the largest) exceed their short-term liabilities. Moreover, the character of assets differs substantially between banks and commodity trading firms. Many bank assets that are funded with short-term liabilities are highly illiquid, meaning 5 Financial Stability Board, Report of G20 Ministers and Governors, Guidance to Assess the Systemic Importance of Financial Institutions, Markets, and Instruments: Initial Considerations. 6 In January, 2014 the FSB proposed to use an asset value of $100 billion as a threshold to determine whether a non-bank financial corporation should be designated as a SIFI. Since such corporations typically have far more fragile capital structures than commodity trading firms, and since most commodity trading firms have assets less than $100 billion, by the FSB criteria even the largest commodity trading firms are not SIFI. 50
SECTION VI that if banks attempt to dispose of assets to de-lever when they face funding stresses, they will have to dispose of these assets at fire sale prices. Moreover, since many banks have similar assets on their balance sheets, fire sales by one bank can reduce the values of similar assets held by other banks, which can put them under financial strain, leading to further fire sales. This vicious cycle is characteristic of financial crises. In contrast, relatively liquid assets (e.g., hedged inventories, trade receivables) predominate on commodity trading firm balance sheets. As a result, the fire sale problem is mitigated. Indeed, many of the short-term liabilities of commodity trading firms are secured and self-liquidating: for instance, a transactional credit issued to purchase an oil cargo is secured by that cargo, is paid off as soon as the cargo is sold, and is not subject to commodity price risk because the bank requires the commodity trading firm to hedge. Even the non-traditional forms of financing employed by some commodity firms, which have been considered to be a form of shadow banking do not have the problematic features of the liabilities that caused severe systemic problems during the Financial Crisis. The liabilities that proved toxic during the Crisis (e.g., asset backed commercial paper) were used to fund long-term illiquid assets. In contrast, facilities like Trafigura s securitization of trade receivables issue liabilities with maturities that are typically greater than the maturities of the securitized assets. Moreover, these assets tend to be of high quality: as discussed in Section IV, default rates on trade credit tend to be very low. Commodity trading firms are not even remotely as important as issuers of credit as banks. One reason that bank failures can be systemically catastrophic is the central role of banks in the supply of credit. If banks fail, or become financially distressed in large numbers, they reduce the amount of credit that they supply, which reduces investment and consumption (especially of durable goods) in the economy. As noted above, commodity trading firms do issue credit to commodity consumers and producers (in the form of prepays, for instance), but ultimately the source of the bulk of this credit is banks. Commodity trading firms commonly purchase payment guarantees from banks when they extend credit to customers: in the case of Trafigura, approximately 80% of the credit it extends is backed by payment guarantees or insurance from banks. Thus, banks bear the bulk of the credit risk, and hence are ultimately the source of credit; the trading firms are basically conduits between banks and customers. To the extent that a particular trading firm has a comparative advantage in serving as a conduit to some customers (because, for instance, its knowledge of the customers business allows it to monitor them more effectively), the firm s failure would impair the flow of credit to its customers. But there are alternative ways of providing this credit (other trading firms can step in the breach, or the customers can borrow directly from banks), and this mitigates the impact of the failure of the individual firm. For many commodities, especially the most important ones, there is relatively little concentration among commodity trading firms. To illustrate the contrast, in the crude oil market, two of the largest traders (Vitol and Trafigura) each account for about 6% of freely traded oil. Glencore accounts for approximately 3%, and Mercuria 3%. 7 Concentrations are somewhat higher in metals Glencore trades about 60% of freely traded zinc (although the termination of its off-take agreement with Nyrstar under terms imposed by the European Commission to secure approval of its purchase of Xstrata will reduce this concentration); 50% of freely traded copper; and 22% of freely traded aluminum. 8 The company also accounts for a large fraction approximately 28% of the global thermal coal trade. Thus, the non-ferrous metals markets are more concentrated and hence more susceptible to a single trading firm s distress, than the oil market. credit providers They mainly operate in fragmented markets It is important to note that concentration is small in commodities that represent a relatively large fraction of trade, and that the markets in which concentration is sometimes large represent very small fractions of trade. For instance, depending on the region, oil represents between 3 and 10% of imports. This is an appreciable fraction, but concentration in oil trading is quite low, with the largest firms handling only around 6% of trade. 7 These figures are from reports on these companies websites. 8 These figures are derived from Glencore s IPO Prospectus. Glencore utilizes publicly available data and its own estimates to determine the addressable quantities that are available to a third party marketer such as Glencore. For instance, commodities produced and consumed by a vertically integrated firm are excluded from the calculation. Domestic Chinese production is also excluded, as are volumes sold directly from a producer to an end-user without use of an intermediary. As an example, when calculating its share of thermal coal trade, Glencore utilizes seaborne volume of 692 million MT, out of a total world output of 4,556 m MT. The addressable market is typically far smaller than total global output. Based on total global output, Glencore calculates its market share to be 13% for zinc, 10% for zinc concentrates, 7% for copper, 4% for copper concentrates, 8% for alumina, 9% for aluminum, and 4% for thermal coal. Glencore considers the total oil market to be accessible to traders. 51
In contrast, other commodities represent much less than 1% of imports (or exports), meaning that even if one of the dominant firms in a concentrated market were to disappear, the potential effect on overall trade and economic activity would be trivial. This conclusion is reinforced when one examines trade in commodities as a function of GDP: even oil imports are less than 2% of GDP for all regions except Asia, where they are less than 3% of GDP. Assets are Commodity trading to trading volumes not prices This means that the failure of a commodity trading firm is unlikely to disrupt severely the trade in any major commodity. This conclusion is strengthened by the next fact: The assets used in commodity trading are readily redeployable, meaning that the financial distress of a trading firm has at most a modest impact on the capacity to trade and transform commodities, and then for only a short interval of time. Much of the physical and human capital deployed in commodity trading is highly re-deployable. In the event of distress of a trading firm, its physical assets and employees can move to other firms. Moreover, insolvency/bankruptcy laws generally facilitate the continued operation of financially distressed firms, so they can continue to provide transformation services even while in financial distress (although perhaps less efficiently, due for instance, to higher costs of funding). These factors limit the duration of the impact of the firm s distress. While redeployment is occurring, or if a firm operates less efficiently while in bankruptcy, customers of the distressed firm will be adversely impacted. This effect will be most acute if the distressed firm has a large share of for a particular commodity or geographic region. However, since such conditions are most likely to occur for smallervolume commodities and regions (because there is less concentration in the trade of major commodities in major markets), the broader systemic implications of such disruptions will be minor. The economics of commodity markets and commodity trading means that large economic downturns are unlikely to have a severe impact on the profitability, and financial condition, of commodity trading firms. If commodity trading firms are robust to economic downturns, they cannot be a vector of contagion that communicates the effects of the downturn to its customers and creditors. Economic theory and a variety of data, demonstrate that commodity trading firms are indeed largely robust. A large economic downturn does lead to a large decline in the demand for most commodities. A decline in demand for a commodity leads to a decline in the demand for some transformations, notably transportation/logistics and processing/refining, but an increase in the demand for others, notably storage. The declines in derived demand tend to result in declines in both volumes and margins, thereby reducing the profitability of the firms that engage in the adversely impacted transformations. To the extent that a commodity trading firm also stores commodities, it benefits from an internal hedge that offsets the losses from supplying transformations in space and time. The magnitudes of these changes in derived demands depend on the magnitude of the demand shock (and hence the severity of the financial crisis) and the elasticity of supplies of the underlying commodities. Since many commodities are highly inelastically supplied, especially in the short run, the effects on margins and volumes, and hence trading firm profits, can be modest. Trade data provide some insights onto this source of risk to commodity trading firms. Figures 2 through 5 depict data relating to world exports by commodity. (Data related to world imports by commodity behave similarly, so I only present charts on exports.) Figure 2 graphs nominal exports by commodity reported in the ITC data for 2001-2011. These are indexed to simplify comparative analysis. Note the large downturns in nominal trade volumes in 2009, reflecting the impact of the financial crisis. Due to the large size of oil and steel and iron exports compared to those for other commodities, Figure 3 graphs nominal exports for all commodities except oil and iron and steel. Virtually all commodities exhibit a noticeable dip in 2009. As noted above, however, although changes in nominal flows reflect changes in both flat prices and quantities, quantities are the major determinants of commodity traders margins and profits. Figure 4 depicts annual nominal exports for each commodity deflated by its average annual price (scaled so that the 2001 average price equals 1.00) and indexed for comparison purposes. The impact of the 2008-2009 Financial Crisis is much less noticeable in the deflated exports than the nominal exports. Only iron and steel exhibit a pronounced dip. Figure 5 presents the deflated exports for all commodities studied excluding oil and iron and steel. These smaller commodities do not exhibit a pronounced decline in deflated exports (a proxy for quantity) in 2009. 52
SECTION VI These charts strongly support the conclusion that a large demand shock primarily affects commodity prices, and has a much smaller impact on the quantities of commodities traded. Inasmuch as the profitability of commodity trading firms is primarily driven by quantities (to the extent that these firms hedge price exposures), the risk that a large demand shock (like that experienced in 2008-2009) poses to the viability of commodity trading firms is limited. Demand shocks arising from a macroeconomic shock such as a financial crisis also affect the funding needs of commodity trading firms. Crucially, adverse shocks of this nature tend to reduce funding needs and liquidity stresses. Adverse demand shocks reduce prices, thereby reducing the amount of capital necessary to carry inventories of commodities as they undergo transformation processes. Moreover, to the extent that commodity trading firms are typically short derivative instruments (which may be marked to market on a daily basis) as hedges of commodity stocks, price declines generate mark-to-market gains on derivatives that result in variation margin inflows. This provides a source of funds to repay credit taken to acquire the inventories. That is, these price declines tend to result in cash inflows prior to obligations to make cash payments, which further ease funding needs of commodity trading firms. Macroeconomic demand shocks funding needs Figures 2-5 illustrate this clearly. The nominal value of virtually all commodities traded declined sharply in 2009, but quantities (as proxied for by deflated exports) did not decline substantially or uniformly across commodities. This decline in nominal trade reflects the pronounced price declines that occurred in late-2008 to mid-2009. Moreover, the sharp decline in the nominal value of a relatively stable quantity of exports means that the financing needed to carry out such exports declined sharply as well. FIGURE 2 INDEXED NOMINAL EXPORTS BY COMMODITY 2000 INDEXED $ NOMINAL VALUE (2001 = 100) 1800 1600 1400 1200 1000 800 600 400 200 0 2001 2002 2003 2004 2005 2006 YEAR 2007 2008 2009 2010 2011 Aluminum Coal Copper Iron/Steel Iron Ore Oil The decline in funding needs during periods of sharp demand declines resulting from a shock arising in the financial system is particularly beneficial, inasmuch as financial shocks constrain the availability of credit. The foregoing analysis implies that trading firms should be relatively robust, even to large shocks emanating from the financial system. This implication is testable, using data from the 2007-2009 financial crisis. I have reviewed data on ADM, Bunge, Cargill, Vitol, Louis Dreyfus, Mercuria Energy Trading, Glencore, Olam, Wilmar, Trafigura, and Noble....which makes them more resilient All of these firms remained profitable throughout the 2007-2009 commodity boom-bust cycle. Between 2007 and 2009 (the nadir of the commodity price cycle), net income changes ranged between -57% (Bunge) and 224% (Wilmar) with a median of between 44% (Cargill) and 113% (Noble). This sample is dominated by firms that are focused on agricultural commodity trading. Glencore is focused on metals and energy, two notably procyclical commodity sectors: its profit declined 24% over the cycle. Trafigura is focused on energy and industrial metals: its earnings rose 85% over the boom-bust cycle. Vitol is another energy-focused trading 53
FIGURE 3 NOMINAL EXPORTS BY COMMODITY EXCLUDING OIL, IRON & STEEL 200,000,000 180,000,000 $ NOMINAL VALUE (000) 160,000,000 140,000,000 120,000,000 100,000,000 80,000,000 60,000,000 40,000,000 20,000,000 0 2001 2002 2003 2004 2005 2006 YEAR 2007 2008 2009 2010 2011 Aluminum Coal Copper Iron Ore FIGURE 4 INDEXED DEFLATED EXPORTS BY COMMODITY INDEXED $ DEFLATED VALUE (BASE=2001 PRICE) 350 300 250 200 150 100 50 0 2001 2002 2003 2004 2005 2006 YEAR 2007 2008 2009 2010 2011 Aluminum Coal Copper Iron/Steel Iron Ore Oil FIGURE 5 DEFLATED EXPORTS BY COMMODITY EXCLUDING OIL & STEEL $ (000) DEFLATED NOMINAL VALUE (BASE= 2001 PRICE) 120,000,000 100,000,000 80,000,000 60,000,000 40,000,000 20,000,000 0 2001 2002 2003 2004 2005 2006 YEAR 2007 2008 2009 2010 2011 Aluminum Coal Copper Iron Ore 54
SECTION VI firm, and it experienced a 91% increase in income over the cycle. A third energy-focused firm, Mercuria Energy Trading, saw its income rise 122%. These figures are worth noting, given the substantial rise, decline, and subsequent rise in oil and metals prices over 2007-2009. This performance likely reflects the fact that economic volatility can create arbitrage opportunities, and serious economic downturns can increase the demand for some transformation activities, notably storage. The variability in performance across the firms for which data is available, with some companies suffering substantial declines in earnings and other substantial rises over the 2007-2009 commodity cycle (and Financial Crisis cycle), is inconsistent with the hypothesis that trading firm financial performance is highly sensitive to global economic conditions. This is in stark contrast to other SIFIs. Trading firms would be more likely to create systemic risk if, like SIFIs, their earnings were highly correlated over the cycle. This is true of large banks, whose profits collapsed during the Crisis. Total profits for the 8 US SIFI banks plunged from $58 billion in 2007 to a loss of $9.8 billion in 2008, and recovered only to $40 billion the following year. European SIFI banks earned a profit of $114 billion in 2007, but suffered a loss of $16.5 billion in 2008, with profits rebounding to $58 billion in 2009. This performance differs starkly from that of commodity trading firms over this period. Trading firms provide logistical services, and recent historical experience shows that even large disruptions of the logistical system have very modest effects on the broader economy. As noted throughout, one of the primary functions of commodity trading firms is to make transformations in space and time logistical transformations. Even if the assets utilized by a distressed trading firm to make these transformations are not redeployed immediately, the impact on the broader economy will almost certainly be minor. Recent experience demonstrates that even a major disruption of the logistical system in a major economic region does not cause an appreciable decline in the world economy. Specifically, the Japanese earthquake and tsunami in 2011 wreaked massive havoc on the single most important trading region in the world, but this had only very small effects on the world economy. These natural disasters seriously disrupted production at numerous firms that played a central role in global supply chains for high value manufactured output. A report prepared under the authority of the Directorate General of the Treasury of France concluded that: Their performance is relatively insensitive to global economic conditions Disruptions to logistics have limited economic impact Japan is a key player in global production chains, particularly in high-technology sectors. Japanese firms account for over 70% of global production in at least 30 technological sectors The triple disaster, which led to a nearly 8% reduction in Japanese products exports in Q2, also caused disruptions to global supply in some sectors, particularly in electronics and the automotive industry. Japan also plays a key role in Asian trade where production chains are highly integrated. Schematically, Japan supplies sophisticated intermediate goods to and buys final goods from its Asian partners including China, the pivot of the new international division of labor, which performs assembly and transformation of the semi-finished products. Given the network structure of production processes, a shock affecting an upstream producer can cause strong fluctuations in the economy as a whole, through cascade effects from one firm to another. 9 Nonetheless, the French Treasury concluded that the effect of the catastrophe on aggregate output was small, even in Asia. It estimates that the effect was 0.1 point of GDP in China and 0.2 percentage points for other Asian dragons in Q2 2011. Furthermore, it concluded that the impact is very low in Europe and the US. Furthermore, it found that virtually zero impact for the full year 2011, because of the restoration of both Japanese production capacity and global supply chains. The IMF Japan Spillover Report also found that the effects of the earthquake were modest (outside of the automobile industry) and short lived (even in the auto sector). 10 The Japanese natural disaster caused the destruction of production capacity. The affected capacity was an essential element of a complex supply chain in high value-added industries. Even so, the spillover effects of this destruction were small and fleeting. This demonstrates the resilience of economic activity to the disruption of trade. 9 The impact of Japan s earthquake on the global economy. Tresor-Economics Report No. 100 (2012). 10 International Monetary Fund: Japan Spillover Report for the Article IV Consultation and Selected Issues (2012). 55
failed it has not caused problems The financial distress of a trading firm would not result in the destruction of any productive assets (although it could impede the efficiency of their use); the assets would be available to be redeployed, or operated by those who control the distressed firm. No single firm, or even multiple firms, is as critical in the global supply chain for large, high value added industries (such as autos and electronics) as the Japanese companies affected by the earthquake and tsunami. Thus, the effects on the broader economy of the financial distress of a large commodity trading firm, or even multiple firms, would almost certainly be smaller, and shorter lived, than the small effects of these natural disasters. There have been numerous instances in which commodity trading firms have suffered large losses, or actually failed, without causing problems in the broader financial system. There have been numerous instances in which large commodity trading firms have suffered large losses, sometimes resulting in the failure of the firms involved, but where there were no pronounced disruptions in the commodity markets in which the firm operated, let alone in the broader economy. In commodities in particular, large losses at Ferruzzi ($4 billion), Metallgesellschaft (over $1 billion), Sumitomo ($2 billion), Constellation (a $10 billion loss in market capitalization), or Amaranth ($6 billion) did not have broader systemic consequences. Enron was the most important trading intermediary in US natural gas and power markets, and its precipitous collapse did not disrupt those markets appreciably, let alone the broader economy. Some months after Enron s demise, the entire merchant energy sector in the US suffered catastrophic financial losses. From 25 April, 2002 through the end of May of that year, the equity values of a portfolio of large energy merchants declined by approximately 91%. The credit rating of every energy merchant firm was downgraded. Many firms exited the business, and one prominent firm (Mirant) declared bankruptcy. Commodity a crucial role, but they are not systemically important Merchant energy firms engaged in the same transformational activities as commodity trading firms, and also provided risk management and financing for their customers similar to those provided by commodity trading firms. Despite the acute financial distress of the entire sector, gas and power continued to flow, houses were heated and lights went on. Moreover, there was no impact on the broader economy. In sum, many commodity trading firms are large, and play a crucial role in facilitating the flow of vital commodities to their highest value uses, but that does not make them systemically important in the same way banks and other major financial institutions are. Commodity trading firms provide very different intermediation services than banks do. What s more, they are not central to the provision of credit in the same way banks are. Furthermore, in comparison to banks, they are not large. They are not, therefore, too big to fail, and should not, therefore, be subject to the same kinds of regulation as banks. 56
SECTION VI 57
AFTERWORD Commodity trading firms transform commodities in space, time, and form in order to enhance their value. Their function is to move commodities from low value uses to high value ones. In so doing, they enhance the wealth and welfare of both the producers and consumers of commodities. It may seem paradoxical, but commodity trading raises the prices that producers receive, and lowers the prices that consumers pay. It is not paradoxical, however, because commodity traders are both buyers and sellers, and are in the business of earning a margin between sales and purchase prices: they care little about the level of prices overall. Competition on margins between traders tends to narrow price differentials and encourages traders to improve the process of transforming commodities from what producers produce to what consumers consume. They do not do this out of altruism. Moreover, their activities are not uniformly beyond reproach. But the profit motive and intense competition combine to create a powerful tendency for these firms to create value, of which they take a relatively small portion. Nonetheless, commodity trading is controversial, especially in times like the present, and the recent past, in which prices have been high. But this is nothing new. Adam Smith noted the same phenomenon when writing in 1776 about criticisms of commodity trading dating back to the 14th century, criticisms eerily similar to those heard today. Smith had an answer to these criticisms, and his answer remains true today even though in size, scope, technology, and financing commodity trading today is vastly different than it was in 1776, let alone the time of Edward VI. Smith understood how the transformation of commodities by competing firms benefits producers and consumers. By highlighting the role of transformations, and analyzing them in detail, I have attempted to provide a conceptual framework for analyzing commodity trading and evaluating the role of commodity trading firms. Hopefully this will contribute to a more informed public discussion of commodity trading, and how it can be improved through good policy. 58
AFTERWORD 59
APPENDIX A TABLE 1 SOURCE DATA FOR INTERNATIONAL TRADE FLOW IN COMMODITIES AGRICULTURAL ENERGY INDUSTRIAL COMMODITY UNCTAD/WTO CODE Animal or Vegetable Fats or Oils* 15 Cane or beet sugar* 1701 Corn* 1005 Cocoa beans 1801 Coffee* 901 Cotton* 52 Cotton neither carded or combed* 5201 Palm Oil* 1511 Rice* 1006 Soyabeans* 1201 Soyabean oil 1507 Wheat* 1001 Coal* 2701 Petroleum oils (crude)* 2709 Iron and steel* 72 Iron Ore* 2601 Aluminum* 76 Aluminum ores and concentrates 2606 Copper* 74 Copper ores and concentrates* 2603 Lead 78 Lead ores and concentrates 2607 Nickel* 75 Nickel ores and concentrates 2604 Tin 80 Tin ores and concentrates 2609 Zinc* 79 Zinc ores and concentrates 2608 Annual nominal export volumes for 28 commodities between 2001 and 2011 can be found on the International Trade Centre s Trade Map statistical database. These data were used to calculate correlations between commodities. A subset of these commodities (asterisked) is represented graphically in Figures 2,3,4 and 5. 60
APPENDIX A 61
APPENDIX B TRADING ACTIVITY AND PHYSICAL ASSET OWNERSHIP FOR LEADING COMMODITY TRADING FIRMS Industrial Metals Petroleum Natural Gas Oilseeds Wheat Cotton Coffee Iron Ore Cocoa FIGURE 1 ADM Corn Sugar Trading x x x Upstream Midstream x x x Downstream x x x Coal Power Industrial Metals Natural Gas Petroleum Oilseeds Iron Ore FIGURE 2 BUNGE Corn Wheat Cotton Sugar Trading x x x x Upstream Midstream x x x x Downstream x x x Coal Cocoa Coffee Power Industrial Metals Natural Gas Petroleum Oilseeds Iron Ore FIGURE 3 CARGILL Corn Wheat Cotton Sugar Cocoa Trading x x x x x x x x x x x x Upstream x x x Midstream x x x x x x Downstream x x x x x Coffee Coal Power Industrial Metals Natural Gas Petroleum Oilseeds Iron Ore FIGURE 4 LOUIS DREYFUS Corn Wheat Cotton Trading x x x x x x x Upstream x x x Midstream x x x x x x x Downstream x x x x x Sugar Cocoa Coffee Coal Power Industrial Metals Natural Gas Petroleum Oilseeds Iron Ore FIGURE 5 GLENCORE Corn Wheat Cotton Sugar Trading x x x x x x x x x Upstream x x x Midstream x x x x x x x Downstream x x x x Cocoa Coffee Coal Power Industrial Metals Natural Gas Petroleum Oilseeds Iron Ore FIGURE 6 GUNVOR Corn Wheat Cotton Sugar Trading x x Upstream x x Midstream x Downstream x Cocoa Coffee Coal Power 62
APPENDIX B Industrial Metals Natural Gas Petroleum Oilseeds Iron Ore FIGURE 7 MERCURIA Corn Wheat Cotton Sugar Cocoa Trading x x x x x x x x x Upstream x x Midstream x x x Downstream Coffee Coal Power Industrial Metals Natural Gas Petroleum Oilseeds Iron Ore FIGURE 8 TRAFIGURA Corn Wheat Cotton Sugar Trading x x x x x Upstream x Midstream x x x x Downstream x Cocoa Coffee Coal Power Industrial Metals Natural Gas Petroleum Oilseeds Iron Ore FIGURE 9 VITOL Corn Wheat Cotton Sugar Cocoa Trading x x x x Upstream x x Midstream x x x Downstream x Coffee Coal Power Industrial Metals Natural Gas Petroleum Oilseeds Iron Ore FIGURE 10 OLAM Corn Wheat Cotton Trading x x x x x x Upstream x x x x Midstream x x x x Downstream x x x x x Sugar Cocoa Coffee Coal Power Industrial Metals Natural Gas Petroleum Oilseeds Iron Ore FIGURE 11 NOBLE Corn Wheat Cotton Sugar Cocoa Trading x x x x x x x x x x x Upstream x x x Midstream x x x x x x x x x x Downstream x x x Coffee Coal Power Industrial Metals Natural Gas Petroleum Oilseeds Iron Ore FIGURE 12 WILMAR Corn Wheat Cotton Sugar Trading x x x Upstream x x Midstream x x x Downstream x x x Coal Cocoa Coffee Power 63
Commodity trading is one of the oldest forms of human activity. It is central to the global economy. Yet up to now there has been remarkably little research into this important area. The Economics of Commodity Trading Firms through a combination of description and analysis. Professor Pirrong employs a variety of economic concepts to investigate the dynamics of the commodity trading business. His analysis produces valuable insights into the nature of the business, and the economic role and social relevance of commodity trading firms. TD/0062.2e
SPECIAL SUPPLEMENT to the April 2011 Oil Market Report The Mechanics of the Derivatives Markets What They Are and How They Function April 2011
PREFACE This supplement to the April 2011 OMR is designed as a reference document for member governments and subscribers. It forms part of an ongoing work programme examining the mechanics of oil price formation and the interactions between the physical and paper markets. Further research will be forthcoming in the OMR, the MTOGM and in the form of stand alone papers in months to come. The work programme is being supported by contributions from member governments, most notably those from Japan and Germany. We are grateful for that support. Further impetus for this work comes from the joint work programme the IEA is undertaking alongside the IEF and OPEC secretariats, as requested by IEF, G8 and G20 Ministers. The work is overseen by David Fyfe, and the supplement s main author is Bahattin Buyuksahin, to whom all enquiries should be addressed.
TABLE OF CONTENTS 1. INTRODUCTION TO DERIVATIVES... 4 1.1 Basics of Derivatives... 5 1.2 Types of Derivatives... 6 1.3 History of Derivatives Markets... 6 1.4 The Markets... 7 1.5 Types of Market Participants in Derivatives Markets... 8 1.5.1 Hedgers... 8 1.5.2 Speculators... 9 1.5.3 Swap Dealers and Commodity Index Traders... 10 2. FORWARDS AND FUTURES... 12 2.1 Forward Contracts... 12 2.2 Futures... 14 2.2.1 Contract Specifications... 15 Box 1: Grade and Quality Specifications of WTI Contract... 16 2.2.2 The Clearinghouse Margins... 17 2.2.3 Settlement Price, Volume and Open Interest in Futures Markets... 19 2.2.4 Types of Orders... 20 2.3 Hedging Using Futures Contracts... 20 2.4 Basis Risk... 22 3. SWAPS... 23 3.1 Mechanics of Swaps... 26 4. OPTIONS... 28 4.1 Call Option... 29 4.2 Put Option... 32 4.3 Moneyness of Options... 33 4.4 Hedging Using Options... 34 5. REFERENCES... 35 6. GLOSSARY OF THE DERIVATIVES MARKET TERMS... 36
1. INTRODUCTION TO DERIVATIVES INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS 1. INTRODUCTION TO DERIVATIVES In the last thirty years, the world of finance and capital markets has experienced a quite spectacular transformation in the derivatives markets. Futures, options and swaps, as well as other structured financial products, are now actively traded on many exchanges and over the counter (OTC) markets throughout the world, not only by professional traders but also by retail investors, whose interest in these derivatives has increased. Derivatives are financial instruments whose returns are derived from those of another financial instrument. As opposed to spot (cash) markets, where the sale is made, the payment is remitted, and the good or security is delivered immediately or shortly thereafter, derivatives are markets for contractual instruments whose performance depends on the performance of another instrument, the so called underlying instrument. For example, a crude oil futures is a derivative whose value depends on the price of crude oil. Derivatives contracts play a very important role in managing the risk of underlying securities such as commodities, bonds, equities and equity indices, currencies, interest rates or liability positions. Commodity derivatives are traded in agricultural products (corn, wheat, soybeans, soybean oil), livestock (live cattle, pork bellies, lean hogs); precious metals (gold, silver, platinum, palladium); industrial metals (copper, zinc, aluminum, tin, nickel); soft commodities (cotton, sugar, coffee, cocoa); forest products (lumber and pulp); and energy products (crude oil, natural gas, gasoline, heating oil, electricity). Financial derivatives, where in many cases no delivery of the physical security is involved, are traded on stocks and stock indices (single stocks, S&P 500, Dow Jones Industrials); government bonds (US Treasury bonds, US Treasury notes); interest rates (EuroDollars) and foreign exchanges (Euro, Japanese Yen, Canadian Dollar). In recent years, new derivatives instruments have been devised, which are different from the more traditional instruments, as the underlying asset of these derivatives is no longer necessarily a liquid, marketable good. For example, derivatives trading has begun on weather and credit risk. The derivatives market as a whole, and over the counter markets in particular, has recently attracted more attention after the onset of the financial crisis in 2008. In this report, we will look at the main building blocks of derivatives markets, including forwards, futures, swaps and options markets. 4 APRIL 2011
INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS 1. INTRODUCTION TO DERIVATIVES 1.1 Basics of Derivatives Derivatives contracts get their name from the fact that they are derived from some other underlying claim, contract, or asset. For instance, a crude oil forward contract is derived from the underlying physical asset crude oil. Derivatives are also called contingent claims. This term reflects the fact that their payoff the cash flow is contingent upon the price of something else. Going back to the crude oil forward contract example, the payoff to a crude oil forward contract is contingent upon the price of crude oil at the expiration of the contract. Hedgers, speculators and arbitrageurs use derivatives instruments for different purposes. Hedgers use derivatives to eliminate uncertainty by transferring the risk they face from potential future movement in prices of the underlying asset. In this regard, derivatives serve as an insurance or risk management tool against unforeseen price movements. Speculators, on the other hand, use these instruments to make profits by betting on the future direction of market prices of the underlying asset. Therefore, derivatives can be used as an alternative to investing directly in the asset without buying and holding the asset itself. Arbitrageurs use derivatives to take offsetting positions in two or more instruments to lock in a profit. In addition to risk management, derivatives markets play a very useful economic role in price discovery. Price discovery is the process of which market participants (buyers and sellers) uncover an asset s full information or permanent value, and then disseminate those prices as information throughout the market and the economy as a whole. Thus, market prices are important not only for those buying and selling the asset or commodity but also for the rest of the global market s participants (consumers or producers) who are affected by the price level. In summary, two of the most important functions of derivatives markets are the transfer of risk and price discovery. In a well functioning futures market, hedgers, who are trying to reduce their exposure to price risk, will trade with someone, generally a speculator, who is willing to accept that risk by taking opposing positions. By taking the opposing positions, these traders facilitate the needs of hedgers to mitigate their price risk, while also adding to overall trading volume, which contributes to the formation of liquid and well functioning markets. APRIL 2011 5
1. INTRODUCTION TO DERIVATIVES INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS 1.2 Types of Derivatives There are four major types of derivatives instruments. In some respects, these may be regarded as building blocks and can be categorised as follows: Forwards Futures Swaps Options Each instrument has its own characteristics, which offers advantages in using them, but also brings disadvantages, which are discussed later in the text. 1.3 History of Derivatives Markets Although derivatives are frequently considered to be something new and exotic, they have been around for millennia. There are examples of derivative contracts in Aristotle s works and the Bible. It is true, however, that the use of financial derivatives has been growing since 1980s. The origins of derivatives trading dates back to 2000 B.C. when merchants, in what is now called Bahrain in the Middle East, made consignment transactions for goods to be sold in India. Derivatives contracts, dating back to the same era, have also been found written on clay tablets from Mesopotamia, when farmers borrowed barley from the King s daughter by promising to return it at harvest time. This trade can either be considered as a commodity loan or as a short selling operation. It is a commodity loan because farmers borrowed barley in order to use it for planting the crop and they promised to return it after harvesting. Of course, it is a short selling trade since farmers do not have any barley at the time of contract agreement. 1 A more literary reference comes some 2 350 years ago from Aristotle, who discussed a case of manipulation call option style investment on olive oil presses. In Politics, Aristotle told the story of a trader, who buys exclusive right to use olive oil presses in the upcoming harvest from the owners of this equipment. The trader paid some down payment for this right. During the harvesting season, the demand for olive oil presses rose as predicted by the trader and he sold his right to use this equipment to other parties. In the meantime, the trader made a profit without actually being in the olive oil production business. The trader s trade carried only his down payment (option premium) as a risk; on the other hand, owners of olive oil presses transferred some of the risks associated with the possibility of a bad crop season to the trader. 1 See Weber (2008) for a detailed excellent review of the history of derivatives markets. 6 APRIL 2011
INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS 1. INTRODUCTION TO DERIVATIVES Derivatives trading in an exchange environment and with trading rules can be traced back to Venice in the 12th century. Forward and options contracts were traded on commodities, shipments and securities in Amsterdam after 1595. The first standardised futures contract can be traced to the Yodoya rice market in Osoka, Japan around 1700. In the US, forward and futures contracts of agricultural products such as wheat and corn have been formally traded on the Chicago Board of Trade 2 (CBOT) since 1848. The CBOT initially offered forward contracts on agricultural commodities. In 1865, the first standardised futures contracts were introduced on the CBOT floor. The Chicago Mercantile Exchange (CME) was established in 1919 to offer futures contracts on livestocks and agricultural products. The CME has increased the number of contracts listings over time and is now best known worldwide for its financial products, including its flagship Eurodollar contract. 1.4 The Markets There are basically two types of markets in which derivatives contracts trade. These are exchange traded markets and over the counter (OTC) markets. Regulated exchanges, since their inception in the mid 1800s until recently, have been the main venue on which producers and large scale consumers of commodities hedge their risk against fluctuations in market prices, while allowing speculators to make profits by anticipating these fluctuations. Exchange traded derivatives are fully standardised and their contract terms are designed by derivatives exchanges. However, due to standardisation and fixed contract specifications in exchange traded contracts, financial institutions began to develop non exchange traded (or over the counter, OTC) derivatives contracts. Instruments in the OTC markets are generally privately negotiated between market makers (or so called swap dealers) and their clients. Unlike exchange traded products, OTC instruments can be customised to fit clients needs. These instruments, like standardised futures contracts, can be used by hedgers to hedge their exposure to the physical asset itself, or by speculators to make speculative profits if prices of the underlying asset move in an expected direction. According to the latest Bank of International Settlements (BIS) survey, the total notional value of all OTC derivatives reached $583 trillion at end June 2010, of which $2.85 trillion (0.5%) was in commodityrelated derivatives. At their peak in end June 2008, the total notional value of commodity related derivatives had reached $13 trillion, or 2% of the total market. The total notional value of all exchangetraded derivatives contracts exceeded $90 trillion at that time. 2 CBOT merged with CME in 2007. APRIL 2011 7
1. INTRODUCTION TO DERIVATIVES INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS Figure 1: Size of Over the Counter and Exchange Traded Derivatives Markets Size of Markets ($ trillion) 800 700 600 500 400 300 200 100 0 OTC Exchange 1.5 Types of Market Participants in Derivatives Markets Trading participants in derivatives markets can be placed into three basic categories as we mentioned earlier: (1) hedgers (2) speculators and (3) arbitrageurs. In addition to these three broad categories, swap dealers and commodity index traders are important types of market participants and have been centre stage during the recent debate on financial regulations. We discuss swap dealers and their business in details in Section 3. 1.5.1 Hedgers Hedgers use derivatives markets to offset the risk of prices moving unfavourably for their ongoing business activities. Hedgers, including both producers (oil producers, farmers, refiners, etc) and consumers (airlines, refiners, etc), hold positions in both the underlying commodity and in the futures (or options) contracts on that commodity. A long futures hedge is appropriate when you know you will purchase an asset in the future and want to lock in the price. A short futures hedge is appropriate when you know you will sell an asset in the future and want to lock in the price. By hedging away risks that you do not want to take, you can take on more risks that you want to take while maintaining desired/target aggregate risk levels. For example, an oil producer can hedge against declines in oil price by selling an oil futures contract (taking a short position) on the exchange in light of its oil position, which is naturally long, in the physical market. If the price of oil increases over time, the profits from the actual sale of oil are offset by losses from holding the futures contract. On the other hand, if prices decline over time, oil producers can offset their losses from the actual sale of oil from selling their short position in the futures market. Basically, whatever happens to prices, hedgers are guaranteed to have constant profit. 8 APRIL 2011
INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS 1. INTRODUCTION TO DERIVATIVES Hedgers, who hold short positions in the physical market, take long positions in the paper market to limit the risk associated with fluctuations in underlying asset prices. For example, an airline company can hedge against a rise in oil prices by buying oil futures contracts (taking a long position) on the exchange for the oil required to operate its business activities (the airline company position is short in the physical market). Some hedgers might be both producers and consumers in some related commodities. For example, refiners use crude oil to produce petroleum products. Crude oil is refined to make petroleum products, in particular heating oil and gasoline. The split of oil into its different components is frequently achieved by a process known as cracking, hence the difference in price between crude oil and equivalent amounts of heating oil and gasoline is called a crack spread. Therefore, refiners can take positions in crack spreads. 3 1.5.2 Speculators Speculators, on the other hand, use derivatives to seek profits by betting on the future direction of market prices of the underlying asset. Hedge funds, financial institutions, commodity trading advisors, commodity pool operators, associate brokers, introducing brokers, floor brokers and traders are all considered to be speculators. In the CFTC s Commitment of Traders report, hedge funds, commodity pool operators, commodity trading advisors and associate persons constitute managed money traders. Speculators use derivatives instruments to make profits by betting on the future direction of market prices of the underlying asset. Traditional speculators can be differentiated based upon the time horizons during which they operate. Scalpers, or market makers, operate at the shortest time horizon sometimes trading within a single second. These traders typically do not trade with a view as to where prices are going, but rather make markets by standing ready to buy or sell at a moment s notice. The goal of a market maker is to buy contracts at a slightly lower price than the current market price and sell 3 The following discussion of crack spread contracts comes from the Energy Information Administration publication Derivatives and Risk Management in the Petroleum, Natural Gas, and Electricity Industries. Refiners profits are tied directly to the spread, or difference, between the price of crude oil and the prices of refined products. Because refiners can reliably predict their costs other than crude oil, the spread is their major uncertainty. One way in which a refiner could ensure a given spread would be to buy crude oil futures and sell product futures. Another would be to buy crude oil call options and sell product put options. Both of those strategies are complex, however, and they require the hedger to tie up funds in margin accounts. To ease this burden, NYMEX in 1994 launched the crack spread contract. NYMEX treats crack spread purchases or sales of multiple futures as a single trade for the purposes of establishing margin requirements. The crack spread contract helps refiners to lock in a crude oil price and heating oil and unleaded gasoline prices simultaneously in order to establish a fixed refining margin. One type of crack spread contract bundles the purchase of three crude oil futures (30 000 barrels) with the sale a month later of two unleaded gasoline futures (20 000 barrels) and one heating oil future (10 000 barrels). The 3 2 1 ratio approximates the real world ratio of refinery output 2 barrels of unleaded gasoline and 1 barrel of heating oil from 3 barrels of crude oil. Buyers and sellers concern themselves only with the margin requirements for the crack spread contract. They do not deal with individual margins for the underlying trades. An average 3 2 1 ratio based on sweet crude is not appropriate for all refiners, however, and the OTC market provides contracts that better reflect the situation of individual refineries. Some refineries specialize in heavy crude oils, while others specialize in gasoline. One thing OTC traders can attempt is to aggregate individual refineries so that the trader s portfolio is close to the exchange ratios. Traders can also devise swaps that are based on the differences between their clients situations and the exchange standards. APRIL 2011 9
1. INTRODUCTION TO DERIVATIVES INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS them at a slightly higher price, perhaps at only a fraction of a cent profit on each contract. Skilled market makers can profit by trading hundreds or even thousands of contracts a day. Market makers provide immediacy to the market. Without a market maker, another market participant would likely have to wait longer until the arrival of a counterparty with an opposite trading interest. Other types of speculators take longer term positions based on their view of where prices may be headed. Day traders establish positions based on their views of where prices might be moving within minutes or hours, while trend followers take positions based on price expectations over a period of days, weeks or months. These speculators can also provide liquidity to hedgers in futures markets. Through their efforts to gather information on underlying commodities, the activity of these traders serves to bring information to the markets and aid in price discovery. 1.5.3 Swap Dealers and Commodity Index Traders Instruments in the OTC markets are generally privately negotiated between market makers (or so called swap dealers) and their client. The party offering the swap, or swap dealer, takes on any price risks associated with the swap and thus must manage the risk of the commodity exposure. The counterparties to swap dealers are generally hedgers, speculators or commodity index traders. Investor interest in commodities, including oil, has risen quite dramatically over the last decade and commodities have become a new asset class in institutional investors portfolio. Partly, this development is due to diversification benefits. In addition, the development of new investment vehicles, such as exchange traded funds, has allowed individual investors to get exposure to movements in commodity prices. Due to the storage and trading costs associated with direct physical investment in commodities, the main vehicle used by investors to gain exposure to commodities is via commodity indices (baskets of short maturity commodity futures contracts that are periodically rolled as they approach expiry), exchange traded funds or other structured products. These instruments provide generally long only exposure to commodities. The vast majority of commodity index trading by principals is conducted offexchange using swap contracts. The main goal of commodity index funds is to track the movement of commodity prices. There exist several major commodity indices as well as sub indices. Standard and Poors GSCI (formerly the Goldman Sachs Commodity Index) is the oldest and most widely tracked index in the market. The S&P GCSI, first 10 APRIL 2011
INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS 1. INTRODUCTION TO DERIVATIVES created in 1991, covers 24 commodities but is heavily tilted toward energy because its weights reflect world production figures. For example, in 2010, energy markets received almost 72% weight. Investors are exposed to three sources of returns in total return commodity index investments. The first type is the yield on the underlying commodity futures. The second type is the roll return, which is generated from the rolling of nearby futures into first deferred contracts. Depending on whether the forward curve is in contango (when longer dated futures prices are higher than nearby contracts) or, conversely, in backwardation (when nearby prices are higher than longer dated futures prices), the roll yield is either negative (in contango) or positive (in backwardation). The third type is the T bill return, which is the return on collateral. Historically, the roll return has constituted the largest contributor in total return. However, the roll return component has been negative since 2005 for the S&P GSCI Total Return Index due to the contango market we observe in crude oil futures markets. Institutional investors generally gain exposure to commodity prices through their investment in a fund that tracks a popular commodity index. The fund managers themselves either directly offset their resulting short positions by going long in futures markets or by entering swap agreements with a swap dealer. In turn, swap dealers in the OTC market generally go long or short in the futures market to offset their net long (or short) position. Of course, the client base of swap dealers also includes traditional hedgers. APRIL 2011 11
2. FORWARDS AND FUTURES INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS 2. FORWARDS AND FUTURES 2.1 Forward Contracts A forward contract is an OTC agreement between two parties to exchange an underlying asset: for an agreed upon price (the forward price or the delivery price) at a given point in time in the future (the expiry date or maturity date) Since it is traded between two parties in the over the counter market, there is a small possibility that either side can default on the contract. Therefore, forward contracts are mainly between big institutions or between a financial institution and one of their clients. Forward contracts are most popular in currency and interest rates markets. The party that has agreed to buy the underlying asset has a long position. The party that has agreed to sell the underlying asset has a short position. By signing a forward contract, one can lock in a price ex ante for buying or selling a security. Ex post, whether one gains or loses from signing the contract depends on the spot price at expiry. If the price of the underlying asset rises, then the party who has a long position in the contract gains while the party who has a short position loses. Example 1: A commodity contract Trader A agrees to sell to Trader B one million barrels of WTI crude oil at the price of $100/bbl with delivery in six months. In this forward contract, WTI crude oil is the underlying asset. Trader A is said to be short the contract, since he must deliver oil in six months. Trader B is said to be long the contract, since he receives the delivery of oil in six months. If at the end of six months the price of oil is at $110, then the trader with a long position has a profit of $10 000 000 and the trader with a short position loses $10 000 000. On the other hand, if the price of oil is $95 at the end of six months, then the trader with a long position loses $5 000 000 and the one with a short position has a profit of $5 000 000. Example 2: A foreign exchange contract On 18 February 2011, Party A signs a forward contract with Party B to sell one million British pounds (GBP) at $1.6190 per GBP six months later. Today (18 February 2011), sign a contract, shake hands. No money changes hands. Party A entered a short position and Party B entered a long position on GBP. 12 APRIL 2011
INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS 2. FORWARDS AND FUTURES But since it is on exchange rates, we can also say: Party A entered a long position and Party B entered a short position on USD. 18 August 2011 (the expiry date), Party A pays one million GBP to Party B, and receives 1.6190 million USD from Party B in return. Currently (18 February, the spot price for the pound (the spot exchange rate) is 1.6234. Six months later (18 August 2011), the exchange rate can be anything (unknown). $1.6190 per GBP is the forward price. The forward price for a contract is the delivery price that would be applicable to the contract if it were negotiated today. It is the delivery price that would make the contract worth exactly zero. In the previous example, Party A agrees to sell one million pounds at $1.6190 per GBP at expiry. If the spot price is $1.61 at expiry, what is the profit and loss (P&L) for party A? On 18 August 2011, Party A can buy one million GBP from the market at the spot price of $1.61 and sell it to Party B per forward contract agreement at $1.6190. The net P&L at expiry is the difference between the strike price (K = 1.6190) and the spot price (S T = 1.61), multiplied by the notional value (one million). Hence, the profit is $9 000. The primary use of a forward contract is to lock in the price at which one buys or sells a particular good in the future. This implies that the contract can be utilised to manage price risk. Forward contracts can be used to hedge against unforeseen movement in market prices. Consider an airline company which is going to buy 100 000 barrels of oil one year from today. Suppose that forward price for delivery in one year is $100/bbl. Suppose that the yield on a oneyear and zero coupon bond is 5%. The airline company can use a forward contract to guarantee the cost of buying oil for the next year. The present value of this cost will be 100/1.05=95.24. The airline company could invest this amount to buy oil in one year or it could pay an oil supplier $100 at the delivery of the oil. If the spot price at the end of one year is above the agreed forward price, the airline company gains from this hedging. If the spot price at maturity is below the forward price, it would lead to the airline company to pay more than the market price of oil. Regardless of the spot price at the delivery, the airline company protects itself from potential loss and eliminates uncertainty regarding price movements. APRIL 2011 13
2. FORWARDS AND FUTURES INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS 2.2 Futures Like a forward contract, a futures contract is a binding agreement between a seller and a buyer to make (seller) and to take (buyer) delivery of the underlying commodity (or financial instrument) at a specified future date with agreed upon payment terms. Unlike forward contracts: Futures contracts are standardised and exchange traded. Default risk is borne by the exchange clearinghouse. Traders are allowed to reverse ( offset ) their positions, so that physical delivery is rare (futures can be used to trade in the risk, not the commodity). This is true because most hedgers are not dealing in the commodity deliverable against the futures contract. For instance, an airline company is not going to use WTI crude oil in Cushing, Oklohama, for its operation, but may use the WTI futures contract as a hedge. That is, most hedgers are cross hedgers. Similarly, speculators are just betting on price movement, and have no interest in owning the physical oil. Therefore, most hedgers and speculators reverse their position prior to delivery. Value is marked to market daily. Different execution details also lead to pricing differences, e.g., effect of marking to market on interest calculation. Table 2.1 : Comparison Between Forward and Futures Contracts FORWARDS Private contracts between two parties Non standard contract Usually one specified delivery date Settled at the end of the contract Delivery or final cash settlement usually occurs Some credit risk FUTURES Exchange traded Standard contract Range of delivery dates Settled daily Delivery is rare, usually parties offset their position before maturity Virtually no credit risk The fact that futures contracts terms are standardised is important because it enables traders to focus their attention on one variable, namely price. Standardisation also makes it possible for traders anywhere in the world to trade in these markets and know exactly what they are trading. This is in sharp contrast to the cash forward contract market, in which changes in specifications from one contract to another might cause price changes from one transaction to another. 14 APRIL 2011
INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS 2. FORWARDS AND FUTURES 2.2.1 Contract Specifications One of the main differences between forward contracts and futures contracts is the fact that futures contracts are standardised. When an exchange introduces a new contract, it has to specify in some detail the exact nature of the asset, the contract size, delivery point, delivery time, and settlement type (physical delivery or cash settlement). The underlying asset in the futures contract can be anything, ranging from commodities to stock indices, equities, bond, foreign exchange, interest rate, and so on. However, the exchange has to specify the exact terms in identifying the contract. The financial assets in futures contracts are well defined and there is no ambiguity. However, in the case of commodities, there may be quite a variation in the quality of what is available in the marketplace. When the asset is specified, the exchange has to specify in detail grade or grades of commodity that are acceptable for delivery. For example, the Chicago Mercantile Exchange (CME) deliverable grade specification of the WTI futures contract is presented in Box 1. Standardisation of futures contracts also requires the specification of the delivery point and the contract size (amount of asset that has to be delivered under one contract). For example, under the WTI futures contracts traded on the CME, delivery can be made F.O.B. at any pipeline or storage facility in Cushing, Oklahoma with pipeline access to TEPPCO, Cushing storage or Equilon Pipeline Company LLC Cushing storage. The contract size, on the other hand, is 1 000 US barrels (42 000 US gallons) of WTI crude oil. Futures contracts are also standardised with respect to the delivery month. The exchange must specify the precise period during the month when delivery can be made. The exchange also specifies when trading in a particular month s contract will begin, the last day on which trading can take place for a given contract as well as the delivery months. For example, CME WTI crude oil futures are listed nine years forward using the following listing schedule: consecutive months are listed for the current year and the next five years; in addition, the June and December contract months are listed beyond the sixth year. Additional months will be added on an annual basis after the December contract expires, so that an additional June and December contract would be added nine years forward, and the consecutive months in the sixth calendar year would be filled in. Even though physical delivery does not occur on most contracts, delivery is important nonetheless. Delivery ties the price of the expiring futures to the price of the physical commodity at delivery. Nonetheless, cash settlement can be considered another way to tie the futures and cash markets together. In a cash settled contract, at expiration the buyer pays the seller the difference between the fixed price established in the contract and the reference price prevailing on payment. APRIL 2011 15
2. FORWARDS AND FUTURES INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS Box 1: Grade and Quality Specifications of WTI Contract (Source CME) Light sweet crude oil meeting all of the following specifications and designations shall be deliverable in satisfaction of futures contract delivery obligations under this rule: (A) Domestic Crudes, (Deliverable at Par) Deliverable Crude Streams West Texas Intermediate Low Sweet Mix (Scurry Snyder) New Mexican Sweet North Texas Sweet Oklahoma Sweet South Texas Sweet Blends of these crude streams are only deliverable if such blends constitute a pipeline's designated common stream shipment which meets the grade and quality specifications for domestic crude. TEPPCO Crude Pipeline, L.P.'s and Equilon Pipeline Company LLC's Common Domestic Sweet Streams that meet quality specifications in Rule 200.12(A)(2 7) are deliverable as Domestic Crude. Sulfur: 0.42% or less by weight as determined by A.S.T.M. Standard D 4294, or its latest revision; (3) Gravity: Not less than 37 degrees API, nor more than 42 degrees API as determined by A.S.T.M. Standard D 287, or its latest revision; Viscosity: Maximum 60 Saybolt Universal Seconds at 100 degrees Fahrenheit as measured by A.S.T.M. Standard D 445 and as calculated for Saybolt Seconds by A.S.T.M. Standard D 2161; Reid vapor pressure: Less than 9.5 pounds per square inch at 100 degrees Fahrenheit, as determined by A.S.T.M. Standard D 5191 96, or its latest revision; Basic Sediment, water and other impurities: Less than 1% as determined by A.S.T.M. D 96 88 or D 4007, or their latest revisions; Pour Point: Not to exceed 50 degrees Fahrenheit as determined by A.S.T.M. Standard D 97. (B) Foreign Crudes Deliverable Crude Streams U.K.: Brent Blend (for which seller shall be paid a 30 cent per barrel discount below the last settlement price) Nigeria: Bonny Light (for which seller shall be paid a 15 cent per barrel premium above the last settlement price) Nigeria: Qua Iboe (for which seller shall be paid a 15 cent per barrel premium above the last settlement price) Norway: Oseberg Blend (for which seller shall be paid a 55 cent per barrel discount below the last settlement price) Colombia: Cusiana (for which seller shall be paid 15 cent per barrel premium above the last settlement price) Each foreign crude stream must meet the following requirements for gravity and sulfur, as determined by A.S.T.M. Standards referenced in Rule 200.12(A)(2 3): Foreign Crude Stream Minimum Gravity Maximum Sulfur Brent Blend 36.4 API 0.46% Bonny Light 33.8 API 0.30% Qua Iboe 34.5 API 0.30% Oseberg Blend 35.4 API 0.30% Cusiana 34.9 API 0.40% 16 APRIL 2011
INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS 2. FORWARDS AND FUTURES 2.2.2 The Clearinghouse Margins Clearing is the process by which trades in futures and options are processed, guaranteed, and settled by an entity known as a clearing house. A complete clearing house acts as the central counterparty to and guarantor of all trades that it has accepted for clearing from its clearing members. The clearing house becomes the buyer to every seller and the seller to every buyer through a process known as novation. The exchange clearing house intermediates all futures transactions. The credit status of the counterparty becomes irrelevant and contracts become fungible. A transactor needs only to worry about the credit status of the clearing house. Clearing houses have a legal relationship only with entities that they have been admitted as clearing members. That is to say, clearing houses have no legal relationship with the customers of their clearing members. Clearing members are generally institutions such as futures commission merchants and broker/dealers that have the financial, risk management, and operational capabilities to function as clearing members. Clearing houses perform the following duties: Match, guarantee, and settle all trades and register positions resulting from such trades. Perform mark to market calculations of all open positions at least once a day and oversee the resulting cash flows between clearing member firms. Manage the risk exposure that clearing firms present to the clearing house. Perform the exercise and assignment of options contracts. Facilitate, but not guarantee, the delivery of physical commodities. Permit multilateral netting of positions and settlement payments. Assuming contracts are fungible (interchangeable), clearing houses offset positions. Enable clearing members to substitute the credit and risk exposure of the clearing house for the credit and risk exposure of each other. Maintain a package of financial safeguards that are designed to mitigate losses in the event a clearing member defaults on its obligations to the clearing house. In the event of such a default, meet the obligations of the defaulter by first utilising the collateral pledged to it by the defaulter. If such collateral is insufficient to cover the entire amount of the defaulted amount, then utilise the components of its financial safeguards package to take care of the remaining defaulted amount. APRIL 2011 17
2. FORWARDS AND FUTURES INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS One of the key safeguards in the risk management systems of futures clearing organisations is the requirement that market participants post collateral, known as margin, to guarantee their performance on contract obligations. In contrast to the operation of credit margins in the stock market, a futures margin is not a partial payment for the position being undertaken. Instead, the futures margin is a performance bond which serves as collateral or as a good faith deposit given by the trader to the broker. Minimum levels for initial and maintenance margins are set by the exchange. However, futures commission merchants (FCM) have the right to demand higher margins from their customers. In a traditional futures market, contracts are margined under a risk based margining system, which is called SPAN. Portfolio margining systems evaluate positions as a group and determine margin requirements based on the estimates of changes in the value of the portfolio that would occur under assumed changes in market conditions. Margin requirements are set to cover the largest portfolio loss generated by a simulation exercise that includes a range of potential market conditions. Marking to market ensures that futures contracts always have zero value; hence the clearing house does not face any risk. Marking to market takes place through margin payments. At the inception of the contract, each party pays an initial margin (typically 10% of the value contracted) to a margin account held by its broker. Initial margin may be paid in interest bearing securities (T bills) so there is no interest cost. If the futures price rises (falls), the longs have made a paper profit (loss) and the shorts a paper loss (profit). The broker pays losses from and receives any profits into the parties margin accounts on the morning following trading. Loss making parties are required to restore their margin accounts to the required level during the course of the same day by payment of variation margins in cash; margin in excess of the required level may be withdrawn by profit making parties. For example, the initial margin for one WTI futures contract is $5 000 and the maintenance margin requirement is $3 750 per contract. Consider the following example. Trader X bought a 10 September 2011 delivery NYMEX crude oil futures contract. Suppose that the current price is $100 (18 February 2011). The broker will require the investor to deposit an initial margin of $50 000 in the margin account. At the end of each day, the margin account is adjusted to reflect the investor s gain or loss. This practice is known as marking to market the account. Whenever the margin account exceeds or falls below the maintenance margin ($3 750 in our example), then the customer receives a margin call from its broker (or broker receives a margin call from the exchange). If the margin account exceeds the maintenance margin, the investor is entitled to withdraw any balance in the margin account in excess of 18 APRIL 2011
INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS 2. FORWARDS AND FUTURES the initial margin and whenever it is below the maintenance level, the customer has to deposit to bring the margin account to its initial margin level. The extra funds deposited are known as a variation margin. Basically, if there is a price decline the investor who has a long position has to deposit extra funds, so called variation margin, to bring the margin account to the initial level. On the other hand, the seller of the contract account will be credited. In practice, there is actually a chain of margins. Traders post margins with brokers. Non clearing brokers post margins with clearing brokers. Clearing brokers post margins with the clearinghouses. The margin posted by clearinghouse members with the clearinghouse is known as a clearing margin. However, in the case of clearinghouse member, there is an original margin but no maintenance margin. Table 2.2 : The following table summarises price changes and margin account. Daily Gain or Cumulative Margin Account Day Futures Prices of WTI Crude Oil ($/bbl) Margin Call (loss) Gain (Loss) Balance 18 Feb 100 50 000 21 Feb 99.5 5 000 5 000 45 000 22 Feb 98 15 000 20 000 30 000 20 000 23 Feb 99 10 000 10 000 60 000 24 Feb 98.5 5 000 15 000 55 000 25 Feb 97 15 000 30 000 40 000 28 Feb 95 20000 50 000 20 000 30 000 01 Mar 95 0 50 000 50 000 02 Mar 99 40 000 10 000 90 000 03 Mar 99 0 10 000 90 000 04 Mar 100 10 000 0 100 000 2.2.3 Settlement Price, Volume and Open Interest in Futures Markets The settlement price is the average of the prices at which the contract traded immediately before the end of trading for the day. The settlement price is very important since it is used to determine margin requirements and the following day's price limits. Volume in futures market represents the total amount of trading activity or contracts that have changed hands in a given commodity market for a single trading day. On the other hand, open interest is the total APRIL 2011 19
2. FORWARDS AND FUTURES INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS number of contracts outstanding that are held by market participants at the end of each day. A contract is created by a seller and buyer of contract, therefore open interest can be calculated as the sum of all the long positions (or equivalently it is the sum of all the short positions). Open interest will increase by one contract if both parties to the trade are initiating a new position (one new buyer and one new seller) and open interest will decrease by one contract if both traders are closing an existing or old position (one old buyer and one old seller). However, if one old trader is passing off his position to a new trader (one old buyer sells to one new buyer), open interest will not change. 2.2.4 Types of Orders The simplest type of order placed with a broker is a market order. A market order is an order to buy or sell a futures contract at whatever price is obtainable at the time it is entered in the ring, pit, or other trading platform. However, there are many other types of orders. Most commonly used orders are the limit order, and the stop order or stop loss order. A limit order is an order in which the customer specifies a minimum sale price or maximum purchase price, as contrasted with a market order, which implies that the order should be filled as soon as possible at the market price. Thus, if the limit price is $95/bbl for one April WTI contract for an investor wanting to sell, the order will be executed only at a price of $95/bbl or more. As opposed to a market order, a limit order will not be executed unless the price reaches $95/bbl. A stop order or stop loss order is an order that becomes a market order when a particular price level is reached. A sell stop is placed below the market; a buy stop is placed above the market. The purpose of a stop order is to close out a position if unfavorable price movements take place. 2.3 Hedging Using Futures Contracts 4 Traditionally, many of the market participants in futures markets were hedgers. Hedgers use futures markets to reduce particular risks arising from fluctuations in the price of the underlying asset. Of course, it might not be possible to eliminate the risks completely due to basis risk, which we discuss later in the text. For the time being, we assume the possibility of a perfect hedge, which completely eliminates the risk. A hedge might involve taking a long position (long hedge) or a short position (short hedge) in the futures contract. 4 Futures contracts can be used in similar fashion for speculation purposes as well. 20 APRIL 2011
INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS 2. FORWARDS AND FUTURES A long hedge is appropriate when a company knows it will have to purchase a certain asset in the future and wants to lock in a price now. For example, an airline company knows that it will require 100 000 barrel of crude oil on 1 July 2011 for its flight operations. The spot price of oil is $95/bbl, and the future price for July delivery (July is the delivery month for June contract) is $99/bbl. In order to avoid any risk associated with price change between now and July, the airline company can buy crude oil now at $95/bbl and store it until July. In this case, the airline company has to pay storage costs as well as interest costs. Alternatively, it can hedge its position by taking a long position in one hundred CME WTI June futures contracts (each contract is for delivery of 1 000 barrels of crude oil) and closing its position before the expiration by selling one hundred such contracts. Suppose that the spot price of oil on 1 July is $102/bbl, which should be very close to the future price. The airline gains from futures contracts approximately 100 000 ($102 $99)=$300 000 In July, the airline pays $102 100 000=$10 200 000 for the crude oil, making the net cost approximately $9 900 000. On the other hand, if the spot price in July turned out to be $90/bbl, then the airline company loses from its futures contract approximately 100 000 ($99 $90)=$900 000 and pays $90 100 000=$9 000 000 for the crude oil in the spot market. Again here, the total net cost of the oil for the airline company would be $9 900 000. No matter what happens to the spot price in July, entering into a futures contract allows the airline company to fix its net cost to the number of oil barrels times the price per barrel. Therefore, hedging using futures contracts eliminates the uncertainty over the cost of funding. A short hedge works in a similar way. Consider an oil producer, who wants to sell again 100 000 barrels of crude oil in July. Assume that all the above information still holds. Since the oil producer wants to sell its oil, it can hedge its cash position by taking a short position in one hundred CME WTI June contracts, which will be delivered in July. The producer again offsets its short position by going long before the expiration of contract. Suppose that the spot price of oil on 1 July is $102/bbl, which should be very close to the futures price. The producer loses from a futures contract approximately 100 000 ($102 $99)=$300 000 APRIL 2011 21
2. FORWARDS AND FUTURES INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS In July, the producer gets $102 100 000=$10 200 000 for the crude oil, making a net revenue from its sales of approximately $9 900 000. On the other hand, if the spot price in July turned out to be $90/bbl, then the producer company gains from its futures contract approximately 100 000 ($99 $90)=$900 000 and gets $90 100 000=$9 000 000 for the crude oil in spot market. Again here, the total net revenue for the oil for the producer would be $9 900 000. No matter what happens to the spot price in July, entering into the futures contract allows the producer to fix its net revenue to the barrel of oil times the price per barrel. Therefore, hedging using futures contracts eliminates the uncertainty over the revenue. 2.4 Basis Risk Up until now, we assumed that hedgers can completely eliminate risks by taking futures positions opposite to their cash positions. However, in reality it is difficult to eliminate all risks. In order to eliminate all risks associated with cash positions, the hedger must know the precise date in the future when an asset would be bought or sold. Even if the hedger knows the exact date of purchase or sale, he might have to close his/her futures position before its delivery month, i.e. there might be a mismatch between the hedge period and available delivery date. Even then, the hedger would need to find the same asset underlying the futures contract as the asset s/he is planning to buy or sell. For all these reasons, the hedger will face basis risk, which can be defined as the difference between the spot price of the asset to be hedged and the futures price of the contract used. If the asset to be hedged and the asset underlying the futures contract are the same, then we should expect the basis risk to be zero at the expiration of the futures contract. Prior to expiration, the basis can be negative or positive. If the basis is positive, i.e. the spot price is greater than the futures price, the situation is known as backwardation. If, on the other hand, the basis is negative, i.e. spot price is less than the futures price, the situation is known as contango. If, on the other hand, the asset to be hedged and the asset underlying the futures contract are different a situation known as cross hedging then we should expect the basis risk to be different from zero even at expiration. Sometimes, it is not possible to find futures contracts for some commodities. Consider an airline company, which is concerned about the future price of jet fuel oil, rather than crude oil. Since there is no futures contract on jet fuel oil, the airline company tries to find an asset underlying the futures contract which is highly correlated with the asset to be hedged. High correlation results in low basis risk and high hedge effectiveness. 22 APRIL 2011
INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS 3. SWAPS 3. SWAPS Forward or futures contracts settle on a single date. However, many transactions occur repeatedly For example, an airline company buys jet fuel oil on an ongoing basis. If a manager seeking to reduce risk confronts a risky payment stream, what is the easiest way to hedge this risk? You can enter into a separate forward contract for each payment you wish to hedge. However, it could be more convenient and entail lower transaction costs, if there were a single transaction that we could use to hedge a stream of payments. Swaps serve exactly this purpose. Swaps are agreements between two companies to exchange cash flows in the future according to a prearranged formula. Swaps, therefore, may be regarded as a portfolio of forward contracts. Swaps are traded on over the counter derivatives markets and are most common in interest rates, currencies and commodities. They often extend much further into the future than exchange contracts. The parties to a swap set: the notional amount; the tenor or maturity of the swap; the payment dates; the floating price index; and the fixed price. The following discussion on the swap market and development in the swap market excerpts from the CFTC Commodity Swap Dealers & Index Traders with Commission Recommendations report. 5 The first swap contracts were negotiated in 1981. In order to reduce overall funding costs for both parties, the World Bank and IBM entered into what has become known as a currency swap. The swap essentially involved a loan in Swiss francs by IBM to the World Bank and a loan in U.S. dollars by the World Bank to IBM. This structure of swapping cash flows ultimately served as the template for swaps on any number of financial assets and commodities. Swaps serve as an effective hedging vehicle in much the same way that financial futures contracts do. For example, a typical futures contract has many of the same characteristics as a swap in that it is essentially a contract where the buyer of the contract agrees at the outset to pay a fixed price for a commodity in return for future delivery of the commodity, which will have an uncertain or floating value at the time of expiration of the contract. 5 See http://www.cftc.gov/ucm/groups/public/@newsroom/documents/file/cftcstaffreportonswapdealers09.pdf APRIL 2011 23
3. SWAPS INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS The party offering the swap, typically called a swap dealer, takes on any price risks associated with the swap and thus must manage the risk of the commodity exposure. In the early development of swap markets, investment banks often served in a brokering capacity to bring together parties with opposite hedging needs. The currency swap between the World Bank and IBM, for example, was brokered by Salomon Brothers. While brokering swaps eliminates market price and credit risk to the broker, the process of matching and negotiating swaps between counterparties with opposite hedging needs could be difficult. As a result, swap brokers (who took on no market risk) evolved into swap dealers (who took the contract onto their books). As noted, when a swap dealer takes a swap onto its books, it takes on any price risks associated with the swap and thus must manage the risk of the commodity exposure. In addition, the counterparty bears a credit risk that the swap dealer may not honour its commitment. This risk can be significant in the case of a swap dealer because it is potentially entering into numerous transactions involving many counterparties, each of which exposes the swap dealer to additional credit risks. As a result of these risks, there has been a natural tendency for financial intermediaries (e.g., commercial banks, investment banks, insurance companies) to become swap dealers. These firms typically have the capitalisation to support their creditworthiness as well as the expertise to manage the market price risks that they take on. In addition, for particular commodity classes, such as agriculture and energy, large commercial companies that have the expertise to manage market price risks have set up affiliates to specialise as swap dealers for those commodities. The utility of swap agreements as a hedging vehicle has led to significant growth in both the size and complexity of the swap market. During the early period in the development of the swap market, the majority of swap agreements involved financial assets. In fact, even today the vast majority of swaps outstanding involve either interest rates or currencies. The OTC swap market has grown significantly because, for many financial entities, the OTC derivatives products offered by swap dealers have distinct advantages relative to futures contracts. While futures markets offer a high degree of liquidity (i.e., the ability to quickly execute trades due to the high number of participants willing to buy and sell contracts), futures contracts are more standardised, meaning that they may not meet the exact needs of a hedger. Swaps, on the other hand, offer additional flexibility since the counterparties can tailor the terms of the contract to meet specific hedging needs. 24 APRIL 2011
INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS 3. SWAPS As an example of the flexibility that swaps can offer, consider again the case of an airline wanting to hedge future jet fuel purchases. Currently there is no jet fuel futures contract available to the airlines to directly hedge their price exposure. Contracts for crude oil (from which jet fuel is made) and heating oil (which is a fuel having similar chemical characteristics to jet fuel) do exist. But while these contracts can be used to hedge jet fuel, the dissimilarities between jet fuel and crude oil or heating oil mean that the airline will inevitably take on what was referred to above as basis risk. That is, the price of jet fuel and the prices of these futures contracts will not tend to move perfectly together, diminishing the utility of the hedge. In contrast, swap dealers can offer the airline the alternative of entering into a contract that directly references the cash price for jet fuel at the specific time and location where the product is needed. By creating a customised OTC derivative product that specifically addresses the price risks faced by the airline, by taking on the administrative costs associated with managing that contract over time, and by assuming the price risks attendant to that contract, the swap dealer facilitates the airline s risk management. When a commercial entity uses a swap to offset its risk, the swap dealer assumes the price risk of the commodity. For example, if the swap dealer enters into a jet fuel swap with an airline, the airline agrees to periodically pay a fixed amount on the swap while the swap dealer pays a floating amount based on a cash market price. At each point in time when the payments are due, a netting of the obligations takes place and the party responsible for the larger payment pays the difference to the other party. Thus, if prices rise, the floating payment will be larger than the fixed price and the swap dealer pays the net amount to the airline. Conversely, if prices fall, the airline will be required to make a payment to the swap dealer. Recall, however, that when the airline makes a payment on the swap to the swap dealer, it means that at the same time, it is paying a lower price to acquire jet fuel in the cash market. The swap dealer, however, has no natural offsetting transaction to counterbalance the risk. That is why swap dealers will, in turn, hedge this price risk in the regulated futures markets. Swap agreements have also become a popular vehicle for noncommercial participants, such as hedge funds, pension funds, large speculators, commodity index traders, and others with large pools of cash, to gain exposure to commodity prices. Recently, portfolio managers have sought to invest in commodities because of the lack of correlation, or even negative correlation, that commodities tend to have with traditional investments in stocks and bonds. In addition, because APRIL 2011 25
3. SWAPS INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS of the ability to tailor transactions, swaps can represent a more efficient means by which these participants can enter the market. Hence, many of the benefits that swap agreements offer commercial hedgers also attract noncommercial interests to the swap market. Since swap dealers are willing to enter into swap contracts on either side of a market, at times they will enter into swaps that create offsetting exposures, reducing the swap dealer s overall market price risk associated with the firm s individual positions opposite its counterparties. Since it is unlikely, however, that a swap dealer could completely offset the market price risks associated with its swap business at all times, dealers often enter the futures markets to offset the residual market price risk. As a result of the growth of the swap market and the dealers who support the market, there has been an associated growth in the open interest of the futures markets related to the commodities for which swaps are offered, as these swap dealers attempt to lay off the residual risk of their swap book. A more recent phenomenon in the derivatives market has been the development of commodity index funds and exchange traded funds for commodities (ETFs) and exchange traded notes (ETNs), which are mainly transacted through swap dealers. Both products are designed to produce a return that mimics a passive investment in a commodity or group of commodities. ETFs and ETNs are traded on securities exchanges and are backed by physical commodities or long futures positions held in a trust. Commodity index funds are funds that enter into swap contracts that track published commodity indexes such as the S&P Goldman Sachs Commodity Index or the Dow Jones AIG Commodity Index. 3.1 Mechanics of Swaps When two parties enter a swap contract, one party makes a payment to the other depending upon whether a price turns out to be greater or less than a reference price that is specified in the swap contract. For example by entering into an oil swap, an oil buyer confronting a stream of uncertain oil payments can lock in a fixed price for oil over a period of time. The swap payments would be based on the fixed price for oil and a market price that varies over time. Suppose Untied Airlines (UA) is going to buy 100 000 barrels of oil one year from today and two years from today. Suppose that the forward price for delivery in one year is $75/bbl and in two years is $90/bbl. Suppose one year and two year zero coupon bond yields are 5% and 5.5%. UA can use a 26 APRIL 2011
INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS 3. SWAPS forward contract to guarantee the cost of buying oil for the next two years. The present value of this cost will be $75 1.05 $90 1.055 $152.29 UA could invest this amount to buy oil in one and two years, or it could pay an oil supplier $152.29 who would commit to delivering one barrel in each of the next two years. This is a prepaid swap. If the payment is done after two years, this is a postpaid swap. Typically, a swap will call equal payments in each year, or $82.28/bbl. This is the price of a two year swap. However, any payments that have a present value of $152.29 are acceptable. In exchange, the swap counterparty delivers 100 000 barrels of crude oil each year. The notional value of the swap can be calculated by multiplying all cash flows by 100 000. Instead of delivery, if the swap counterparties settled with cash, the oil buyer, UA, pays the swap counterparty the difference between $82.28/bbl and the spot price (if the difference is negative, the counterparty pays the buyer), and the oil buyer then buys the oil in the spot market. For example, if the spot price is $90/bbl, the swap counterparty pays the buyer Spot price swap price=$90 $82.28=$7.72 If the spot price is $80/bbl, then oil buyer makes a payment to the swap counterparty Spot price swap price=$80 $82.28= $2.28 Whatever the spot price, the net cost to the buyer is the swap price, $82.28/bbl Although the swap price is close to the mean of forward prices ($82.50/bbl), it is not exactly the same. Why? Suppose the swap price is $82.50/bbl, then the oil buyer would then be committing to pay more than $7.50 more than the forward price the first year and would pay $7.50 less than the forward price the second year. Thus relative to the forward curve, the buyer would have made an interest free loan to the counterparty. If the swap price is $82.28, then we are overpaying $7.28 in the first year and underpaying $7.72 in the second year, relative to the forward curve. The swap is equivalent to being long on the two forward contracts, coupled with an agreement to lend $7.28 to the counterparty in the first year, and receive $7.72 in second year. The interest rate on this loan is $7.72/$7.28 1=6%. Where does 6% come from? 6% is the one year implied forward yield from year one to year two. APRIL 2011 27
4. OPTIONS INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS 4. OPTIONS An option is a contract that gives the option holder the right/option, but no obligation, to buy or sell a security (or a futures contract) to the option writer/seller at (or up to) a given time in the future (the expiry date or maturity date) for a pre specified price (the strike price or exercise price, K). The option purchaser (holder) is the person who buys a call or a put option and pays the option premium, i.e. the person who establishes a long options position. This is the party with the right, but not the obligation, under the terms of the contract. The option writer, or grantor, is the person who sells a call or put option and receives the option premium, i.e. the person who establishes a short position. This party is obligated to perform under the terms of such an option. A call option gives the holder the right to buy a security and a put option gives the holder the right to sell a security. Where the underlying interest is represented by a futures contract, the right to buy is actually a right to be long on a futures contract at a specified price level. Conversely, the right to sell represents the right to a short futures position at a specified price level. Options allow one to take advantage of changes in futures prices without actually having a position in the futures market. Options can be American, European or Bermudan. American options can be exercised at any time prior to expiry. European options can only be exercised at the expiry. Bermudan option can only be exercised during the specified period. The price at which the futures contract underlying an option can be purchased (if a call) or sold (if a put) is called the strike price or the exercise price. In the call and put definitions above, this is the predetermined price. It is important to note that for every option buyer there is an option seller. At any time before the option expires, the option buyer can exercise the option. Since the buyer decides whether to exercise, the seller cannot make money at expiration. To take this risk, the seller is compensated by the option premium, which is agreed when the contract is signed. The option premium is determined through trading on an exchange market. Therefore, we should expect to see different option premia for different strike prices. Effectively, the exercise of a call gives the option purchaser a long position in the underlying futures contract at the option s strike price; the exercise of a put option gives the option purchaser a short futures position at the option s strike price. The option buyer can also sell the option to someone else or 28 APRIL 2011
INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS 5. REFERENCES do nothing and let the option expire. The choice of action is left entirely up to the option buyer. The option buyer obtains this right by paying the premium to the option seller. A call option buyer will only choose to exercise if the stock price is greater/higher than the strike price. If the stock price is less than the strike price, the investor would clearly choose not to exercise the option, and the investor only loses the option premium. On the other hand, a put option buyer will only to choose to exercise the option when the stock price is less than strike price. If the stock price is more than the strike price, the investor would clearly choose not to exercise the option and would only lose the option premium. What about the option seller? The option seller receives the premium from the option buyer. If the option buyer exercises the option, the option seller is obligated to take the opposite futures position at the same strike price. Because of the seller s obligation to take a futures position if the option is exercised, an option seller must post a margin and faces the possibility that the margin will be called if the market moves against his potential futures position. 4.1 Call Option A call option is a contract where the buyer has the right, but not the obligation, to buy an underlying security. Since the buyer decides whether or not to buy, the seller cannot make money at expiration. To take this risk, the seller is compensated by the option premium, which is agreed when the contract is signed. Consider a call option on the S&R index with six months to expiration and strike price of $1000 and premium of $93.81. 6 And assume that the risk free rate is 2% over six months. Suppose that the index in six months is $1100. Clearly it is worthwhile to pay the $1000 strike price to acquire the index worth $1100. If on the other hand the index is $900 at expiration, it is not worthwhile paying the $1000 strike price to buy the index worth $900. In this case: The buyer is not obliged to buy the index and hence will only exercise the option if the payoff is positive. Purchased call payoff = max(0,s T K) In our example, K=1000. If S=1100 then the call payoff Purchased call payoff = max(0,1100 1000)=$100 If S=900, then the call payoff is Purchased call payoff = max(0,900 1000)=$0 6 The discussions on call and put options draws upon McDonald (2006). APRIL 2011 29
4. OPTIONS INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS The payoff does not take into account the initial cost (option premium) of acquiring the position. For a purchased option, the premium is paid at the time the option is acquired. In computing profit at expiration, we use the future value of the premium. Purchased call profit = max(0,s T K) future value of option premium Purchased call profit = Purchased call payoff future value of option premium If the index at the expiration is 1100, then profit is Purchased call profit=max(0, 1100 1000) 93.81 1.02=$4.32 If the index at the expiration is 900, then the owner does not exercise the option. The loss will be future value of option premium. Maximum loss will be the option premium. Purchased call profit=max(0, 900 1000) 93.81 1.02= $95.68 The Payoff at Expiration with a Strike Price of $1000 Payoff ($) 250 200 150 100 50 0 50 100 150 200 250 800 850 900 950 1000 1050 1100 1150 1200 S&R Index Price ($) Call Payoff 30 APRIL 2011
INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS 5. REFERENCES Profit at Expiration for Call Option with K=1000 and Long Forward Profit ($) 200 150 100 50 0 50 100 150 200 250 Index price=1095.68 Call Profit Long Forward Profit 800 850 900 950 1000 1050 1100 1150 1200 S&R Index Price ($) The option writer (seller of option) has a short position in a call option. The writer receives the premium for the option and then has an obligation to sell the underlying security in exchange for the strike price if the option buyer exercises the option. The payoff and profit to a written call are just the opposite of those for a purchased call. Written call payoff = max(0,s T K) = min(0,k S T ) Written call profit = max(0,s T K)+future value of option premium In our example, if S=1100 then the option writer payoff will be $100 and profit will be $4.32. If on the other hand, S=900, then payoff will be 0 and profit will be the future value of premium, $95.68. APRIL 2011 31
4. OPTIONS INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS Payoff ($) 250 200 150 100 50 0 50 100 150 200 250 Payoff for Option Writer with Strike Price of $1000 800 850 900 950 1000 1050 1100 1150 1200 S&R Index Price ($) Written Call Payoff Profit for Option Writer with Strike Price of $1000 Profit ($) 250 200 150 100 50 0 50 100 150 200 800 850 900 950 1000 1050 1100 1150 1200 S&R Price Index ($) Index Price= 1020 Index Price=1095.68 Written Call Profit Short Forward 4.2 Put Option A put option is a contract where the buyer has the right to sell, but not the obligation. Since the buyer decides whether to sell, the seller cannot make money at expiration. To take this risk, the seller is compensated by the option premium, which is agreed when the contract is signed. Example: Put Option Consider a put option on the S&R index with six months to expiration and strike price of $1000 and premium of $74.20. And assume that the risk free rate is 2% over six months. Suppose that the index in 32 APRIL 2011
INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS 5. REFERENCES six months is $1100. Clearly it is not worthwhile to sell the index worth $1100 for the strike price of $1000. If on the other hand the index is $900 at expiration, it is worthwhile selling the index for $1000. The buyer is not obliged to sell the index and hence will only exercise the option if the payoff is positive. Purchased put payoff = max(0,k S T ) In our example, K=1000. If S=1100 then the put payoff Purchased put payoff = max(0,1000 1100)=$0 If S=900, then the put payoff is Purchased put payoff = max(0,1000 900)=$100 The payoff does not take into account the initial cost of acquiring the position. For a purchased option, the premium is paid at the time the option is acquired. In computing profit at expiration, we use the future value of the premium. Purchased put profit = max(0,k S T ) future value of option premium Purchased put profit = Purchased put payoff future value of option premium If the index at the expiration is 1100, then the option buyer will not exercise his right to sell and the maximum loss will be the future value of the option premium. Purchased put profit = max(0,1000 1100) 74.2 1.02= $75.68 If the index at the expiration is 900, then the owner exercises the option i.e. sells. The profit will be Purchased put profit = max(0,1000 900) 74.2 1.02=$24.32 The option writer (seller of option) has a long position in a put option. The writer receives the premium for the option and then has an obligation to buy the underlying security in exchange for the strike price if the option buyer exercises the option. The payoff and profit to a written put are just the opposite of those for a purchased put. Written put payoff = max(0,k S T ) = min(0,s T K) Written put profit= max(0,k S T )+future value of option premium In our example, if S=1100 then the put buyer will not exercise the put, thus put writer earns profit, which will be option premium. If, on the other hand, S=900, then the option buyer exercises the option and the option seller (writer) will lose $24.32 ( 100+$75.68). 4.3 Moneyness of Options Options are generally referred to as in the money, at the money, or out of money. The moneyness of an option depends on the strike price (K) relative to the spot (S t )/forward (F t ) price of the underlying asset. APRIL 2011 33
4. OPTIONS INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS An option is said to be in the money if the option has positive value if exercised right now: S t > K for call options and S t < K for put options. Sometimes it is also defined in terms of the forward price at the same maturity (in the money forward): F t > K for call and F t < K for put. The option has positive intrinsic value (defined as the maximum of zero and the value the option would have if it is exercised today) when in the money. The intrinsic value is (S t K)+ for call, (K S t )+ for put options. We can also define intrinsic value in terms of the forward price. An option is said to be out of the money when it has zero intrinsic value. S t < K for call options and S t > K for put options. Out of the money forward: F t < K for call and F t > K for put. An option is said to be at the money spot (or forward) when the strike is equal to the spot (or forward). 4.4 Hedging Using Options Options can be used for hedging purposes. Consider a trader (an airline company) who thinks that oil prices are going to move substantially higher in the near future and wants some protection. In this case, the trader might buy a call option. Let us assume that it is 11 March and a July call contract with a $100 strike price is at $4 option premium. Assume that the July futures contract is currently trading at $100. If the trader decides to buy the call option, he has to pay the premium of (1000 4=$4000) per contract. By purchasing this call option, the trader has the right to buy a July futures contract at $100/bbl. The seller of the contract receives a $4000 option premium per contract and is obligated to take a short futures position at $100/bbl in the July contract if the option buyer chooses to exercise his option. Let s say that by May the July futures price has risen to $110/bbl. The trader s July contract has a value of at least $10 ($110 $100). The trader at this point can sell his option to someone else for $10/bbl and be out of the market. His total profit will be $6000 (1000 (10 4)) per contract. Or alternatively, he will exercise his option and he will get one long July futures contract. The hedger in this case limited his risk of a substantial rise in prices. If, on the other hand, prices decline, the trader will not exercise his option and he will lose only the premium he paid when he signed the contract. 34 APRIL 2011
INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS 5. REFERENCES 5. REFERENCES CFTC (2008) Commodity Swap Dealers & Index Traders with Commission Recommendations. http://www.cftc.gov/ucm/groups/public/@newsroom/documents/file/cftcstaffreportonswapdealers09.pdf McDonald, Robert L. (2006). Derivatives Markets. 2 nd Edition, Addison Wesley. Weber, Ernst Juerg (2008). A Short History of Derivative Security Markets. Available at SSRN: http://ssrn.com/abstract=1141689 APRIL 2011 35
6. GLOSSARY OF THE DERIVATIVES MARKET INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS 6. GLOSSARY OF THE DERIVATIVES MARKET TERMS 7 A Abandon: To elect not to exercise or offset a long option position. Accommodation Trading: Non competitive trading entered into by a trader, usually to assist another with illegal trades. Accumulator: A contract in which the seller agrees to deliver a specified quantity of a commodity or other asset to the buyer at a pre determined price on a series of specified accumulation dates over a specified period of time. The contract typically has a knock out price, which, if reached, will trigger the cancellation of all remaining accumulations. Moreover, the amount of the commodity to be delivered may be doubled or otherwise adjusted on those accumulation dates when the price of the asset reaches a specified price different from the knockout price. Actuals: The physical or cash commodity, as distinguished from a futures contract. See Cash and Spot Commodity. Agency Bond: A debt security issued by a government sponsored enterprise such as Fannie Mae or Freddie Mac, designed to resemble a U.S. Treasury bond. Agency Note: A debt security issued by a government sponsored enterprise such as Fannie Mae or Freddie Mac, designed to resemble a U.S. Treasury note. Aggregation: The principle under which all futures positions owned or controlled by one trader (or group of traders acting in concert) are combined to determine reporting status and compliance with speculative position limits. Agricultural Trade Option Merchant: Any person that is in the business of soliciting or entering option transactions involving an enumerated agricultural commodity that are not conducted or executed on or subject to the rules of an exchange. Algorithmic Trading: The use of computer programs for entering trading orders with the computer algorithm initiating orders or placing bids and offers. Allowances: (1) The discounts (premiums) allowed for grades or locations of a commodity lower (higher) than the par (or basis) grade or location specified in the futures contract. See Differentials. (2) The tradable right to emit a specified amount of a pollutant under a cap and trade system. American Option: An option that can be exercised at any time prior to or on the expiration date. See European Option. Approved Delivery Facility: Any bank, stockyard, mill, storehouse, plant, elevator, or other depository that is authorized by an exchange for the delivery of commodities tendered on futures contracts. 7 Source: CFTC. This glossary is available at http://www.cftc.gov/ucm/groups/public/@educationcenter/documents/file/cftcglossary.pdf 36 APRIL 2011
INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS 6. GLOSSARY OF THE DERIVATIVES MARKET Arbitrage: A strategy involving the simultaneous purchase and sale of identical or equivalent commodity futures contracts or other instruments across two or more markets in order to benefit from a discrepancy in their price relationship. In a theoretical efficient market, there is a lack of opportunity for profitable arbitrage. See Spread. Arbitration: A process for settling disputes between parties that is less structured than court proceedings. The National Futures Association arbitration program provides a forum for resolving futures related disputes between NFA members or between NFA members and customers. Other forums for customer complaints include the American Arbitration Association. Artificial Price: A cash market or futures price that has been affected by a manipulation and is thus higher or lower than it would have been if it reflected the forces of supply and demand. Asian Option: An exotic option whose payoff depends on the average price of the underlying asset during a specified period preceding the option expiration date. Ask: The price level of an offer, as in bid ask spread. Assignable Contract: A contract that allows the holder to convey his rights to a third party. Exchangetraded contracts are not assignable. Assignment: Designation by a clearing organization of an option writer who will be required to buy (in the case of a put) or sell (in the case of a call) the underlying futures contract or security when an option has been exercised, especially if it has been exercised early. Associated Person (AP): An individual who solicits or accepts (other than in a clerical capacity) orders, discretionary accounts, or participation in a commodity pool, or supervises any individual so engaged, on behalf of a futures commission merchant, an introducing broker, a commodity trading advisor, a commodity pool operator, or an agricultural trade option merchant. At the Market: An order to buy or sell a futures contract at whatever price is obtainable when the order reaches the trading facility. See Market Order. At the Money: When an option's strike price is the same as the current trading price of the underlying commodity, the option is at the money. Auction Rate Security: A debt security, typically issued by a municipality, in which the yield is reset on each payment date via a Dutch auction. Audit Trail: The record of trading information identifying, for example, the brokers participating in each transaction, the firms clearing the trade, the terms and time or sequence of the trade, the order receipt and execution time, and, ultimately, and when applicable, the customers involved. Automatic Exercise: A provision in an option contract specifying that it will be exercised automatically on the expiration date if it is in the money by a specified amount, absent instructions to the contrary. APRIL 2011 37
6. GLOSSARY OF THE DERIVATIVES MARKET INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS B Back Months: Futures delivery months other than the spot or front month (also called deferred months). Back Office: The department in a financial institution that processes and deals and handles delivery, settlement, and regulatory procedures. Back pricing: Fixing the price of a commodity for which the commitment to purchase has been made in advance. The buyer can fix the price relative to any monthly or periodic delivery using the futures markets. Back Spread: A delta neutral ratio spread in which more options are bought than sold. A back spread will be profitable if volatility increases. See Delta. Backwardation: Market situation in which futures prices are progressively lower in the distant delivery months. For instance, if the gold quotation for January is $960.00 per ounce and that for June is $945.00 per ounce, the backwardation for five months against January is $15.00 per ounce. (Backwardation is the opposite of contango). See Inverted Market. Banging the Close: A manipulative or disruptive trading practice whereby a trader buys or sells a large number of futures contracts during the closing period of a futures contract (that is, the period during which the futures settlement price is determined) in order to benefit an even larger position in an option, swap, or other derivative that is cash settled based on the futures settlement price on that day. Banker's Acceptance: A draft or bill of exchange accepted by a bank where the accepting institution guarantees payment. Used extensively in foreign trade transactions. Basis: The difference between the spot or cash price of a commodity and the price of the nearest futures contract for the same or a related commodity (typically calculated as cash minus futures). Basis is usually computed in relation to the futures contract next to expire and may reflect different time periods, product forms, grades, or locations. Basis Grade: The grade of a commodity used as the standard or par grade of a futures contract. Basis Point: The measurement of a change in the yield of a debt security. One basis point equals 1/100 of one percent. Basis Quote: Offer or sale of a cash commodity in terms of the difference above or below a futures price (e.g., 10 cents over December corn). Basis Risk: The risk associated with an unexpected widening or narrowing of the basis (that is, the difference between the futures price and the relevant cash price) between the time a hedge position is established and the time that it is lifted. Basis Swap: A swap whose cash settlement price is calculated based on the basis between a futures contract (e.g., natural gas) and the spot price of the underlying commodity or a closely related commodity (e.g., natural gas at a location other than the futures delivery location) on a specified date. 38 APRIL 2011
INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS 6. GLOSSARY OF THE DERIVATIVES MARKET Bear: One who expects a decline in prices. The opposite of a bull. A news item is considered bearish if it is expected to result in lower prices. Bear Market: A market in which prices generally are declining over a period of months or years. Opposite of bull market. Bear Market Rally: A temporary rise in prices during a bear market. See Correction. Bear Spread: (1) A strategy involving the simultaneous purchase and sale of options of the same class and expiration date, but different strike prices. In a bear spread, the option that is purchased has a lower delta than the option that is bought. For example, in a call bear spread, the purchased option has a higher exercise price than the option that is sold. Also called bear vertical spread. (2) The simultaneous purchase and sale of two futures contracts in the same or related commodities with the intention of profiting from a decline in prices but at the same time limiting the potential loss if this expectation does not materialize. In agricultural products, this is accomplished by selling a nearby delivery and buying a deferred delivery. Bear Vertical Spread: See Bear Spread. Bermuda Option: An exotic option which can be exercised on a specified set of predetermined dates during the life of the option. Beta (Beta Coefficient): A measure of the variability of rate of return or value of a stock or portfolio compared to that of the overall market, typically used as a measure of riskiness. Bid: An offer to buy a specific quantity of a commodity at a stated price. Bid Ask Spread or Bid Offer Spread: The difference between the bid price and the ask or offer price. Binary Option: A type of option whose payoff is either a fixed amount or zero. For example, there could be a binary option that pays $100 if a hurricane makes landfall in Florida before a specified date and zero otherwise. Also called a digital option. Blackboard Trading: The practice, no longer used, of buying and selling commodities by posting prices on a blackboard on a wall of a commodity exchange. Black Scholes Model: An option pricing model initially developed by Fischer Black and Myron Scholes for securities options and later refined by Black for options on futures. Block Trade: A large transaction that is negotiated off an exchange s centralized trading facility and then executed on the trading facility, as permitted under exchange rules. Board Order: See Market if Touched Order. Board of Trade: Any organized exchange or other trading facility for the trading of futures and/or option contracts. APRIL 2011 39
6. GLOSSARY OF THE DERIVATIVES MARKET INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS Boiler Room: An enterprise that often is operated out of inexpensive, low rent quarters (hence the term boiler room ), that uses high pressure sales tactics (generally over the telephone), and possibly false or misleading information to solicit generally unsophisticated investors. Booking the Basis: A forward pricing sales arrangement in which the cash price is determined either by the buyer or seller within a specified time. At that time, the previously agreed basis is applied to the then current futures quotation. Book Transfer: A series of accounting or bookkeeping entries used to settle a series of cash market transactions. Box Spread: An option position in which the owner establishes a long call and a short put at one strike price and a short call and a long put at another strike price, all of which are in the same contract month in the same commodity. Break: A rapid and sharp price decline. Broad Based Security Index: Any index of securities that does not meet the legal definition of narrowbased security index. Broker: A person paid a fee or commission for executing buy or sell orders for a customer. In commodity futures trading, the term may refer to: (1) Floor broker, a person who actually executes orders on the trading floor of an exchange; (2) Account executive or associated person, the person who deals with customers in the offices of futures commission merchants; or (3) the futures commission merchant. Broker Association: Two or more persons with exchange trading privileges who (1) share responsibility for executing customer orders; (2) have access to each other's unfilled customer orders as a result of common employment or other types of relationships; or (3) share profits or losses associated with their brokerage or trading activity. Bucketing: Directly or indirectly taking the opposite side of a customer's order into a broker s own account or into an account in which a broker has an interest, without open and competitive execution of the order on an exchange. Also called trading against. Bucket Shop: A brokerage enterprise that books (i.e., takes the opposite side of) retail customer orders without actually having them executed on an exchange. Bull: One who expects a rise in prices. The opposite of a bear. A news item is considered bullish if it is expected to result in higher prices. Bullion: Bars or ingots of precious metals, usually cast in standardized sizes. Bull Market: A market in which prices generally are rising over a period of months or years. Opposite of a bear market. Bull Spread: (1) A strategy involving the simultaneous purchase and sale of options of the same class and expiration date but different strike prices. In a bull vertical spread, the purchased option has a higher 40 APRIL 2011
INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS 6. GLOSSARY OF THE DERIVATIVES MARKET delta than the option that is sold. For example, in a call bull spread, the purchased option has a lower exercise price than the sold option. Also called bull vertical spread. (2) The simultaneous purchase and sale of two futures contracts in the same or related commodities with the intention of profiting from a rise in prices but at the same time limiting the potential loss if this expectation is wrong. In agricultural commodities, this is accomplished by buying the nearby delivery and selling the deferred. Bull Vertical Spread: See Bull Spread. Bust: To cancel a trade that was executed in error. Buoyant: A market in which prices have a tendency to rise easily with a considerable show of strength. Bunched Order: A discretionary order entered on behalf of multiple customers. Bust: An executed trade cancelled by an exchange that is considered to have been executed in error. Butterfly Spread: A three legged option spread in which each leg has the same expiration date but different strike prices. For example, a butterfly spread in soybean call options might consist of one long call at a $5.50 strike price, two short calls at a $6.00 strike price, and one long call at a $6.50 strike price. Buyer: A market participant who takes a long futures position or buys an option. An option buyer is also called a taker, holder, or owner. Buyer s Call: A purchase of a specified quantity of a specific grade of a commodity at a fixed number of points above or below a specified delivery month futures price with the buyer allowed a period of time to fix the price either by purchasing a futures contract for the account of the seller or telling the seller when he wishes to fix the price. See Seller s Call. Buyer s Market: A condition of the market in which there is an abundance of goods available and hence buyers can afford to be selective and may be able to buy at less than the price that previously prevailed. See Seller's Market. Buying Hedge (or Long Hedge): Hedging transaction in which futures contracts are bought to protect against possible increases in the cost of commodities. See Hedging. Buy (or Sell) On Close: To buy (or sell) at the end of the trading session within the closing price range. Buy (or Sell) On Opening: To buy (or sell) at the beginning of a trading session within the open price range. C C & F: Cost and Freight paid to a point of destination and included in the price quoted; same as C.A.F. Calendar Spread: (1) The purchase of one delivery month of a given futures contract and simultaneous sale of a different delivery month of the same futures contract; (2) the purchase of a put or call option and the simultaneous sale of the same type of option with typically the same strike price but a different expiration date. Also called a horizontal spread or time spread. Call: (1) An option contract that gives the buyer the right but not the obligation to purchase a commodity, security, or other asset or to enter into a long futures position at a given price (the strike APRIL 2011 41
6. GLOSSARY OF THE DERIVATIVES MARKET INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS price ) prior to or on a specified expiration date; (2) a period at the opening and the close of some futures markets in which the price for each futures contract was established by auction; or (3) the requirement that a financial instrument such as a bond be returned to the issuer prior to maturity, with principal and accrued interest paid off upon return. See Buyer s Call, Seller s Call. Call Around Market: A market, commonly used for options on futures on European exchanges, in which brokers contact each other outside of the exchange trading facility to arrange block trades. Call Cotton: Cotton bought or sold on call. See Buyer s Call, Seller s Call. Called: Another term for exercised when an option is a call. In the case of an option on a physical, the writer of a call must deliver the indicated underlying commodity when the option is exercised or called. In the case of an option on a futures contract, a futures position will be created that will require margin, unless the writer of the call has an offsetting position. Call Rule: An exchange regulation under which an official bid price for a cash commodity is competitively established at the close of each day's trading. It holds until the next opening of the exchange. Cap and Trade: A market based pollution control system in which total emissions of a pollutant are capped at a specified level. Allowances (or the right to emit a specified amount of a pollutant) are issued to firms and can be bought and sold on an organized market or OTC. Capping: Effecting transactions in an instrument underlying an option shortly before the option's expiration date to depress or prevent a rise in the price of the instrument so that previously written call options will expire worthless, thus protecting premiums previously received. See Pegging. Carrying Broker: An exchange member firm, usually a futures commission merchant, through whom another broker or customer elects to clear all or part of its trades. Carrying Charges: Also called Cost of Carry. Cost of storing a physical commodity or holding a financial instrument over a period of time. These charges include insurance, storage, and interest on the deposited funds, as well as other incidental costs. It is a carrying charge market when there are higher futures prices for each successive contract maturity. If the carrying charge is adequate to reimburse the holder, it is called full carry. See Negative Carry, Positive Carry, and Contango. Carry Trade: A trade where one borrows a currency or commoidity commodity or currency with a low cost of carry and lends a similar instrument with a high cost of carry in order to profit from the differential. Cascade: A situation in which the execution of market orders or stop loss orders on an electronic trading system triggers other stop loss orders which may, in turn, trigger still more stop loss orders. This may lead to a very large price move if there are no safety mechanisms to prevent cascading. Cash Commodity: The physical or actual commodity as distinguished from the futures contract, sometimes called spot commodity or actuals. Cash Forward Sale: See Forward Contract. 42 APRIL 2011
INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS 6. GLOSSARY OF THE DERIVATIVES MARKET Cash Market: The market for the cash commodity (as contrasted to a futures contract) taking the form of: (1) an organized, self regulated central market (e.g., a commodity exchange); (2) a decentralized over the counter market; or (3) a local organization, such as a grain elevator or meat processor, which provides a market for a small region. Cash Price: The price in the marketplace for actual cash or spot commodities to be delivered via customary market channels. Cash Settlement: A method of settling futures options and other derivatives whereby the seller (or short) pays the buyer (or long) the cash value of the underlying commodity or a cash amount based on the level of an index or price according to a procedure specified in the contract. Also called Financial Settlement. Compare to physical delivery. CCC: See Commodity Credit Corporation. CD: See Certificate of Deposit. CEA: Commodity Exchange Act or Commodity Exchange Authority. Certificate of Deposit (CD): A time deposit with a specific maturity traditionally evidenced by a certificate. Large denomination CDs are typically negotiable. CFTC: See Commodity Futures Trading Commission. CFTC Form 40: The form used by large traders to report their futures and option positions and the purposes of those positions. CFO: Cancel Former Order. Centralized Counterparty (CCP): See Clearing Organization. Certificated or Certified Stocks: Stocks of a commodity that have been inspected and found to be of a quality deliverable against futures contracts, stored at the delivery points designated as regular or acceptable for delivery by an exchange. In grain, called stocks in deliverable position. See Deliverable Stocks. Changer: Formerly, a clearing member of both the Mid America Commodity Exchange (MidAm) and another futures exchange who, for a fee, would assume the opposite side of a transaction on MidAm by taking a spread position between MidAm and the other futures exchange that traded an identical, but larger, contract. Through this service, the changer provided liquidity for MidAm and an economical mechanism for arbitrage between the two markets. MidAm was a subsidiary of the Chicago Board of Trade (CBOT). MidAm was closed by the CBOT in 2003 after MidAm s contracts were delisted on MidAm and relisted on the CBOT as Mini contracts. The CBOT continued to use changers for former MidAm contracts traded on an open outcry platform. Charting: The use of graphs and charts in the technical analysis of futures markets to plot trends of price movements, average movements of price, volume of trading, and open interest. APRIL 2011 43
6. GLOSSARY OF THE DERIVATIVES MARKET INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS Chartist: Technical trader who reacts to signals derived from graphs of price movements. Cheapest to Deliver: Usually refers to the selection of a class of bonds or notes deliverable against an expiring bond or note futures contract. The bond or note that has the highest implied repo rate is considered cheapest to deliver. Chooser Option: An exotic option that is transacted in the present, but that at some specified future date is chosen to be either a put or a call option. Churning: Excessive trading of a discretionary account by a person with control over the account for the purpose of generating commissions while disregarding the interests of the customer. Circuit Breakers: A system of coordinated trading halts and/or price limits on equity markets and equity derivative markets designed to provide a cooling off period during large, intraday market declines. The first known use of the term circuit breaker in this context was in the Report of the Presidential Task Force on Market Mechanisms (January 1988), which recommended that circuit breakers be adopted following the market break of October 1987. C.I.F: Cost, insurance, and freight paid to a point of destination and included in the price quoted. Class (of options): Options of the same type (i.e., either puts or calls, but not both) covering the same underlying futures contract or other asset (e.g., a March call with a strike price of 62 and a May call with a strike price of 58). Clearing: The procedure through which the clearing organization becomes the buyer to each seller of a futures contract or other derivative, and the seller to each buyer for clearing members. Clearing Association: See Clearing Organization. Clearing House: See Clearing Organization. Clearing Member: A member of a clearing organization. All trades of a non clearing member must be processed and eventually settled through a clearing member. Clearing Organization: An entity through which futures and other derivative transactions are cleared and settled. It is also charged with assuring the proper conduct of each contract s delivery procedures and the adequate financing of trading. A clearing organization may be a division of a particular exchange, an adjunct or affiliate thereof, or a freestanding entity. Also called a clearing house, multilateral clearing organization, or clearing association. See Derivatives Clearing Organization. Clearing Price: See Settlement Price. Close: The exchange designated period at the end of the trading session during which all transactions are considered made at the close. See Call. Closing Out: Liquidating an existing long or short futures or option position with an equal and opposite transaction. Also known as Offset. 44 APRIL 2011
INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS 6. GLOSSARY OF THE DERIVATIVES MARKET Closing Price (or Range): The price (or price range) recorded during trading that takes place in the final period of a trading session s activity that is officially designated as the close. Co Location: The placement of servers used by market participants in close physical proximity to an electronic trading facility's matching engine in order to facilitate high frequency trading. Combination: Puts and calls held either long or short with different strike prices and/or expirations. Types of combinations include straddles and strangles. Commercial: An entity involved in the production, processing, or merchandising of a commodity. Commercial Grain Stocks: Domestic grain in store in public and private elevators at important markets and grain afloat in vessels or barges in lake and seaboard ports. Commercial Paper: Short term promissory notes issued in bearer form by large corporations, with maturities ranging from 5 to 270 days. Since the notes are unsecured, the commercial paper market generally is dominated by large corporations with impeccable credit ratings. Commission: (1) The charge made by a futures commission merchant for buying and selling futures contracts; or (2) the fee charged by a futures broker for the execution of an order. Note: when capitalized, the word Commission usually refers to the CFTC. Commitments of Traders Report (COT): A weekly report from the CFTC providing a breakdown of each Tuesday's open interest for markets in which 20 or more traders hold positions equal to or above the reporting levels established by the CFTC. Open interest is broken down by aggregate commercial, non commercial, and non reportable holdings. Commitments: See Open Interest. Commodity: (1) A commodity, as defined in the Commodity Exchange Act, includes the agricultural commodities enumerated in Section 1a(4) of the Commodity Exchange Act, 7 USC 1a(4), and all other goods and articles, except onions as provided in Public Law 85 839 (7 USC 13 1), a 1958 law that banned futures trading in onions, and all services, rights, and interests in which contracts for future delivery are presently or in the future dealt in. (2) A physical commodity such as an agricultural product or a natural resource as opposed to a financial instrument such as a currency or interest rate. Commodity Credit Corporation: A government owned corporation established in 1933 to assist American agriculture. Major operations include price support programs, foreign sales, and export credit programs for agricultural commodities. Commodity Exchange Act: The Commodity Exchange Act, 7 USC 1, et seq., provides for the federal regulation of commodity futures and options trading and was enacted in 1936. Commodity Exchange Authority: A regulatory agency of the U.S. Department of Agriculture established to regulate futures trading under the 1936 Commodity Exchange Act prior to 1975. The Commodity APRIL 2011 45
6. GLOSSARY OF THE DERIVATIVES MARKET INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS Exchange Authority was the predecessor of the Commodity Futures Trading Commission. Before World War II, this agency was known as the Commodity Exchange Administration. Commodity Exchange Commission: A commission consisting of the Secretary of Agriculture, Secretary of Commerce, and the Attorney General, responsible for administering the Commodity Exchange Act prior to 1975. Among other things, the CEC was responsible for setting Federal speculative position limits. Commodity Futures Trading Commission (CFTC): The Federal regulatory agency established by the Commodity Futures Trading Act of 1974 to administer the Commodity Exchange Act. Commodity Index: An index of a specified set of (physical) commodity prices or commodity futures prices. Commodity Index Fund: An investment fund that enters into futures or commodity swap positions for the purpose of replicating the return of an index of commodity prices or commodity futures prices. Commodity Index Swap: A swap whose cash flows are intended to replicate a commodity index. Commodity Index Trader: An entity that conducts futures trades on behalf of a commodity index fund or to hedge commodity index swap positions. Commodity Linked Bond: A bond in which payment to the investor is dependent to a certain extent on the price level of a commodity, such as crude oil, gold, or silver, at maturity. Commodity Option: An option on a commodity or a futures contract. Commodity Pool: An investment trust, syndicate, or similar form of enterprise operated for the purpose of trading commodity futures or option contracts. Typically thought of as an enterprise engaged in the business of investing the collective or pooled funds of multiple participants in trading commodity futures or options, where participants share in profits and losses on a pro rata basis. Commodity Pool Operator (CPO): A person engaged in a business similar to an investment trust or a syndicate and who solicits or accepts funds, securities, or property for the purpose of trading commodity futures contracts or commodity options. The commodity pool operator either itself makes trading decisions on behalf of the pool or engages a commodity trading advisor to do so. Commodity Trading Advisor (CTA): A person who, for pay, regularly engages in the business of advising others as to the value of commodity futures or options or the advisability of trading in commodity futures or options, or issues analyses or reports concerning commodity futures or options. Commodity Swap: A swap in which the payout to at least one counterparty is based on the price of a commodity or the level of a commodity index. Confirmation Statement: A statement sent by a futures commission merchant to a customer when a futures or options position has been initiated which typically shows the price and the number of contracts bought and sold. See P&S (Purchase and Sale Statement). Congestion: (1) A market situation in which shorts attempting to cover their positions are unable to find an adequate supply of contracts provided by longs willing to liquidate or by new sellers willing to enter 46 APRIL 2011
INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS 6. GLOSSARY OF THE DERIVATIVES MARKET the market, except at sharply higher prices (see Squeeze, Corner); (2) in technical analysis, a period of time characterized by repetitious and limited price fluctuations. Consignment: A shipment made by a producer or dealer to an agent elsewhere with the understanding that the commodities in question will be cared for or sold at the highest obtainable price. Title to the merchandise shipped on consignment rests with the shipper until the goods are disposed of according to agreement. Contango: Market situation in which prices in succeeding delivery months are progressively higher than in the nearest delivery month; the opposite of backwardation. Contract: (1) A term of reference describing a unit of trading for a commodity future or option or other derivative; (2) an agreement to buy or sell a specified commodity, detailing the amount and grade of the product and the date on which the contract will mature and become deliverable. Contract Grades: Those grades of a commodity that have been officially approved by an exchange as deliverable in settlement of a futures contract. Contract Market: A board of trade or exchange designated by the Commodity Futures Trading Commission to trade futures or options under the Commodity Exchange Act. A contract market can allow both institutional and retail participants and can list for trading futures contracts on any commodity, provided that each contract is not readily susceptible to manipulation. Also called designated contract market. See Derivatives Transaction Execution Facility. Contract Month: See Delivery Month. Contract Size: The actual amount of a commodity represented in a contract. Contract Unit: See Contract Size. Controlled Account: An account for which trading is directed by someone other than the owner. Also called a Managed Account or a Discretionary Account. Convergence: The tendency for prices of physicals and futures to approach one another, usually during the delivery month. Also called a narrowing of the basis. Conversion: A position created by selling a call option, buying a put option, and buying the underlying instrument (for example, a futures contract), where the options have the same strike price and the same expiration. See Reverse Conversion. Conversion Factors: Numbers published by a futures exchange to determine invoice prices for debt instruments deliverable against bond or note futures contracts. A separate conversion factor is published for each deliverable instrument. Invoice price = Contract Size Futures Settlement Price Conversion Factor + Accrued Interest. Core Principle: A provision of the Commodity Exchange Act with which a contract market, derivatives transaction execution facility, or derivatives clearing organization must comply on an ongoing basis. APRIL 2011 47
6. GLOSSARY OF THE DERIVATIVES MARKET INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS There are 18 core principles for contract markets, 9 core principles for derivatives transaction execution facilities, and 14 core principles for derivatives clearing organizations. Corner: (1) Securing such relative control of a commodity that its price can be manipulated, that is, can be controlled by the creator of the corner; or (2) in the extreme situation, obtaining contracts requiring the delivery of more commodities than are available for delivery. See Squeeze, Congestion. Corn Hog Ratio: See Feed Ratio. Correction: A temporary decline in prices during a bull market that partially reverses the previous rally. See Bear Market Rally. Cost of Carry: See Carrying Charges. Cost of Tender: Total of various charges incurred when a commodity is certified and delivered on a futures contract. COT: See Commitments of Traders Report. Counterparty: The opposite party in a bilateral agreement, contract, or transaction, such as a swap. In the retail foreign exchange (or Forex) context, the party to which a retail customer sends its funds; lawfully, the party must be one of those listed in Section 2(c)(2)(B)(ii)(I) (VI) of the Commodity Exchange Act. Counterparty Risk: The risk associated with the financial stability of the party entered into contract with. Forward contracts impose upon each party the risk that the counterparty will default, but futures contracts executed on a designated contract market are guaranteed against default by the clearing organization. Counter Trend Trading: In technical analysis, the method by which a trader takes a position contrary to the current market direction in anticipation of a change in that direction. Coupon (Coupon Rate): A fixed dollar amount of interest payable per annum, stated as a percentage of principal value, usually payable in semiannual installments. Cover: (1) Purchasing futures to offset a short position (same as Short Covering); see Offset, Liquidation; (2) to have in hand the physical commodity when a short futures sale is made, or to acquire the commodity that might be deliverable on a short sale. Covered Option: A short call or put option position that is covered by the sale or purchase of the underlying futures contract or other underlying instrument. For example, in the case of options on futures contracts, a covered call is a short call position combined with a long futures position. A covered put is a short put position combined with a short futures position. Cox Ross Rubinstein Option Pricing Model: An option pricing model developed by John Cox, Stephen Ross, and Mark Rubinstein that can be adopted to include effects not included in the Black Scholes Model (e.g., early exercise and price supports). CPO: See Commodity Pool Operator. 48 APRIL 2011
INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS 6. GLOSSARY OF THE DERIVATIVES MARKET Crack Spread: (1) In energy futures, the simultaneous purchase of crude oil futures and the sale of petroleum product futures to establish a refining margin. One can trade a gasoline crack spread, a heating oil crack spread, or a 3 2 1 crack spread which consists of three crude oil futures contracts spread against two gasoline futures contracts and one heating oil futures contract. The 3 2 1 crack spread is designed to approximate the typical ratio of gasoline and heating oil that results from refining a barrel of crude oil. See Gross Processing Margin. (2) Calculation showing the theoretical market value of petroleum products that could be obtained from a barrel of crude after the oil is refined or cracked. This does not necessarily represent the refining margin because a barrel of crude yields varying amounts of petroleum products. Credit Default Option: A put option that makes a payoff in the event the issuer of a specified reference asset defaults. Also called default option. Credit Default Swap: A bilateral over the counter (OTC) contract in which the seller agrees to make a payment to the buyer in the event of a specified credit event in exchange for a fixed payment or series of fixed payments; the most common type of credit derivative; also called credit swap; similar to credit default option. Credit Derivative: A derivative contract designed to assume or shift credit risk, that is, the risk of a credit event such as a default or bankruptcy of a borrower. For example, a lender might use a credit derivative to hedge the risk that a borrower might default or have its credit rating downgraded. Common credit derivatives include, credit default swaps, credit default options, credit spread options, downgrade options, and total return swaps. Credit Event: An event such as a debt default or bankruptcy that will affect the payoff on a credit derivative, as defined in the derivative agreement. Credit Rating: A rating determined by a rating agency that indicates the agency s opinion of the likelihood that a borrower such as a corporation or sovereign nation will be able to repay its debt. The rating agencies include Standard & Poor s, Fitch, and Moody s. Credit Spread: The difference between the yield on the debt securities of a particular corporate or sovereign borrower (or a class of borrowers with a specified credit rating) and the yield of similar maturity Treasury debt securities. Credit Spread Option: An option whose payoff is based on the credit spread between the debt of a particular borrower and similar maturity Treasury debt. Credit Swap: See Credit Default Swap. Crop Year: The time period from one harvest to the next, varying according to the commodity (e.g., July 1 to June 30 for wheat; September 1 to August 31 for soybeans). APRIL 2011 49
6. GLOSSARY OF THE DERIVATIVES MARKET INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS Cross Hedge: Hedging a cash market position in a futures or option contract for a different but price related commodity. Cross Margining: A procedure for margining related securities, options, and futures contracts jointly when different clearing organizations clear each side of the position. Cross Rate: In foreign exchange, the price of one currency in terms of another currency in the market of a third country. For example, the exchange rate between Japanese yen and Euros would be considered a cross rate in the U.S. market. Cross Trading: Offsetting or noncompetitive match of the buy order of one customer against the sell order of another, a practice that is permissible only when executed in accordance with the Commodity Exchange Act, CFTC rules, and rules of the exchange. Crush Spread: In the soybean futures market, the simultaneous purchase of soybean futures and the sale of soybean meal and soybean oil futures to establish a processing margin. See Gross Processing Margin, Reverse Crush Spread. CTA: See Commodity Trading Advisor. CTI (Customer Type Indicator) Codes: These consist of four identifiers that describe transactions by the type of customer for which a trade is effected. The four codes are: (1) trading by a person who holds trading privileges for his or her own account or an account for which the person has discretion; (2) trading for a clearing member s proprietary account; (3) trading for another person who holds trading privileges who is currently present on the trading floor or for an account controlled by such other person; and (4) trading for any other type of customer. Transaction data classified by the above codes is included in the trade register report produced by a clearing organization. Curb Trading: Trading by telephone or by other means that takes place after the official market has closed and that originally took place in the street on the curb outside the market. Under the Commodity Exchange Act and CFTC rules, curb trading is illegal. Also known as kerb trading. Currency Swap: A swap that involves the exchange of one currency (e.g., U.S. dollars) for another (e.g., Japanese yen) on a specified schedule. Current Delivery Month: See Spot Month D Daily Price Limit: The maximum price advance or decline from the previous day's settlement price permitted during one trading session, as fixed by the rules of an exchange. Day Ahead: See Next Day. Day Order: An order that expires automatically at the end of each day's trading session. There may be a day order with time contingency. For example, an off at a specific time order is an order that remains 50 APRIL 2011
INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS 6. GLOSSARY OF THE DERIVATIVES MARKET in force until the specified time during the session is reached. At such time, the order is automatically canceled. Day Trader: A trader, often a person with exchange trading privileges, who takes positions and then offsets them during the same trading session prior to the close of trading. DCM: Designated Contract Market. Dealer: An individual or firm that acts as a market maker in an instrument such as a security or foreign currency. Dealer/Merchant (AD): A large trader that declares itself a Dealer/Merchant on CFTC Form 40, which provides as examples wholesaler, exporter/importer, shipper, grain elevator operator, crude oilmarketer. Deck: The orders for purchase or sale of futures and option contracts held by a floor broker. Also referred to as an order book. Declaration Date: See Expiration Date. Declaration (of Options): See Exercise. Default: Failure to perform on a futures contract as required by exchange rules, such as failure to meet a margin call, or to make or take delivery. Default Option: See Credit Default Option. Deferred Futures: See Back Months. Deliverable Grades: See Contract Grades. Deliverable Stocks: Stocks of commodities located in exchange approved storage for which receipts may be used in making delivery on futures contracts. In the cotton trade, the term refers to cotton certified for delivery. Also see Certificated or Certified Stocks. Deliverable Supply: The total supply of a commodity that meets the delivery specifications of a futures contract. See Economically Deliverable Supply. Delivery: The tender and receipt of the actual commodity, the cash value of the commodity, or of a delivery instrument covering the commodity (e.g., warehouse receipts or shipping certificates), used to settle a futures contract. See Notice of Delivery, Delivery Notice. Delivery, Current: Deliveries being made during a present month. Sometimes current delivery is used as a synonym for nearby delivery. Delivery Date: The date on which the commodity or instrument of delivery must be delivered to fulfill the terms of a contract. Delivery Instrument: A document used to effect delivery on a futures contract, such as a warehouse receipt or shipping certificate. APRIL 2011 51
6. GLOSSARY OF THE DERIVATIVES MARKET INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS Delivery Month: The specified month within which a futures contract matures and can be settled by delivery or the specified month in which the delivery period begins. Delivery, Nearby: The nearest traded month, the front month. In plural form, one of the nearer trading months. Delivery Notice: The written notice given by the seller of his intention to make delivery against an open short futures position on a particular date. This notice, delivered through the clearing organization, is separate and distinct from the warehouse receipt or other instrument that will be used to transfer title. Also called Notice of Intent to Deliver or Notice of Delivery. Delivery Option: A provision of a futures contract that provides the short with flexibility in regard to timing, location, quantity, or quality in the delivery process. Delivery Point: A location designated by a commodity exchange where stocks of a commodity represented by a futures contract may be delivered in fulfillment of the contract. Also called Location. Delivery Price: The price fixed by the clearing organization at which deliveries on futures are invoiced generally the price at which the futures contract is settled when deliveries are made. Also called Invoice Price. Delta: The expected change in an option's price given a one unit change in the price of the underlying futures contract or physical commodity. For example, an option with a delta of 0.5 would change $.50 when the underlying commodity moves $1.00. Delta Margining or Delta Based Margining: An option margining system used by some exchanges that equates the changes in option premiums with the changes in the price of the underlying futures contract to determine risk factors upon which to base the margin requirements. Delta Neutral: Refers to a position involving options that is designed to have an overall delta of zero. Deposit: See Initial Margin. Depository Receipt: See Vault Receipt. Derivative: A financial instrument, traded on or off an exchange, the price of which is directly dependent upon (i.e., derived from ) the value of one or more underlying securities, equity indices, debt instruments, commodities, other derivative instruments, or any agreed upon pricing index or arrangement (e.g., the movement over time of the Consumer Price Index or freight rates). They are used to hedge risk or to exchange a floating rate of return for fixed rate of return. Derivatives include futures, options, and swaps. For example, futures contracts are derivatives of the physical contract and options on futures are derivatives of futures contracts. Derivatives Clearing Organization: A clearing organization or similar entity that, in respect to a contract (1) enables each party to the contract to substitute, through novation or otherwise, the credit of the derivatives clearing organization for the credit of the parties; (2) arranges or provides, on a multilateral 52 APRIL 2011
INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS 6. GLOSSARY OF THE DERIVATIVES MARKET basis, for the settlement or netting of obligations resulting from such contracts; or (3) otherwise provides clearing services or arrangements that mutualize or transfer among participants in the derivatives clearing organization the credit risk arising from such contracts. Derivatives Transaction Execution Facility (DTEF): A board of trade that is registered with the CFTC as a DTEF. A DTEF is subject to fewer regulatory requirements than a contract market. To qualify as a DTEF, an exchange can only trade certain commodities (including excluded commodities and other commodities with very high levels of deliverable supply) and generally must exclude retail participants (retail participants may trade on DTEFs through futures commission merchants with adjusted net capital of at least $20 million or registered commodity trading advisors that direct trading for accounts containing total assets of at least $25 million). See Derivatives Transaction Execution Facilities. Designated Contract Market: See Contract Market. Designated Self Regulatory Organization (DSRO): Self regulatory organizations (i.e., the commodity exchanges and registered futures associations) must enforce minimum financial and reporting requirements for their members, among other responsibilities outlined in the CFTC's regulations. When a futures commission merchant (FCM) is a member of more than one SRO, the SROs may decide among themselves which of them will assume primary responsibility for these regulatory duties and, upon approval of the plan by the Commission, be appointed the designated self regulatory organization for that FCM. Diagonal Spread: A spread between two call options or two put options with different strike prices and different expiration dates. See Horizontal Spread, Vertical Spread. Differentials: The discount (premium) allowed for grades or locations of a commodity lower (higher) than the par of basis grade or location specified in the futures contact. See Allowances. Digital Option: See Binary Option. Directional Trading: Trading strategies designed to speculate on the direction of the underlying market, especially in contrast to volatility trading. Disclosure Document: A statement that must be provided to prospective customers that describes trading strategy, potential risk, commissions, fees, performance, and other relevant information. Discount: (1) The amount a price would be reduced to purchase a commodity of lesser grade; (2) sometimes used to refer to the price differences between futures of different delivery months, as in the phrase July at a discount to May, indicating that the price for the July futures is lower than that of May. Discretionary Account: An arrangement by which the holder of an account gives written power of attorney to someone else, often a commodity trading advisor, to buy and sell without prior approval of the holder; often referred to as a managed account or controlled account. Distillates: A category of petroleum products that includes diesel fuels and fuel oils such as heating oil. APRIL 2011 53
6. GLOSSARY OF THE DERIVATIVES MARKET INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS DRT ( Disregard Tape ) or Not Held Order: Absent any restrictions, a DRT (Not Held Order) means any order giving the floor broker complete discretion over price and time in execution of an order, including discretion to execute all, some, or none of this order. Distant or Deferred Months: See Back Month. Dominant Future: That future having the largest amount of open interest. Double Hedging: As used by the CFTC, it implies a situation where a trader holds a long position in the futures market in excess of the speculative position limit as an offset to a fixed price sale, even though the trader has an ample supply of the commodity on hand to fill all sales commitments. DSRO: See Designated Self Regulatory Organization. DTEF: See Derivatives Transaction Execution Facility. Dual Trading: Dual trading occurs when: (1) a floor broker executes customer orders and, on the same day, trades for his own account or an account in which he has an interest; or (2) a futures commission merchant carries customer accounts and also trades or permits its employees to trade in accounts in which it has a proprietary interest, also on the same trading day. Dutch Auction: An auction of a debt instrument (such as a Treasury note) in which all successful bidders receive the same yield (the lowest yield that results in the sale of the entire amount to be issued). Duration: A measure of a bond's price sensitivity to changes in interest rates. E Ease Off: A minor and/or slow decline in the price of a market. ECN: Electronic Communications Network, frequently used for creating electronic stock or futures markets. Economically Deliverable Supply: That portion of the deliverable supply of a commodity that is in position for delivery against a futures contract, and is not otherwise unavailable for delivery. For example, Treasury bonds held by long term investment funds are not considered part of the economically deliverable supply of a Treasury bond futures contract. Efficient Market: In economic theory, an efficient market is one in which market prices adjust rapidly to reflect new information. The degree to which the market is efficient depends on the quality of information reflected in market prices. In an efficient market, profitable arbitrage opportunities do not exist and traders cannot expect to consistently outperform the market unless they have lower cost access to information that is reflected in market prices or unless they have access to information before it is reflected in market prices. See Random Walk. EFP: See Exchange for Physical. EIA: See Energy Information Administration. 54 APRIL 2011
INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS 6. GLOSSARY OF THE DERIVATIVES MARKET Electronic Trading Facility: A trading facility that operates by an electronic or telecommunications network instead of a trading floor and maintains an automated audit trail of transactions. Eligible Commercial Entity: An eligible contract participant or other entity approved by the CFTC that has a demonstrable ability to make or take delivery of an underlying commodity of a contract; incurs risks related to the commodity; or is a dealer that regularly provides risk management, hedging services, or market making activities to entities trading commodities or derivative agreements, contracts, or transactions in commodities. Eligible Contract Participant: An entity, such as a financial institution, insurance company, or commodity pool, that is classified by the Commodity Exchange Act as an eligible contract participant based upon its regulated status or amount of assets. This classification permits these persons to engage in transactions (such as trading on a derivatives transaction execution facility) not generally available to non eligible contract participants, i.e., retail customers. Elliot Wave: (1) A theory named after Ralph Elliot, who contended that the stock market tends to move in discernible and predictable patterns reflecting the basic harmony of nature and extended by other technical analysts to futures markets; (2) in technical analysis, a charting method based on the belief that all prices act as waves, rising and falling rhythmically. E Local: A person with trading privileges at an exchange with an electronic trading facility who trades electronically (rather than in a pit or ring) for his or her own account, often at a trading arcade. E Mini: A mini contract that is traded exclusively on an electronic trading facility. E Mini is a trademark of the Chicago Mercantile Exchange. Emergency: Any market occurrence or circumstance which requires immediate action and threatens or may threaten such things as the fair and orderly trading in, or the liquidation of, or delivery pursuant to, any contracts on a contract market. Energy Information Administration (EIA): An agency of the US Department of Energy that provides statistics, data, analysis on resources, supply, production, consumption for all energy sources. EIA data includes weekly inventory statistics for crude oil and petroleum products as well as weekly natural storage data. Enumerated Agricultural Commodities: The commodities specifically listed in Section 1a(3) of the Commodity Exchange Act: wheat, cotton, rice, corn, oats, barley, rye, flaxseed, grain sorghums, mill feeds, butter, eggs, Solanum tuberosum (Irish potatoes), wool, wool tops, fats and oils (including lard, tallow, cottonseed oil, peanut oil, soybean oil, and all other fats and oils), cottonseed meal, cottonseed, peanuts, soybeans, soybean meal, livestock, livestock products, and frozen concentrated orange juice. Equity: As used on a trading account statement, refers to the residual dollar value of a futures or option trading account, assuming it was liquidated at current prices. APRIL 2011 55
6. GLOSSARY OF THE DERIVATIVES MARKET INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS ETF: See Exchange Traded Fund. EURIBOR (Euro Interbank Offered Rate): The euro denominated rate of interest at which banks borrow funds from other banks, in marketable size, in the interbank market. Euribor is sponsored by the European Banking Federation. See LIBOR, TIBOR.Euro: The official currency of most members of the European Union. Eurocurrency: Certificates of Deposit (CDs), bonds, deposits, or any capital market instrument issued outside of the national boundaries of the currency in which the instrument is denominated (for example, Eurodollars, Euro Swiss francs, or Euroyen). Eurodollars: U.S. dollar deposits placed with banks outside the U.S. Holders may include individuals, companies, banks, and central banks. European Option: An option that may be exercised only on the expiration date. See American Option. Even Lot: A unit of trading in a commodity established by an exchange to which official price quotations apply. See Round Lot. Event Market: A market in derivatives whose payoff is based on a specified event or occurrence such as the release of a macroeconomic indicator, a corporate earnings announcement, or the dollar value of damages caused by a hurricane. Exchange: A central marketplace with established rules and regulations where buyers and sellers meet to trade futures and options contracts or securities. Exchanges include designated contract markets and derivatives transaction execution facilities. Exchange for Physicals (EFP): A transaction in which the buyer of a cash commodity transfers to the seller a corresponding amount of long futures contracts, or receives from the seller a corresponding amount of short futures, at a price difference mutually agreed upon. In this way, the opposite hedges in futures of both parties are closed out simultaneously. Also called Exchange of Futures for Cash, AA (against actuals), or Ex Pit transactions. Exchange of Futures for Cash: See Exchange for Physicals. Exchange of Futures for Swaps (EFS): A privately negotiated transaction in which a position in a physical delivery futures contract is exchanged for a cash settled swap position in the same or a related commodity, pursuant to the rules of a futures exchange. See Exchange for Physicals. Exchange Rate: The price of one currency stated in terms of another currency. Exchange Risk Factor: The delta of an option as computed daily by the exchange on which it is traded. Exchange Traded Fund (ETF): An investment vehicle holding a commodity or other asset that issues shares that are traded like a stock on a securities exchange. Excluded Commodity: In general, the Commodity Exchange Act defines an excluded commodity as: any financial instrument such as a security, currency, interest rate, debt instrument, or credit rating; any 56 APRIL 2011
INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS 6. GLOSSARY OF THE DERIVATIVES MARKET economic or commercial index other than a narrow based commodity index; or any other value that is out of the control of participants and is associated with an economic consequence. See the Commodity Exchange Act definition of excluded commodity. Exempt Board of Trade: A trading facility that trades commodities (other than securities or securities indexes) having a nearly inexhaustible deliverable supply and either no cash market or a cash market so liquid that any contract traded on the commodity is highly unlikely to be susceptible to manipulation. An exempt board of trade s contracts must be entered into by parties that are eligible contract participants. Exempt Commercial Market: An electronic trading facility that trades exempt commodities on a principal to principal basis solely between persons that are eligible commercial entities. Exempt Commodity: The Commodity Exchange Act defines an exempt commodity as any commodity other than an excluded commodity or an agricultural commodity. Examples include energy commodities and metals. Exempt Foreign Firm: A foreign firm that does business with U.S. customers only on foreign exchanges and is exempt from registration under CFTC regulations based upon compliance with its home country s regulatory framework (also known as a Rule 30.10 firm ). Exercise Price (Strike Price): The price, specified in the option contract, at which the underlying futures contract, security, or commodity will move from seller to buyer. Exotic Options: Any of a wide variety of options with non standard payout structures or other features, including Asian options and lookback options. Exotic options are mostly traded in the over the counter market. Expiration Date: The date on which an option contract automatically expires; the last day an option may be exercised. Extrinsic Value: See Time Value. Ex Pit: See Transfer Trades and Exchange for Physicals F FAB (Five Against Bond) Spread: A futures spread trade involving the buying (selling) of a five year Treasury note futures contract and the selling (buying) of a long term (15 30 year) Treasury bond futures contract. Fannie Mae: A corporation (government sponsored enterprise) created by Congress to support the secondary mortgage market (formerly the Federal National Mortgage Association). It purchases and sells residential mortgages insured by the Federal Home Administration (FHA) or guaranteed by the Veteran's Administration (VA). See Freddie Mac. FAN (Five Against Note) Spread: A futures spread trade involving the buying (selling) of a five year Treasury note futures contract and the selling (buying) of a ten year Treasury note futures contract. APRIL 2011 57
6. GLOSSARY OF THE DERIVATIVES MARKET INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS Fast Market: An open outcry market situation where transactions in the pit or ring take place in such volume and with such rapidity that price reporters fall behind with price quotations, label each quote as FAST and show a range of prices. Also called a fast tape. The Federal Energy Regulatory Commission: (FERC): An independent agency of the U.S. Government that regulates the interstate transmission of natural gas, oil, and electricity. FERC also regulates natural gas and hydropower projects. Federal Limit: A speculative position limit that is established and administered by the CFTC rather than an exchange. Feed Ratio: The relationship of the cost of feed, expressed as a ratio to the sale price of animals, such as the corn hog ratio. These serve as indicators of the profit margin or lack of profit in feeding animals to market weight. FERC: See Federal Energy Regulatory Commission. FIA: See Futures Industry Association. Fibonacci Numbers: A number sequence discovered by a thirteenth century Italian mathematician Leonardo Fibonacci (circa 1170 1250), who introduced Arabic numbers to Europe, in which the sum of any two consecutive numbers equals the next highest number i.e., following this sequence: 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, and so on. The ratio of any number to its next highest number approaches 0.618 after the first four numbers. These numbers are used by technical analysts to determine price objectives from percentage retracements. Fictitious Trading: Wash trading, bucketing, cross trading, or other schemes which give the appearance of trading but actually no bona fide, competitive trade has occurred. Fill: The execution of an order. Fill or Kill Order (FOK): An order that demands immediate execution or cancellation. Typically involving a designation, added to an order, instructing the broker to offer or bid (as the case may be) one time only; if the order is not filled immediately, it is then automatically cancelled. Final Settlement Price: The price at which a cash settled futures contract is settled at maturity, pursuant to a procedure specified by the exchange. Financial: Can be used to refer to a derivative that is financially settled or cash settled. See Physical. Financial Commodity: Any futures or option contract that is not based on an agricultural commodity or a natural resource such as energy or metals. It includes currencies, equity securities, fixed income securities, and indexes of various kinds. Financial Future: A futures contract on a financial commodity. Financial Settlement: See Cash settlement 58 APRIL 2011
INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS 6. GLOSSARY OF THE DERIVATIVES MARKET First Notice Day: The first day on which notices of intent to deliver actual commodities against futures market positions can be received. First notice day may vary with each commodity and exchange. Fix, Fixing: See Gold Fixing. Fixed Income Security: A security whose nominal (or current dollar) yield is fixed or determined with certainty at the time of purchase, typically a debt security. Floor Broker: A person with exchange trading privileges who, in any pit, ring, post, or other place provided by an exchange for the meeting of persons similarly engaged, executes for another person any orders for the purchase or sale of any commodity for future delivery. Floor Trader: A person with exchange trading privileges who executes his own trades by being personally present in the pit or ring for futures trading. See Local. F.O.B. (Free On Board): Indicates that all delivery, inspection and elevation, or loading costs involved in putting commodities on board a carrier have been paid. Forced Liquidation: The situation in which a customer's account is liquidated (open positions are offset) by the brokerage firm holding the account, usually after notification that the account is under margined due to adverse price movements and failure to meet margin calls. Force Majeure: A clause in a supply contract that permits either party not to fulfill the contractual commitments due to events beyond their control. These events may range from strikes to export delays in producing countries. Foreign Exchange: Trading in foreign currency. Forex: Refers to the over the counter market for foreign exchange transactions. Also called the foreign exchange market. Forwardation: See Contango. Forward Contract: A cash transaction common in many industries, including commodity merchandising, in which a commercial buyer and seller agree upon delivery of a specified quality and quantity of goods at a specified future date. Terms may be more personalized than is the case with standardized futures contracts (i.e., delivery time and amount are as determined between seller and buyer). A price may be agreed upon in advance, or there may be agreement that the price will be determined at the time of delivery. Forward Market: The over the counter market for forward contracts. Forward Months: Futures contracts, currently trading, calling for later or distant delivery. See Deferred Futures, Back Months. Forward Rate Agreement (FRA): An OTC forward contract on short term interest rates. The buyer of a FRA is a notional borrower, i.e., the buyer commits to pay a fixed rate of interest on some notional amount that is never actually exchanged. The seller of a FRA agrees notionally to lend a sum of money to APRIL 2011 59
6. GLOSSARY OF THE DERIVATIVES MARKET INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS a borrower. FRAs can be used either to hedge interest rate risk or to speculate on future changes in interest rates. Freddie Mac: A corporation (government sponsored enterprise) created by Congress to support the secondary mortgage market (formerly the Federal Home Loan Mortgage Corporation). It purchases and sells residential mortgages insured by the Federal Home Administration (FHA) or guaranteed by the Veterans Administration (VA). See Fannie Mae. Front Month: The spot or nearby delivery month, the nearest traded contract month. See Back Month. Front Running: With respect to commodity futures and options, taking a futures or option position based upon non public information regarding an impending transaction by another person in the same or related future or option. Also known as trading ahead. Front Spread: A delta neutral ratio spread in which more options are sold than bought. Also called ratio vertical spread. A front spread will increase in value if volatility decreases. Full Carrying Charge, Full Carry: See Carrying Charges. Fund of Funds: A commodity pool that invests in other commodity pools rather than directly in futures and options contracts. Fundamental Analysis: Study of basic, underlying factors that will affect the supply and demand of the commodity being traded in futures contracts. See Technical Analysis. Fungibility: The characteristic of interchangeability. Futures contracts for the same commodity and delivery month traded on the same exchange are fungible due to their standardized specifications for quality, quantity, delivery date, and delivery locations. Futures: See Futures Contract. Futures Commission Merchant (FCM): Individuals, associations, partnerships, corporations, and trusts that solicit or accept orders for the purchase or sale of any commodity for future delivery on or subject to the rules of any exchange and that accept payment from or extend credit to those whose orders are accepted. Futures Contract: An agreement to purchase or sell a commodity for delivery in the future: (1) at a price that is determined at initiation of the contract; (2) that obligates each party to the contract to fulfill the contract at the specified price; (3) that is used to assume or shift price risk; and (4) that may be satisfied by delivery or offset. Futures equivalent: A term frequently used with reference to speculative position limits for options on futures contracts. The futures equivalent of an option position is the number of options multiplied by the previous day's risk factor or delta for the option series. For example, ten deep out of money options with a delta of 0.20 would be considered two futures equivalent contracts. The delta or risk factor used for this purpose is the same as that used in delta based margining and risk analysis systems. 60 APRIL 2011
INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS 6. GLOSSARY OF THE DERIVATIVES MARKET Futures Industry Association (FIA): A membership organization for futures commission merchants (FCMs) which, among other activities, offers education courses on the futures markets, disburses information, and lobbies on behalf of its members. Futures Option: An option on a futures contract. Futures Price: (1) Commonly held to mean the price of a commodity for future delivery that is traded on a futures exchange; (2) the price of any futures contract. G Gamma: A measurement of how fast the delta of an option changes, given a unit change in the underlying futures price; the delta of the delta. Ginzy Trading: A non competitive trade practice in which a floor broker, in executing an order particularly a large order will fill a portion of the order at one price and the remainder of the order at another price to avoid an exchange's rule against trading at fractional increments or "split ticks." Give Up: A contract executed by one broker for the client of another broker that the client orders to be turned over to the second broker. The broker accepting the order from the customer collects a fee from the carrying broker for the use of the facilities. Often used to consolidate many small orders or to disperse large ones. Gold Certificate: A certificate attesting to a person's ownership of a specific amount of gold bullion. Gold Fixing (Gold Fix): The setting of the gold price at 10:30 a.m. (first fixing) and 3:00 p.m. (second fixing) in London by representatives of the London gold market. Gold/Silver Ratio: The number of ounces of silver required to buy one ounce of gold at current spot prices. Good This Week Order (GTW): Order which is valid only for the week in which it is placed. Good 'Till Canceled Order (GTC): An order which is valid until cancelled by the customer. Unless specified GTC, unfilled orders expire at the end of the trading day. See Open Order. GPM: See Gross Processing Margin. Grades: Various qualities of a commodity. Grading Certificates: A formal document setting forth the quality of a commodity as determined by authorized inspectors or graders. Grain Futures Act: Federal statute that provided for the regulation of trading in grain futures, effective June 22, 1923; administered by the Grain Futures Administration, an agency of the U.S. Department of Agriculture. The Grain Futures Act was amended in 1936 by the Commodity Exchange Act and the Grain Futures Administration became the Commodity Exchange Administration, later the Commodity Exchange Authority. APRIL 2011 61
6. GLOSSARY OF THE DERIVATIVES MARKET INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS Grantor: The maker, writer, or issuer of an option contract who, in return for the premium paid for the option, stands ready to purchase the underlying commodity (or futures contract) in the case of a put option or to sell the underlying commodity (or futures contract) in the case of a call option. Gross Processing Margin (GPM): Refers to the difference between the cost of a commodity and the combined sales income of the finished products that result from processing the commodity. Various industries have formulas to express the relationship of raw material costs to sales income from finished products. See Crack Spread, Crush Spread, and Spark Spread. GTC: See Good 'Till Canceled Order. GTW: See Good This Week Order. Guaranteed Introducing Broker: An introducing broker that has entered into a guarantee agreement with a futures commission merchant (FCM), whereby the FCM agrees to be jointly and severally liable for all of the introducing broker s obligations under the Commodity Exchange Act. By entering into the agreement, the introducing broker is relieved from the necessity of raising its own capital to satisfy minimum financial requirements. In contrast, an independent introducing broker must raise its own capital to meet minimum financial requirements. H Haircut: In computing the value of assets for purposes of capital, segregation, or margin requirements, a percentage reduction from the stated value (e.g., book value or market value) to account for possible declines in value that may occur before assets can be liquidated. Hand Held Terminal: A small computer terminal used by floor brokers or floor traders on an exchange to record trade information and transmit that information to the clearing organization. Hardening: (1) Describes a price which is gradually stabilizing; (2) a term indicating a slowly advancing market. Hard Position Limit: A Speculative Position Limit, especially in contrast to a position accountability level. Head and Shoulders: In technical analysis, a chart formation that resembles a human head and shoulders and is generally considered to be predictive of a price reversal. A head and shoulders top (which is considered predictive of a price decline) consists of a high price, a decline to a support level, a rally to a higher price than the previous high price, a second decline to the support level, and a weaker rally to about the level of the first high price. The reverse (upside down) formation is called a head and shoulders bottom (which is considered predictive of a price rally). Heavy: A market in which prices are demonstrating either an inability to advance or a slight tendency to decline. Hedge Exemption: An exemption from speculative position limits for bona fide hedgers and certain other persons who meet the requirements of exchange and CFTC rules. 62 APRIL 2011
INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS 6. GLOSSARY OF THE DERIVATIVES MARKET Hedge Fund: A private investment fund or pool that trades and invests in various assets such as securities, commodities, currency, and derivatives on behalf of its clients, typically wealthy individuals. Some commodity pool operators operate hedge funds. Hedge Ratio: Ratio of the value of futures contracts purchased or sold to the value of the cash commodity being hedged, a computation necessary to minimize basis risk. Hedger: A trader who enters into positions in a futures market opposite to positions held in the cash market to minimize the risk of financial loss from an adverse price change; or who purchases or sells futures as a temporary substitute for a cash transaction that will occur later. One can hedge either a long cash market position (e.g., one owns the cash commodity) or a short cash market position (e.g., one plans on buying the cash commodity in the future). Henry Hub: A natural gas pipeline hub in Louisiana that serves as the delivery point for New York Mercantile Exchange natural gas futures contracts and often serves as a benchmark for wholesale natural gas prices across the U.S. Hidden Quantity Order: An order placed on an electronic trading system whereby only a portion of the order is visible to other market participants. As the displayed part of the order is filled, additional quantities become visible. Also called Iceberg, Max Show. High Frequency Trading: Computerized or algorithmic trading in which transactions are completed in very small fractions of a second. Historical Volatility: A statistical measure (specifically, the annualized standard deviation) of the volatility of a futures contract, security, or other instrument over a specified number of past trading days. Hog Corn Ratio: See Feed Ratio. Horizontal Spread (also called Time Spread or Calendar Spread): An option spread involving the simultaneous purchase and sale of options of the same class and strike prices but different expiration dates. See Diagonal Spread, Vertical Spread. Hybrid Instruments: Financial instruments that possess, in varying combinations, characteristics of forward contracts, futures contracts, option contracts, debt instruments, bank depository interests, and other interests. Certain hybrid instruments are exempt from CFTC regulation. IJK IB: See Introducing Broker. Iceberg: See Hidden Quantity Order. Implied Repo Rate: The rate of return that can be obtained from selling a debt instrument futures contract and simultaneously buying a bond or note deliverable against that futures contract with borrowed funds. The bond or note with the highest implied repo rate is cheapest to deliver. APRIL 2011 63
6. GLOSSARY OF THE DERIVATIVES MARKET INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS Implied Volatility: The volatility of a futures contract, security, or other instrument as implied by the prices of an option on that instrument, calculated using an option pricing model. Index Arbitrage: The simultaneous purchase (sale) of stock index futures and the sale (purchase) of some or all of the component stocks that make up the particular stock index to profit from sufficiently large intermarket spreads between the futures contract and the index itself. Also see Arbitrage, Program Trading. Indirect Bucketing: Also referred to as indirect trading against. Refers to when a floor broker effectively trades opposite his customer in a pair of non competitive transactions by buying (selling) opposite an accommodating trader to fill a customer order and by selling (buying) for his personal account opposite the same accommodating trader. The accommodating trader assists the floor broker by making it appear that the customer traded opposite him rather than opposite the floor broker. Inflation Indexed Debt Instrument: Generally a debt instrument (such as a bond or note) on which the payments are adjusted for inflation and deflation. In a typical inflation indexed instrument, the principal amount is adjusted monthly based on an inflation index such as the Consumer Price Index. Initial Deposit: See Initial Margin. Initial Margin: Customers' funds put up as security for a guarantee of contract fulfillment at the time a futures market position is established. See Original Margin. In Position: Refers to a commodity located where it can readily be moved to another point or delivered on a futures contract. Commodities not so situated are "out of position." Soybeans in Mississippi are out of position for delivery in Chicago, but in position for export shipment from the Gulf of Mexico. In Sight: The amount of a particular commodity that arrives at terminal or central locations in or near producing areas. When a commodity is in sight, it is inferred that reasonably prompt delivery can be made; the quantity and quality also become known factors rather than estimates. Instrument: A tradable asset such as a commodity, security, or derivative, or an index or value that underlies a derivative or could underlie a derivative. Intercommodity Spread: A spread in which the long and short legs are in two different but generally related commodity markets. Also called an intermarket spread. See Spread. Interdelivery Spread: A spread involving two different months of the same commodity. Also called an intracommodity spread. See Spread. Interest Rate Futures: Futures contracts traded on fixed income securities such as U.S. Treasury issues, or based on the levels of specified interest rates such as LIBOR (London Interbank Offered Rate). Currency is excluded from this category, even though interest rates are a factor in currency values. Interest Rate Swap: A swap in which the two counterparties agree to exchange interest rate flows. Typically, one party agrees to pay a fixed rate on a specified series of payment dates and the other party 64 APRIL 2011
INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS 6. GLOSSARY OF THE DERIVATIVES MARKET pays a floating rate that may be based on LIBOR (London Interbank Offered Rate) on those payment dates. The interest rates are paid on a specified principal amount called the notional principal. Intermarket Spread: See Spread and Intercommodity Spread. Intermediary: A person who acts on behalf of another person in connection with futures trading, such as a futures commission merchant, introducing broker, commodity pool operator, commodity trading advisor, or associated person. International Swaps and Derivatives Association (ISDA): A New York based group of major international swaps dealers, that publishes the Code of Standard Wording, Assumptions and Provisions for Swaps, or Swaps Code, for U.S. dollar interest rate swaps as well as standard master interest rate, credit, and currency swap agreements and definitions for use in connection with the creation and trading of swaps. In The Money: A term used to describe an option contract that has a positive value if exercised. A call with a strike price of $390 on gold trading at $400 is in the money 10 dollars. See Intrinsic Value. Intracommodity Spread: See Spread and Interdelivery Spread. Intrinsic Value: A measure of the value of an option or a warrant if immediately exercised, that is, the extent to which it is in the money. The amount by which the current price for the underlying commodity or futures contract is above the strike price of a call option or below the strike price of a put option for the commodity or futures contract. Introducing Broker (IB): A person (other than a person registered as an associated person of a futures commission merchant) who is engaged in soliciting or in accepting orders for the purchase or sale of any commodity for future delivery on an exchange who does not accept any money, securities, or property to margin, guarantee, or secure any trades or contracts that result therefrom. Inverted Market: A futures market in which the nearer months are selling at prices higher than the more distant months; a market displaying inverse carrying charges, characteristic of markets with supply shortages. See Backwardation. Invisible Supply: Uncounted stocks of a commodity in the hands of wholesalers, manufacturers, and producers that cannot be identified accurately; stocks outside commercial channels but theoretically available to the market. See Visible Supply. Invoice Price: The price fixed by the clearing house at which deliveries on futures are invoiced generally the price at which the futures contract is settled when deliveries are made. Also called Delivery Price. ISDA: See International Swaps and Derivatives Association. Job Lot: A form of contract having a smaller unit of trading than is featured in a regular contract. Kerb Trading or Dealing: See Curb Trading. Knock In: A provision in an option or other derivative contract, whereby the contract is activated only if the price of the underlying instrument reaches a specified level before a specified expiration date. APRIL 2011 65
6. GLOSSARY OF THE DERIVATIVES MARKET INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS Knock Out: A provision in an option or other derivative contract, whereby the contract is immediately canceled if the price of the underlying instrument reaches a specified level during the life of the contract. L Large Order Execution (LOX) Procedures: Rules in place at the Chicago Mercantile Exchange that authorize a member firm that receives a large order from an initiating party to solicit counterparty interest off the exchange floor prior to open execution of the order in the pit and that provide for special surveillance procedures. The parties determine a maximum quantity and an "intended execution price." Subsequently, the initiating party's order quantity is exposed to the pit; any bids (or offers) up to and including those at the intended execution price are hit (acceptable). The unexecuted balance is then crossed with the contraside trader found using the LOX procedures. Large Traders: A large trader is one who holds or controls a position in any one future or in any one option expiration series of a commodity on any one exchange equaling or exceeding the exchange or CFTC specified reporting level. Last Notice Day: The final day on which notices of intent to deliver on futures contracts may be issued. Last Trading Day: Day on which trading ceases for the maturing (current) delivery month. Latency: The amount of time that elapses between the placement of a market order or marketable limit order on an electronic trading system and the execution of that order. Latency: The amount of time that elapses between the placement of a market order or marketable limit order on an electronic trading system and the execution of that order. Leaps: Long dated, exchange traded options. Stands for Long term Equity Anticipation Securities. Leverage: The ability to control large dollar amounts of a commodity or security with a comparatively small amount of capital. LIBOR: The London Interbank Offered Rate. The rate of interest at which banks borrow funds (denominated in U.S. dollars) from other banks, in marketable size, in the London interbank market. LIBOR rates are disseminated by the British Bankers Association, which also disseminates LIBOR rates for British pounds sterling. Some interest rate futures contracts, including Eurodollar futures, are cash settled based on LIBOR. Also see EURIBOR and TIBOR. Licensed Warehouse: A warehouse approved by an exchange from which a commodity may be delivered on a futures contract. See Regular Warehouse. Life of Contract: Period between the beginning of trading in a particular futures contract and the expiration of trading. In some cases, this phrase denotes the period already passed in which trading has already occurred. For example, The life of contract high so far is $2.50. Same as life of delivery or life of the future. 66 APRIL 2011
INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS 6. GLOSSARY OF THE DERIVATIVES MARKET Limit (Up or Down): The maximum price advance or decline from the previous day's settlement price permitted during one trading session, as fixed by the rules of an exchange. In some futures contracts, the limit may be expanded or removed during a trading session a specified period of time after the contract is locked limit. See Daily Price Limit. Limit Move: See Locked Limit. Limit Only: The definite price stated by a customer to a broker restricting the execution of an order to buy for not more than, or to sell for not less than, the stated price. Limit Order: An order in which the customer specifies a minimum sale price or maximum purchase price, as contrasted with a market order, which implies that the order should be filled as soon as possible at the market price. Liquidation: The closing out of a long position. The term is sometimes used to denote closing out a short position, but this is more often referred to as covering. See Cover, Offset. Liquid Market: A market in which selling and buying can be accomplished with minimal effect on price. Local: An individual with exchange trading privileges who trades for his own account, traditionally on an exchange floor, and whose activities provide market liquidity. See Floor Trader, E Local. Location: A Delivery Point for a futures contract. Locked In: A hedged position that cannot be lifted without offsetting both sides of the hedge (spread). See Hedging. Also refers to being caught in a limit price move. Locked Limit: A price that has advanced or declined the permissible limit during one trading session, as fixed by the rules of an exchange. Also called Limit Move. London Gold Market: Refers to the dealers in the London Bullion Market Association who set (fix) the gold price in London. See Gold Fixing. Long: (1) One who has bought a futures contract to establish a market position; (2) a market position that obligates the holder to take delivery; (3) one who owns an inventory of commodities. See Short. Long Hedge: See Buying Hedge. Long the Basis: A person or firm that has bought the spot commodity and hedged with a sale of futures is said to be long the basis. Lookalike Option: An over the counter option that is cash settled based on the settlement price of a similar exchange traded futures contract on a specified trading day. Lookalike Swap: An over the counter swap that is cash settled based on the settlement price of a similar exchange traded futures contract on a specified trading day. Lookback Option: An exotic option whose payoff depends on the minimum or maximum price of the underlying asset during some portion of the life of the option. Lookback options allow the buyer to pay or receive the most favorable underlying price during the lookback period. APRIL 2011 67
6. GLOSSARY OF THE DERIVATIVES MARKET INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS Lot: A unit of trading. See Even Lot, Job Lot, and Round Lot. M Macro Fund: A hedge fund that specializes in strategies designed to profit from expected macroeconomic events. Maintenance Margin: See Margin. Managed Account: See Controlled Account and Discretionary Account. Managed Money Trader (MMTs): A futures market participant who engages in futures trades on behalf of investment funds or clients. While MMTs are commonly equated with hedge funds, they may include Commodity Pool Operators and other managed accounts as well as hedge funds. While CFTC Form 40 does not provide a place to declare oneself a Managed Money Trader, a large trader can declare itself a Hedge Fund (H) or Managed Accounts and Commodity Pools. Manipulation: Any planned operation, transaction, or practice that causes or maintains an artificial price. Specific types include corners and squeezes as well as unusually large purchases or sales of a commodity or security in a short period of time in order to distort prices, and putting out false information in order to distort prices. Manufacturer (AM): A large trader that declares itself a Manufacturer on CFTC Form 40, which provides as examples refiner, miller, crusher, fabricator, sawmill, coffee roaster, cocoa grinder. Many to Many: Refers to a trading platform in which multiple participants have the ability to execute or trade commodities, derivatives, or other instruments by accepting bids and offers made by multiple other participants. In contrast to one to many platforms, many to many platforms are considered trading facilities under the Commodity Exchange Act. Traditional exchanges are many to many platforms. Margin: The amount of money or collateral deposited by a customer with his broker, by a broker with a clearing member, or by a clearing member with a clearing organization. The margin is not partial payment on a purchase. Also called Performance Bond. (1) Initial margin is the amount of margin required by the broker when a futures position is opened; (2) Maintenance margin is an amount that must be maintained on deposit at all times. If the equity in a customer's account drops to or below the level of maintenance margin because of adverse price movement, the broker must issue a margin call to restore the customer's equity to the initial level. See Variation Margin. Exchanges specify levels of initial margin and maintenance margin for each futures contract, but futures commission merchants may require their customers to post margin at higher levels than those specified by the exchange. Futures margin is determined by the SPAN margining system, which takes into account all positions in a customer s portfolio. 68 APRIL 2011
INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS 6. GLOSSARY OF THE DERIVATIVES MARKET Margin Call: (1) A request from a brokerage firm to a customer to bring margin deposits up to initial levels; (2) a request by the clearing organization to a clearing member to make a deposit of original margin, or a daily or intra day variation margin payment because of adverse price movement, based on positions carried by the clearing member. Market if Touched (MIT) Order: An order that becomes a market order when a particular price is reached. A sell MIT is placed above the market; a buy MIT is placed below the market. Also referred to as a board order. Compare to Stop Order. Market Maker: A professional securities dealer or person with trading privileges on an exchange who has an obligation to buy when there is an excess of sell orders and to sell when there is an excess of buy orders. By maintaining an offering price sufficiently higher than their buying price, these firms are compensated for the risk involved in allowing their inventory of securities to act as a buffer against temporary order imbalances. In the futures industry, this term is sometimes loosely used to refer to a floor trader or local who, in speculating for his own account, provides a market for commercial users of the market. Occasionally a futures exchange will compensate a person with exchange trading privileges to take on the obligations of a market maker to enhance liquidity in a newly listed or lightly traded futures contract. See Specialist System. Market on Close: An order to buy or sell at the end of the trading session at a price within the closing range of prices. See Stop Close Only Order. Market on Opening: An order to buy or sell at the beginning of the trading session at a price within the opening range of prices. Market Order: An order to buy or sell a futures contract at whatever price is obtainable at the time it is entered in the ring, pit, or other trading platform. See At the Market Limit Order. Mark to Market: Part of the daily cash flow system used by U.S. futures exchanges to maintain a minimum level of margin equity for a given futures or option contract position by calculating the gain or loss in each contract position resulting from changes in the price of the futures or option contracts at the end of each trading session. These amounts are added or subtracted to each account balance. Maturity: Period within which a futures contract can be settled by delivery of the actual commodity. Max Show: See Hidden Quantity Order. Maximum Price Fluctuation: See Limit (Up or Down) and Daily Price Limit. Member Rate: Commission charged for the execution of an order for a person who is a member of or has trading privileges at the exchange. Mini: Refers to a futures contract that has a smaller contract size than an otherwise identical futures contract. APRIL 2011 69
6. GLOSSARY OF THE DERIVATIVES MARKET INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS Minimum Price Contract: A hybrid commercial forward contract for agricultural products that includes a provision guaranteeing the person making delivery a minimum price for the product. For agricultural commodities, these contracts became much more common with the introduction of exchange traded options on futures contracts, which permit buyers to hedge the price risks associated with such contracts. Minimum Price Fluctuation (Minimum Tick): Smallest increment of price movement possible in trading a given contract. Minimum Tick: See Minimum Price Fluctuation. MMBTU: Million British Thermal Units, the unit of trading in the natural gas futures market. MOB Spread: A spread between the municipal bond futures contract and the Treasury bond contract, also known as munis over bonds. Momentum: In technical analysis, the relative change in price over a specific time interval. Often equated with speed or velocity and considered in terms of relative strength. Money Market: The market for short term debt instruments. Multilateral Clearing Organization: See Clearing Organization N Naked Option: The sale of a call or put option without holding an equal and opposite position in the underlying instrument. Also referred to as an uncovered option, naked call, or naked put. Narrow Based Security Index: In general, the Commodity Exchange Act defines a narrow based security index as an index of securities that meets one of the following four requirements (1) it has nine or fewer components; (2) one component comprises more than 30 percent of the index weighting; (3) the five highest weighted components comprise more than 60 percent of the index weighting, or (4) the lowest weighted components comprising in the aggregate 25 percent of the index s weighting have an aggregate dollar value of average daily volume over a six month period of less than $50 million ($30 million if there are at least 15 component securities). However, the legal definition in Section 1a(25) of the Commodity Exchange Act, 7 USC 1a(25), contains several exceptions to this provision. See Broad Based Security Index, Security Future. National Futures Association (NFA): A self regulatory organization whose members include futures commission merchants, commodity pool operators, commodity trading advisors, introducing brokers, commodity exchanges, commercial firms, and banks, that is responsible under CFTC oversight for certain aspects of the regulation of FCMs, CPOs, CTAs, IBs, and their associated persons, focusing primarily on the qualifications and proficiency, financial condition, retail sales practices, and business conduct of these futures professionals. NFA also performs arbitration and dispute resolution functions for industry participants. Nearbys: The nearest delivery months of a commodity futures market. 70 APRIL 2011
INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS 6. GLOSSARY OF THE DERIVATIVES MARKET Nearby Delivery Month: The month of the futures contract closest to maturity; the front month or lead month. Negative Carry: The cost of financing a financial instrument (the short term rate of interest), when the cost is above the current return of the financial instrument. See Carrying Charges and Positive Carry. Net Asset Value (NAV): The value of each unit of participation in a commodity pool. Net Position: The difference between the open long contracts and the open short contracts held by a trader in any one commodity. NFA: National Futures Association. Next Day: A spot contract that provides for delivery of a commodity on the next calendar day or the next business day. Also called day ahead. NOB (Note Against Bond) Spread: A futures spread trade involving the buying (selling) of a ten year Treasury note futures contract and the selling (buying) of a Treasury bond futures contract. Non Member Traders: Speculators and hedgers who trade on the exchange through a member or a person with trading privileges but who do not hold exchange memberships or trading privileges. Nominal Price (or Nominal Quotation): Computed price quotation on a futures or option contract for a period in which no actual trading took place, usually an average of bid and asked prices or computed using historical or theoretical relationships to more active contracts. Notice Day: Any day on which notices of intent to deliver on futures contracts may be issued. Notice of Intent to Deliver: A notice that must be presented by the seller of a futures contract to the clearing organization prior to delivery. The clearing organization then assigns the notice and subsequent delivery instrument to a buyer. Also notice of delivery. Notional Principal: In an interest rate swap, forward rate agreement, or other derivative instrument, the amount or, in a currency swap, each of the amounts to which interest rates are applied in order to calculate periodic payment obligations. Also called the notional amount, the contract amount, the reference amount, and the currency amount. NYMEX Lookalike: A lookalike swap or lookalike option that is based on a futures contract traded on the New York Mercantile Exchange (NYMEX). O OCO: See One Cancels the Other Order. Offer: An indication of willingness to sell at a given price; opposite of bid, the price level of the offer may be referred to as the ask. Off Exchange: See Over the Counter. APRIL 2011 71
6. GLOSSARY OF THE DERIVATIVES MARKET INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS Offset: Liquidating a purchase of futures contracts through the sale of an equal number of contracts of the same delivery month, or liquidating a short sale of futures through the purchase of an equal number of contracts of the same delivery month. See Closing Out and Cover. Omnibus Account: An account carried by one futures commission merchant, the carrying FCM, for another futures commission merchant, the originating FCM, in which the transactions of two or more persons, who are customers of the originating FCM, are combined and carried by the carrying FCM. Omnibus account titles must clearly show that the funds and trades therein belong to customers of the originating FCM. An originating broker must use an omnibus account to execute or clear trades for customers at a particular exchange where it does not have trading or clearing privileges. On Track (or Track Country Station): (1) A type of deferred delivery in which the price is set f.o.b. seller's location, and the buyer agrees to pay freight costs to his destination; (2) commodities loaded in railroad cars on tracks. One Cancels the Other (OCO) Order: A pair of orders, typically limit orders, whereby if one order is filled, the other order will automatically be cancelled. For example, an OCO order might consist of an order to buy 10 calls with a strike price of 50 at a specified price or buy 20 calls with a strike price of 55 (with the same expiration date) at a specified price. One to Many: Refers to a proprietary trading platform in which the platform operator posts bids and offers for commodities, derivatives, or other instruments and serves as a counterparty to every transaction executed on the platform. In contrast to many to many platforms, one to many platforms are not considered trading facilities under the Commodity Exchange Act. Opening Price (or Range): The price (or price range) recorded during the period designated by the exchange as the official opening. Opening: The period at the beginning of the trading session officially designated by the exchange during which all transactions are considered made at the opening. Open Interest: The total number of futures contracts long or short in a delivery month or market that has been entered into and not yet liquidated by an offsetting transaction or fulfilled by delivery. Also called open contracts or open commitments. Open Order (or Orders): An order that remains in force until it is canceled or until the futures contracts expire. See Good 'Till Canceled and Good This Week orders. Open Outcry: A method of public auction, common to most U.S. commodity exchanges during the 20 th century, where trading occurs on a trading floor and traders may bid and offer simultaneously either for their own accounts or for the accounts of customers. Transactions may take place simultaneously at different places in the trading pit or ring. At most exchanges been replaced or largely replaced by electronic trading platforms. See Specialist System. 72 APRIL 2011
INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS 6. GLOSSARY OF THE DERIVATIVES MARKET Open Trade Equity: The unrealized gain or loss on open futures positions. Option: A contract that gives the buyer the right, but not the obligation, to buy or sell a specified quantity of a commodity or other instrument at a specific price within a specified period of time, regardless of the market price of that instrument. Also see Put and Call. Option Buyer: The person who buys calls, puts, or any combination of calls and puts. Option Delta: See Delta. Option Writer: The person who originates an option contract by promising to perform a certain obligation in return for the price or premium of the option. Also known as option grantor or option seller. Option Pricing Model: A mathematical model used to calculate the theoretical value of an option. Inputs to option pricing models typically include the price of the underlying instrument, the option strike price, the time remaining till the expiration date, the volatility of the underlying instrument, and the risk free interest rate (e.g., the Treasury bill interest rate). Examples of option pricing models include Black Scholes and Cox Ross Rubinstein. Original Margin: Term applied to the initial deposit of margin money each clearing member firm is required to make according to clearing organization rules based upon positions carried, determined separately for customer and proprietary positions; similar in concept to the initial margin or security deposit required of customers by exchange rules. See Initial Margin. OTC: See Over the Counter. Out of Position: See In Position. Out Of The Money: A term used to describe an option that has no intrinsic value. For example, a call with a strike price of $400 on gold trading at $390 is out of the money 10 dollars. Outright: An order to buy or sell only one specific type of futures contract; an order that is not a spread order. Out Trade: A trade that cannot be cleared by a clearing organization because the trade data submitted by the two clearing members or two traders involved in the trade differs in some respect (e.g., price and/or quantity). In such cases, the two clearing members or traders involved must reconcile the discrepancy, if possible, and resubmit the trade for clearing. If an agreement cannot be reached by the two clearing members or traders involved, the dispute would be settled by an appropriate exchange committee. Overbought: A technical opinion that the market price has risen too steeply and too fast in relation to underlying fundamental factors. Rank and file traders who were bullish and long have turned bearish. Overnight Trade: A trade which is not liquidated during the same trading session during which it was established. APRIL 2011 73
6. GLOSSARY OF THE DERIVATIVES MARKET INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS Oversold: A technical opinion that the market price has declined too steeply and too fast in relation to underlying fundamental factors; rank and file traders who were bearish and short have turned bullish. Over the Counter (OTC): The trading of commodities, contracts, or other instruments not listed on any exchange. OTC transactions can occur electronically or over the telephone. Also referred to as Off Exchange. P P&S (Purchase and Sale Statement): A statement sent by a futures commission merchant to a customer when any part of a futures position is offset, showing the number of contracts involved, the prices at which the contracts were bought or sold, the gross profit or loss, the commission charges, the net profit or loss on the transactions, and the balance. FCMs also send P&S Statements whenever any other event occurs that alters the account balance including when the customer deposits or withdraws margin and when the FCM places excess margin in interest bearing instruments for the customer s benefit. Paper Profit or Loss: The profit or loss that would be realized if open contracts were liquidated as of a certain time or at a certain price. Par: (1) Refers to the standard delivery point(s) and/or quality of a commodity that is deliverable on a futures contract at contract price. Serves as a benchmark upon which to base discounts or premiums for varying quality and delivery locations; (2) in bond markets, an index (usually 100) representing the face value of a bond. Path Dependent Option: An option whose valuation and payoff depends on the realized price path of the underlying asset, such as an Asian option or a Lookback option. Pay/Collect: A shorthand method of referring to the payment of a loss (pay) and receipt of a gain (collect) by a clearing member to or from a clearing organization that occurs after a futures position has been marked to market. See Variation Margin. Pegged Price: The price at which a commodity has been fixed by agreement. Pegging: Effecting transactions in an instrument underlying an option to prevent a decline in the price of the instrument shortly prior to the option s expiration date so that previously written put options will expire worthless, thus protecting premiums previously received. See Capping. Performance Bond: See Margin. Physical: A contract or derivative that provides for the physical delivery of a commodity rather than cash settlement. See Financial. Physical Commodity: A commodity other than a financial commodity, typically an agricultural commodity, energy commodity or a metal. Physical Delivery: A provision in a futures contract or other derivative for delivery of the actual commodity to satisfy the contract. Compare to cash settlement. 74 APRIL 2011
INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS 6. GLOSSARY OF THE DERIVATIVES MARKET Pip: The smallest price unit of a commodity or currency. Pit: A specially constructed area on the trading floor of some exchanges where trading in a futures contract or option is conducted. On other exchanges, the term ring designates the trading area for commodity contract. Pit Brokers: See Floor Broker. Point and Figure: A method of charting that uses prices to form patterns of movement without regard to time. It defines a price trend as a continued movement in one direction until a reversal of a predetermined criterion is met. Point Balance: A statement prepared by futures commission merchants to show profit or loss on all open contracts using an official closing or settlement price, usually at calendar month end. Ponzi Scheme: Named after Charles Ponzi, a man with a remarkable criminal career in the early 20 th century, the term has been used to describe pyramid arrangements whereby an enterprise makes payments to investors from the proceeds of a later investment rather than from profits of the underlying business venture, as the investors expected, and gives investors the impression that a legitimate profitmaking business or investment opportunity exists, where in fact it is a mere fiction. Pork Bellies: One of the major cuts of the hog carcass that, when cured, becomes bacon. Portfolio Insurance: A trading strategy that uses stock index futures and/or stock index options to protect stock portfolios against market declines. Portfolio Margining: A method for setting margin requirements that evaluates positions as a group or portfolio and takes into account the potential for losses on some positions to be offset by gains on others. Specifically, the margin requirement for a portfolio is typically set equal to an estimate of the largest possible decline in the net value of the portfolio that could occur under assumed changes in market conditions. Sometimes referred to as risked based margining. Also see Strategy Based Margining. Position: An interest in the market, either long or short, in the form of one or more open contracts. Position Accountability: A rule adopted by an exchange requiring persons holding a certain number of outstanding contracts to report the nature of the position, trading strategy, and hedging information of the position to the exchange, upon request of the exchange. See Speculative Position Limit. Position Limit: See Speculative Position Limit. Position Trader: A commodity trader who either buys or sells contracts and holds them for an extended period of time, as distinguished from a day trader, who will normally initiate and offset a futures position within a single trading session. Positive Carry: The cost of financing a financial instrument (the short term rate of interest), where the cost is less than the current return of the financial instrument. See Carrying Charges and Negative Carry. APRIL 2011 75
6. GLOSSARY OF THE DERIVATIVES MARKET INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS Posted Price: An announced or advertised price indicating what a firm will pay for a commodity or the price at which the firm will sell it. Prearranged Trading: Trading between brokers in accordance with an expressed or implied agreement or understanding, which is a violation of the Commodity Exchange Act and CFTC regulations. Premium: (1) The payment an option buyer makes to the option writer for granting an option contract; (2) the amount a price would be increased to purchase a better quality commodity; (3) refers to a futures delivery month selling at a higher price than another, as July is at a premium over May. Price Banding: A CME Group and ICE instituted mechanism to ensure a fair and orderly market on an electronic trading platform. This mechanism subjects all incoming orders to price verification and rejects all orders with clearly erroneous prices. Price bands are monitored throughout the day and adjusted if necessary. Price Basing: A situation where producers, processors, merchants, or consumers of a commodity establish commercial transaction prices based on the futures prices for that or a related commodity (e.g., an offer to sell corn at 5 cents over the December futures price). This phenomenon is commonly observed in grain and metal markets. Price Discovery: The process of determining the price level for a commodity based on supply and demand conditions. Price discovery may occur in a futures market or cash market. Price Movement Limit: See Limit (Up or Down). Primary Market: (1) For producers, their major purchaser of commodities; (2) to processors, the market that is the major supplier of their commodity needs; and (3) in commercial marketing channels, an important center at which spot commodities are concentrated for shipment to terminal markets. Producer (AP): A large trader that declares itself a Producer on CFTC Form 40, which provides as examples, farmer and miner. A firm that extracts crude oil or natural gas from the ground would also be considered a Producer. Program Trading: The purchase (or sale) of a large number of stocks contained in or comprising a portfolio. Originally called program trading when index funds and other institutional investors began to embark on large scale buying or selling campaigns or programs to invest in a manner that replicates a target stock index, the term now also commonly includes computer aided stock market buying or selling programs, and index arbitrage. Prompt Date: The date on which the buyer of an option will buy or sell the underlying commodity (or futures contract) if the option is exercised. Prop Shop: A proprietary trading group, especially one where the group's traders trade electronically at a physical facility operated by the group. 76 APRIL 2011
INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS 6. GLOSSARY OF THE DERIVATIVES MARKET Proprietary Account: An account that a futures commission merchant carries for itself or a closely related person, such as a parent, subsidiary or affiliate company, general partner, director, associated person, or an owner of 10 percent or more of the capital stock. The FCM must segregate customer funds from funds related to proprietary accounts. Proprietary Trading Group: An organization whose owners, employees, and/or contractors trade in the name of accounts owned by the group and exclusively use the funds of the group for all of their trading activity. Public: In trade parlance, non professional speculators as distinguished from hedgers and professional speculators or traders. Public Elevators: Grain elevators in which bulk storage of grain is provided to the public for a fee. Grain of the same grade but owned by different persons is usually mixed or commingled as opposed to storing it "identity preserved." Some elevators are approved by exchanges as regular for delivery on futures contracts, see Regular Warehouse. Purchase and Sale Statement: See P&S. Put: An option contract that gives the holder the right but not the obligation to sell a specified quantity of a particular commodity, security, or other asset or to enter into a short futures position at a given price (the "strike price") prior to or on a specified expiration date. Pyramiding: The use of profits on existing positions as margin to increase the size of the position, normally in successively smaller increments. QR Qualified Eligible Person (QEP): The definition of QEP is too complex to summarize here; please see CFTC Regulation 4.7(a)(2) and (a)(3), 17 CFR 4.7(a)(2) and (a)(3), for the full definition. Quick Order: See Fill or Kill Order. Quotation: The actual price or the bid or ask price of either cash commodities or futures contracts. Rally: An upward movement of prices. Random Walk: An economic theory that market price movements move randomly. This assumes an efficient market. The theory also assumes that new information comes to the market randomly. Together, the two assumptions imply that market prices move randomly as new information is incorporated into market prices. The theory implies that the best predictor of future prices is the current price, and that past prices are not a reliable indicator of future prices. If the random walk theory is correct, technical analysis cannot work. Range: The difference between the high and low price of a commodity, futures, or option contract during a given period. APRIL 2011 77
6. GLOSSARY OF THE DERIVATIVES MARKET INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS Ratio Hedge: The number of options compared to the number of futures contracts bought or sold in order to establish a hedge that is neutral or delta neutral. Ratio Spread: This strategy, which applies to both puts and calls, involves buying or selling options at one strike price in greater number than those bought or sold at another strike price. Ratio spreads are typically designed to be delta neutral. Back spreads and front preads are types of ratio spreads. Ratio Vertical Spread: See Front Spread. Reaction: A downward price movement after a price advance. Recovery: An upward price movement after a decline. Reference Asset: An asset, such as a corporate or sovereign debt instrument, that underlies a credit derivative. Regular Warehouse: A processing plant or warehouse that satisfies exchange requirements for financing, facilities, capacity, and location and has been approved as acceptable for delivery of commodities against futures contracts. See Licensed Warehouse. Replicating Portfolio: A portfolio of assets for which changes in value match those of a target asset. For example, a portfolio replicating a standard option can be constructed with certain amounts of the asset underlying the option and bonds. Sometimes referred to as a synthetic asset. Repo or Repurchase Agreement: A transaction in which one party sells a security to another party while agreeing to repurchase it from the counterparty at some date in the future, at an agreed price. Repos allow traders to short sell securities and allow the owners of securities to earn added income by lending the securities they own. Through this operation the counterparty is effectively a borrower of funds to finance further. The rate of interest used is known as the repo rate. Reporting Level: Sizes of positions set by the exchanges and/or the CFTC at or above which commodity traders or brokers who carry these accounts must make daily reports about the size of the position by commodity, by delivery month, and whether the position is controlled by a commercial or noncommercial trader. See the Large Trader Reporting Program. Resistance: In technical analysis, a price area where new selling will emerge to dampen a continued rise. See Support. Resting Order: A limit order to buy at a price below or to sell at a price above the prevailing market that is being held by a floor broker. Such orders may either be day orders or open orders. Retail Customer: A customer that does not qualify as an eligible contract participant under Section 1a(12) of the Commodity Exchange Act, 7 USC 1a(12). An individual with total assets that do not exceed $10 million, or $5 million if the individual is entering into an agreement, contract, or transaction to manage risk, would be considered a retail customer. 78 APRIL 2011
INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS 6. GLOSSARY OF THE DERIVATIVES MARKET Retender: In specific circumstances, some exchanges permit holders of futures contracts who have received a delivery notice through the clearing organization to sell a futures contract and return the notice to the clearing organization to be reissued to another long; others permit transfer of notices to another buyer. In either case, the trader is said to have retendered the notice. Retracement: A reversal within a major price trend. Reversal: A change of direction in prices. See Reverse Conversion. Reverse Conversion or Reversal: With regard to options, a position created by buying a call option, selling a put option, and selling the underlying instrument (for example, a futures contract). See Conversion. Reverse Crush Spread: The sale of soybean futures and the simultaneous purchase of soybean oil and meal futures. See Crush Spread. Riding the Yield Curve: Trading in an interest rate futures contract according to the expectations of change in the yield curve. Ring: A circular area on the trading floor of an exchange where traders and brokers stand while executing futures trades. Some exchanges use pits rather than rings. Risked Based Margining: See Portfolio Margining. Risk Factor: See Delta. Risk/Reward Ratio: The relationship between the probability of loss and profit. This ratio is often used as a basis for trade selection or comparison. Roll Over: A trading procedure involving the shift of one month of a straddle into another future month while holding the other contract month. The shift can take place in either the long or short straddle month. The term also applies to lifting a near futures position and re establishing it in a more deferred delivery month. Round Lot: A quantity of a commodity equal in size to the corresponding futures contract for the commodity. See Even Lot. Round Trip Trading: See Wash Trading. Round Turn: A completed transaction involving both a purchase and a liquidating sale, or a sale followed by a covering purchase. Rules: The principles for governing an exchange. In some exchanges, rules are adopted by a vote of the membership, while in others, they can be imposed by the governing board. Runners: Messengers or clerks who deliver orders received by phone clerks to brokers for execution in the pit. APRIL 2011 79
6. GLOSSARY OF THE DERIVATIVES MARKET INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS S Sample Grade: Usually the lowest quality of a commodity, too low to be acceptable for delivery in satisfaction of futures contracts. Scale Down (or Up): To purchase or sell a scale down means to buy or sell at regular price intervals in a declining market. To buy or sell on scale up means to buy or sell at regular price intervals as the market advances. Scalper: A speculator often with exchange trading privileges who buys and sells rapidly, with small profits or losses, holding his positions for only a short time during a trading session. Typically, a scalper will stand ready to buy at a fraction below the last transaction price and to sell at a fraction above, e.g., to buy at the bid and sell at the offer or ask price, with the intent of capturing the spread between the two, thus creating market liquidity. See Day Trader, Position Trader, High Frequency Trading. Seasonality Claims: Misleading sales pitches that one can earn large profits with little risk based on predictable seasonal changes in supply or demand, published reports or other well known events. Seat: An instrument granting trading privileges on an exchange. A seat may also represent an ownership interest in the exchange. Securities and Exchange Commission (SEC): The Federal regulatory agency established in 1934 to administer Federal securities laws. Security: Generally, a transferable instrument representing an ownership interest in a corporation (equity security or stock) or the debt of a corporation, municipality, or sovereign. Other forms of debt such as mortgages can be converted into securities. Certain derivatives on securities (e.g., options on equity securities) are also considered securities for the purposes of the securities laws. Security futures products are considered to be both securities and futures products. Futures contracts on broad based securities indexes are not considered securities. Security Deposit: See Margin. Security Future: A contract for the sale or future delivery of a single security or of a narrow based security index. Security Futures Product: A security future or any put, call, straddle, option, or privilege on any security future. Self Regulatory Organization (SRO): Exchanges and registered futures associations that enforce financial and sales practice requirements for their members. See Designated Self Regulatory Organizations. Seller's Call: Seller's call, also referred to as call purchase, is the same as the buyer's call except that the seller has the right to determine the time to fix the price. See Buyer s Call. Seller's Market: A condition of the market in which there is a scarcity of goods available and hence sellers can obtain better conditions of sale or higher prices. See Buyer's Market. 80 APRIL 2011
INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS 6. GLOSSARY OF THE DERIVATIVES MARKET Seller's Option: The right of a seller to select, within the limits prescribed by a contract, the quality of the commodity delivered and the time and place of delivery. Selling Hedge (or Short Hedge): Selling futures contracts to protect against possible decreased prices of commodities. See Hedging. Series (of Options): Options of the same type (i.e., either puts or calls, but not both), covering the same underlying futures contract or other underlying instrument, having the same strike price and expiration date. Settlement: The act of fulfilling the delivery requirements of the futures contract. Settlement Price: The daily price at which the clearing organization clears all trades and settles all accounts between clearing members of each contract month. Settlement prices are used to determine both margin calls and invoice prices for deliveries. The term also refers to a price established by the exchange to even up positions which may not be able to be liquidated in regular trading. Shipping Certificate: A negotiable instrument used by several futures exchanges as the futures delivery instrument for several commodities (e.g., soybean meal, plywood, and white wheat). The shipping certificate is issued by exchange approved facilities and represents a commitment by the facility to deliver the commodity to the holder of the certificate under the terms specified therein. Unlike an issuer of a warehouse receipt, who has physical product in store, the issuer of a shipping certificate may honor its obligation from current production or through put as well as from inventories. Shock Absorber: A temporary restriction in the trading of certain stock index futures contracts that becomes effective following a significant intraday decrease in stock index futures prices. Designed to provide an adjustment period to digest new market information, the restriction bars trading below a specified price level. Shock absorbers are generally market specific and at tighter levels than circuit breakers. Short: (1) The selling side of an open futures contract; (2) a trader whose net position in the futures market shows an excess of open sales over open purchases. See Long. Short Covering: See Cover. Short Hedge: See Selling Hedge. Short Selling: Selling a futures contract or other instrument with the idea of delivering on it or offsetting it at a later date. Short Squeeze: See Squeeze. Short the Basis: The purchase of futures as a hedge against a commitment to sell in the cash or spot markets. See Hedging. APRIL 2011 81
6. GLOSSARY OF THE DERIVATIVES MARKET INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS Significant Price Discovery Contract (SPDC): A contract traded on an Exempt Commercial Market (ECM) which performs a significant price discovery function as determined by the CFTC pursuant to CFTC Regulation 36.3 (c). ECMs with SPDCs are subject to additional regulatory and reporting requirements. Single Stock Future: A futures contract on a single stock as opposed to a stock index. Single stock futures were illegal in the U.S. prior to the passage of the Commodity Futures Modernization Act in 2000. See Security Future, Security Futures Product. Small Traders: Traders who hold or control positions in futures or options that are below the reporting level specified by the exchange or the CFTC. Soft: (1) A description of a price that is gradually weakening; or (2) this term also refers to certain soft commodities such as sugar, cocoa, and coffee. Sold Out Market: When liquidation of a weakly held position has been completed, and offerings become scarce, the market is said to be sold out. SPAN (Standard Portfolio Analysis of Risk ): As developed by the Chicago Mercantile Exchange, the industry standard for calculating performance bond requirements (margins) on the basis of overall portfolio risk. SPAN calculates risk for all enterprise levels on derivative and non derivative instruments at numerous exchanges and clearing organizations worldwide. Spark Spread: The differential between the price of electricity and the price of natural gas or other fuel used to generate electricity, expressed in equivalent units. See Gross Processing Margin. SPDC: See Significant Price Discovery Contract. Specialist System: A type of trading formerly used for the exchange trading of securities in which one individual or firm acts as a market maker in a particular security, with the obligation to provide fair and orderly trading in that security by offsetting temporary imbalances in supply and demand by trading for the specialist s own account. Like open outcry, the specialist system was supplanted by electronic trading during the early 21st century. In 2008, the New York Stock Exchange replaced the specialist system with a competitive dealer system. Specialists were converted into Designated Market Makers who have a different set of privileges and obligations than specialists had. Speculative Bubble: A rapid run up in prices caused by excessive buying that is unrelated to any of the basic, underlying factors affecting the supply or demand for a commodity or other asset. Speculative bubbles are usually associated with a bandwagon effect in which speculators rush to buy the commodity (in the case of futures, to take positions ) before the price trend ends, and an even greater rush to sell the commodity (unwind positions) when prices reverse. Speculative Limit: See Speculative Position Limit. Speculative Position Limit: The maximum position, either net long or net short, in one commodity future (or option) or in all futures (or options) of one commodity combined that may be held or controlled by 82 APRIL 2011
INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS 6. GLOSSARY OF THE DERIVATIVES MARKET one person (other than a person eligible for a hedge exemption) as prescribed by an exchange and/or by the CFTC. Speculator: In commodity futures, a trader who does not hedge, but who trades with the objective of achieving profits through the successful anticipation of price movements. Split Close: A condition that refers to price differences in transactions at the close of any market session. Spot: Market of immediate delivery of and payment for the product. Spot Commodity: (1) The actual commodity as distinguished from a futures contract; (2) sometimes used to refer to cash commodities available for immediate delivery. See Actuals or Cash Commodity. Spot Month: The futures contract that matures and becomes deliverable during the present month. Also called Current Delivery Month. Spot Price: The price at which a physical commodity for immediate delivery is selling at a given time and place. See Cash Price. Spread (or Straddle): The purchase of one futures delivery month against the sale of another futures delivery month of the same commodity; the purchase of one delivery month of one commodity against the sale of that same delivery month of a different commodity; or the purchase of one commodity in one market against the sale of the commodity in another market, to take advantage of a profit from a change in price relationships. The term spread is also used to refer to the difference between the price of a futures month and the price of another month of the same commodity. A spread can also apply to options. See Arbitrage. Squeeze: A market situation in which the lack of supplies tends to force shorts to cover their positions by offset at higher prices. Also see Congestion, Corner. SRO: See Self Regulatory Organization. Stop Close Only Order: A stop order that can be executed, if possible, only during the closing period of the market. See also Market on Close Order. Stop Limit Order: A stop limit order is an order that goes into force as soon as there is a trade at the specified price. The order, however, can only be filled at the stop limit price or better. Stop Logic Functionality: A provision applicable to futures traded on the CME s Globex electronic trading system designed to prevent excessive price movements caused by cascading stop orders. Stop Logic Functionality introduces a momentary pause in matching (Reserved State) when triggered stops would cause the market to trade outside predefined values. The momentary pause provides an opportunity for additional bids or offers to be posted Stop Loss Order: See Stop Order. APRIL 2011 83
6. GLOSSARY OF THE DERIVATIVES MARKET INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS Stop Order: This is an order that becomes a market order when a particular price level is reached. A sell stop is placed below the market, a buy stop is placed above the market. Sometimes referred to as stop loss order. Compare to market if touched order. Straddle: (1) See Spread; (2) an option position consisting of the purchase of put and call options having the same expiration date and strike price. Strangle: An option position consisting of the purchase of put and call options having the same expiration date, but different strike prices. Strategy Based Margining: A method for setting margin requirements whereby the potential for gains on one position in a portfolio to offset losses on another position is taken into account only if the portfolio implements one of a designated set of recognized trading strategies as set out in the rules of an exchange or clearing organization. Also see Portfolio Margining. Street Book: A daily record kept by futures commission merchants and clearing members showing details of each futures and option transaction, including date, price, quantity, market, commodity, future, strike price, option type, and the person for whom the trade was made. Strike Price (Exercise Price): The price, specified in the option contract, at which the underlying futures contract, security, or commodity will move from seller to buyer. Strip: A sequence of futures contract months (e.g., the June, July, and August natural gas futures contracts) that can be executed as a single transaction. STRIPS (Separate Trading of Registered Interest and Principal Securities): A book entry system operated by the Federal Reserve permitting separate trading and ownership of the principal and coupon portions of selected Treasury securities. It allows the creation of zero coupon Treasury securities from designated whole bonds. Strong Hands: When used in connection with delivery of commodities on futures contracts, the term usually means that the party receiving the delivery notice probably will take delivery and retain ownership of the commodity; when used in connection with futures positions, the term usually means positions held by trade interests or well financed speculators. Support: In technical analysis, a price area where new buying is likely to come in and stem any decline. See Resistance. Swap: In general, the exchange of one asset or liability for a similar asset or liability for the purpose of lengthening or shortening maturities, or otherwise shifting risks. This may entail selling one securities issue and buying another in foreign currency; it may entail buying a currency on the spot market and simultaneously selling it forward. Swaps also may involve exchanging income flows; for example, exchanging the fixed rate coupon stream of a bond for a variable rate payment stream, or vice versa, 84 APRIL 2011
INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS 6. GLOSSARY OF THE DERIVATIVES MARKET while not swapping the principal component of the bond. Swaps are generally traded over the counter. See Commodity Swap. Swap Dealer (AS): An entity such as a bank or investment bank that markets swaps to end users. Swap dealers often hedge their swap positions in futures markets. Alternatively, an entity that declares itself a Swap/Derivatives Dealer on CFTC Form 40. Swaption: An option to enter into a swap i.e., the right, but not the obligation, to enter into a specified type of swap at a specified future date. Switch: Offsetting a position in one delivery month of a commodity and simultaneous initiation of a similar position in another delivery month of the same commodity, a tactic referred to as rolling forward. Synthetic Futures: A position created by combining call and put options. A synthetic long futures position is created by combining a long call option and a short put option for the same expiration date and the same strike price. A synthetic short futures contract is created by combining a long put and a short call with the same expiration date and the same strike price. Systematic Risk: Market risk due to factors that cannot be eliminated by diversification. Systemic Risk: The risk that a default by one market participant will have repercussions on other participants due to the interlocking nature of financial markets. For example, Customer A s default in X market may affect Intermediary B s ability to fulfill its obligations in Markets X, Y, and Z. T Taker: The buyer of an option contract. TAS: See Trading at Settlement. T Bond: See Treasury Bond. Technical Analysis: An approach to forecasting commodity prices that examines patterns of price change, rates of change, and changes in volume of trading and open interest, without regard to underlying fundamental market factors. Technical analysis can work consistently only if the theory that price movements are a random walk is incorrect. See Fundamental Analysis. TED Spread: (1) The difference between the interest rate on three month U.S. Treasury bills and threemonth LIBOR; (2) the difference between the price of the three month U.S. Treasury bill futures contract and the price of the three month Eurodollar time deposit futures contract with the same expiration month (Treasury Over Eurodollar). Tender: To give notice to the clearing organization of the intention to initiate delivery of the physical commodity in satisfaction of a short futures contract. Also see Retender. Tenderable Grades: See Contract Grades. APRIL 2011 85
6. GLOSSARY OF THE DERIVATIVES MARKET INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS Terminal Elevator: An elevator located at a point of greatest accumulation in the movement of agricultural products that stores the commodity or moves it to processors. Terminal Market: Usually synonymous with commodity exchange or futures market, specifically in the United Kingdom. TIBOR (Tokyo Interbank Offered Rate): A daily reference rate based on the interest rates at which banks offer to lend unsecured funds to other banks in the Japan wholesale money market (or interbank market). TIBOR is published daily by the Japanese Bankers Association (JBA). See EURIBOR, LIBOR. Tick: Refers to a minimum change in price up or down. An up tick means that the last trade was at a higher price than the one preceding it. A down tick means that the last price was lower than the one preceding it. See Minimum Price Fluctuation. Time Decay: The tendency of an option to decline in value as the expiration date approaches, especially if the price of the underlying instrument is exhibiting low volatility. See Time Value. Time of Day Order: This is an order that is to be executed at a given minute in the session. For example, Sell 10 March corn at 12:30 p.m. Time Spread: The selling of a nearby option and buying of a more deferred option with the same strike price. Also called Horizontal Spread. Time Value: That portion of an option's premium that exceeds the intrinsic value. The time value of an option reflects the probability that the option will move into the money. Therefore, the longer the time remaining until expiration of the option, the greater its time value. Also called Extrinsic Value. Total Return Swap: A type of credit derivative in which one counterparty receives the total return (interest payments and any capital gains or losses) from a specified reference asset and the other counterparty receives a specified fixed or floating cash flow that is not related to the creditworthiness of the reference asset. Also called total rate of return swap, or TR swap. To Arrive Contract: A transaction providing for subsequent delivery within a stipulated time limit of a specific grade of a commodity. Trade Option: A commodity option transaction in which the purchaser is reasonably believed by the writer to be engaged in business involving use of that commodity or a related commodity. Trader: (1) A merchant involved in cash commodities; (2) a professional speculator who trades for his own account and who typically holds exchange trading privileges. Trading Ahead: See Front Running. Trading Arcade: A facility, often operated by a clearing member that clears trades for locals, where e locals who trade for their own account can gather to trade on an electronic trading facility (especially if the exchange is all electronic and there is no pit or ring). 86 APRIL 2011
INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS 6. GLOSSARY OF THE DERIVATIVES MARKET Trading at Settlement (TAS): An exchange rule which permits the parties to a futures trade during a trading day to agree that the price of the trade will be that day s settlement price (or the settlement price plus or minus a specified differential). Trading Facility: A person or group of persons that provides a physical or electronic facility or system in which multiple participants have the ability to execute or trade agreements, contracts, or transactions by accepting bids and offers made by other participants in the facility or system. See Many to Many. Trading Floor: A physical trading facility where traders make bids and offers via open outcry or the specialist system. Transaction: The entry or liquidation of a trade. Transfer Trades: Entries made upon the books of futures commission merchants for the purpose of: (1) transferring existing trades from one account to another within the same firm where no change in ownership is involved; (2) transferring existing trades from the books of one FCM to the books of another FCM where no change in ownership is involved. Also called Ex Pit transactions. Transferable Option (or Contract): A contract that permits a position in the option market to be offset by a transaction on the opposite side of the market in the same contract. Transfer Notice: A term used on some exchanges to describe a notice of delivery. See Retender. Treasury Bills (or T Bills): Short term zero coupon U.S. government obligations, generally issued with various maturities of up to one year. Treasury Bonds (or T Bonds): Long term (more than ten years) obligations of the U.S. government that pay interest semiannually until they mature, at which time the principal and the final interest payment is paid to the investor. Treasury Notes: Same as Treasury bonds except that Treasury notes are medium term (more than one year but not more than ten years). Trend: The general direction, either upward or downward, in which prices have been moving. Trendline: In charting, a line drawn across the bottom or top of a price chart indicating the direction or trend of price movement. If up, the trendline is called bullish; if down, it is called bearish. UV Unable: All orders not filled by the end of a trading day are deemed unable and void, unless they are designated GTC (Good Until Canceled) or open. Uncovered Option: See Naked Option. Underlying Commodity: The cash commodity underlying a futures contract. Also, the commodity or futures contract on which a commodity option is based, and which must be accepted or delivered if the option is exercised. APRIL 2011 87
6. GLOSSARY OF THE DERIVATIVES MARKET INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS Variable Price Limit: A price limit schedule, determined by an exchange, that permits variations above or below the normally allowable price movement for any one trading day. Variation Margin: Payment made on a daily or intraday basis by a clearing member to the clearing organization based on adverse price movement in positions carried by the clearing member, calculated separately for customer and proprietary positions. Vault Receipt: A document indicating ownership of a commodity stored in a bank or other depository and frequently used as a delivery instrument in precious metal futures contracts. Vega: Coefficient measuring the sensitivity of an option value to a change in volatility. Vertical Spread: Any of several types of option spread involving the simultaneous purchase and sale of options of the same class and expiration date but different strike prices, including bull vertical spreads, bear vertical spreads, back spreads, and front spreads. See Horizontal Spread and Diagonal Spread. Visible Supply: Usually refers to supplies of a commodity in licensed warehouses. Often includes floats and all other supplies in sight in producing areas. See Invisible Supply. Volatility: A statistical measurement (the annualized standard deviation of returns) of the rate of price change of a futures contract, security, or other instrument underlying an option. See Historical Volatility, Implied Volatility. Volatility Quote Trading: Refers to the quoting of bids and offers on option contracts in terms of their implied volatility rather than as prices. Volatility Spread: A delta neutral option spread designed to speculate on changes in the volatility of the market rather than the direction of the market. Volatility Trading: Strategies designed to speculate on changes in the volatility of the market rather than the direction of the market. Volume: The number of contracts traded during a specified period of time. It is most commonly quoted as the number of contracts traded, but for some physical commodities may be quoted as the total of physical units, such as bales, bushels, or barrels. Volume Weighted Average Price (VWAP): A method of determining the settlement price in certain futures contracts. It is the average futures transaction price, weighted by volume, during a specified period of time. WXYZ Warehouse Receipt: A document certifying possession of a commodity in a licensed warehouse that is recognized for delivery purposes by an exchange. Warrant: An issuer based product that gives the buyer the right, but not the obligation, to buy (in the case of a call) or to sell (in the case of a put) a stock or a commodity at a set price during a specified period. 88 APRIL 2011
INTERNATIONAL ENERGY AGENCY THE MECHANICS OF THE DERIVATIVES MARKETS 6. GLOSSARY OF THE DERIVATIVES MARKET Warrant or Warehouse Receipt for Metals: Certificate of physical deposit, which gives title to physical metal in an exchange approved warehouse. Wash Sale: See Wash Trading. Wash Trading: Entering into, or purporting to enter into, transactions to give the appearance that purchases and sales have been made, without incurring market risk or changing the trader's market position. The Commodity Exchange Act prohibits wash trading. Also called Round Trip Trading, Wash Sales. Weak Hands: When used in connection with delivery of commodities on futures contracts, the term usually means that the party probably does not intend to retain ownership of the commodity; when used in connection with futures positions, the term usually means positions held by small speculators. Weather Derivative: A derivative whose payoff is based on a specified weather event, for example, the average temperature in Chicago in January. Such a derivative can be used to hedge risks related to the demand for heating fuel or electricity. Wild Card Option: Refers to a provision of any physical delivery Treasury bond or Treasury note futures contract that permits shorts to wait until as late as 8:00 p.m. Chicago time on any notice day to announce their intention to deliver at invoice prices that are fixed at 2:00 p.m., the close of futures trading, on that day. Winter Wheat: Wheat that is planted in the fall, lies dormant during the winter, and is harvested beginning about May of the next year. Writer: The issuer, grantor, or seller of an option contract. Yield Curve: A graphic representation of market yield for a fixed income security plotted against the maturity of the security. The yield curve is positive when long term rates are higher than short term rates. Yield to Maturity: The rate of return an investor receives if a fixed income security is held to maturity. Zero Coupon: Refers to a debt instrument that does not make coupon payments, but, rather, is issued at a discount to par and redeemed at par at maturity. APRIL 2011 89
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Swaps: Dodd-Frank Memories Amid repeated Dodd-Frank extensions, swaps end-users may need an aide-mémoire 2013-07-02, by Gordon E. Goodman Things are seldom what they seem, Skim milk masquerades as cream; Highlows pass as patent leathers; Jackdaws strut in peacock's feathers. -- "HMS Pinafore," Gilbert & Sullivan, 1878 At this point in the process of implementing the changes that were required by the Dodd-Frank Wall Street Reform and Consumer Protection Act -- with respect to recordkeeping, reporting and governance -- almost everything was supposed to have been completed by now. A final piece of the puzzle was to have occurred during April 2013, when real-time and general reporting was to have begun. However, as with many of the early Dodd-Frank schedules, the reporting deadline was extended through a "no-action" letter issued by the Commodity Futures Trading Commission (CFTC) during early April. The CFTC's repeated extensions may have lulled the risk community into a sense that perhaps it would all go away. This is not the case. So, for risk managers who may have forgotten the many changes required by Dodd Frank (and in particular for the non-swap dealers, non-major swap participants, non-financial entities and end-users), the following is a refreshed to-do list, an aide-mémoire. This article is intended to cover many of the issues and questions confronted by "end-users." End-user is the generic term that I will use in this article when talking about the "nons" generally, but please note that though speculative traders and end-users are both "nons," they have quite different requirements under Dodd-Frank with respect to mandatory clearing. Each end-user should consider its own circumstances in designing an appropriate compliance program, because this article does not cover every minute detail. End-User Qualification To begin, in order to qualify as an end-user (Category 3), a company must be neither a swap dealer nor a major swap participant (Category 1). Nor can the company be a "financial entity" (Category 2). In a subsequent article, I will provide more detail on financial entities (one of the less discussed terms in Dodd-Frank), but for present purposes, they are persons predominantly engaged in activities that are financial in nature, as defined by the Federal Reserve under the Bank Holding Company Act. With respect to the first part of the end-user requirement (i.e., being neither a swap dealer nor an MSP), this can only be determined by running the "de minimis" tests that determine whether a company is a swap dealer and the various MSP tests that determine whether a company is a major swap participant.
In particular, end-users should make sure that they are not dealing in significant quantities of swaps with "special entities" (primarily government organizations) under Dodd-Frank. At a minimum, end-users should stay well under the de minimis thresholds that apply to swap trades with special entities. The $8 billion threshold that generally applies under the de minimis test drops to $800 million for special entities that engage in utility operations and to just $25 million for non-utility special entities (all calculated on gross notional amounts). One additional point for foreign companies to keep in mind is that the definition of a "financial entity" is based on the percentage of their assets and income that are derived from financial activities (sometimes called the "85/85" test). This calculation can be significantly influenced by how derivatives are treated within the company's financial statements -- U.S. Generally Accepted Accounting Principles present derivatives on a net basis while the European International Financial Reporting Standards present derivatives on a gross basis. End-User Next Steps Assuming a company qualifies for the end-user exemption from mandatory clearing (see above), companies that are subject to SEC reporting obligations (generally, U.S. public companies) must then adopt annual board resolutions to make this election. These resolutions can be adopted by the board itself or by a suitable committee of the board -- e.g., the audit committee or the finance committee. Though there is no statement within Dodd-Frank about companies that are not subject to SEC reporting obligations, it is a best risk practice for all companies that claim end-user status to adopt these same board resolutions. Swap dealers will probably be asking for proof of end-user status to all of their customers under Dodd-Frank's "know your counterparty" (KYC) rules that apply to swap dealers, so companies claiming end-user status should adopt appropriate board resolutions. Under CFTC rules, the annual board resolution must be filed with a swap data repository (SDR). For non-reporting end-users (i.e., end-users whose counterparties will do the swap reporting), this may be an issue if they do not have an existing relationship with an SDR. Based on recent discussions, at least one of the SDRs is working on providing a filing mechanism for the nonreporting end-users at this time. Keep in mind that the purpose of filing a board resolution with an SDR is to claim an exemption from the mandatory clearing requirement, but to date there have been few swap categories listed by the CFTC that are actually subject to mandatory clearing. In particular, the CFTC has yet to include any of the energy commodity swaps in the list of swaps subject to mandatory clearing -- so the timing for adoption of a board resolution has been extended (originally, this was due to be in place by September 2013). Hedging As part of this board resolution, a company claiming end-user exemption from mandatory clearing must represent that it uses swaps to hedge or mitigate commercial risk arising from its underlying physical business -- e.g., oil and gas production or gasoline refining. An important
point to consider is that the board resolution itself is necessary, but not sufficient, to receive an exemption from mandatory clearing. The transactions themselves must be used for hedging purposes. What this means is that even after making an election and filing the annual board resolution with an SDR, a company can still only be exempted from mandatory clearing if its swaps are really being used for hedging purposes. Assume for a moment that a company uses swaps for two purposes within its business: to hedge its physical oil and gas production and to engage in some limited speculative trading activity. In effect, it is an end-user when it is hedging its physical transactions, but it is a trader when it engages in speculative activity (for which the exemption from mandatory clearing is not available). A company like this should still proceed to pass an appropriate board resolution claiming exemption from mandatory clearing, but only for those transactions that are being used as hedges (and not for its speculative trading activity). Remember that end-users and speculative traders are both "nons," but they have different results under Dodd-Frank with respect to the mandatory clearing exemption rules. Another point to consider is that qualifying swaps are also excluded from certain parts of the de minimis and MSP tests. In order to qualify as a hedge, swaps must come under one of the following standards: the "mitigation of commercial risk" standard (the Dodd-Frank standard), the "bona fide hedge" standard (the Commodities Exchange Act standard) or the accounting hedge standards set by FASB. De Minimis and MSP Tests Going forward, the de minimis and MSP tests described previously have to be run on a regular basis. A company that passes these tests today (and therefore can initially qualify for end-user status) may fail these same tests next year or the year after. So building a robust mechanism for running these tests as part of a company's base risk system is an important consideration. The de minimis calculations are run on a trailing 12-month basis in relation to the gross notional amount of a company's dealing swaps, while MSP tests are run on a quarterly basis looking at current and expected future exposures (MTMs) of the company's swaps (but only looking at the negative MTM values). The de minimis tests currently have three thresholds: an $8 billion threshold for all entities, an $800 million threshold for utility special entities and a $25 million threshold for non-utility special entities. The CFTC has indicated that these thresholds will apply during a "phase-in" period that will last about five years. At the end of the phase-in period, the CFTC may reduce its de minimis thresholds to lower levels. The MSP tests are more complicated than the de minimis tests, but they have been set at levels that should only capture the very largest swap market participants. The details of the MSP tests will be studied in more detail in a subsequent article.
It is logical to anticipate that if any company expects to fail the MSP test for a quarterly period, it would probably file an election to become a swap dealer, since the MSP status carries most of the burdens with few of the benefits associated with swap dealer status. Meeting Financial Obligations In the board resolution electing end-user exemption from mandatory clearing, a company must indicate how it will meet its financial obligations. For companies that have historically set the margin thresholds in their ISDA credit support annex (CSA) at relatively high levels in order to avoid the need for daily exchanges of margin, they may want to reconsider the best levels to set under Dodd-Frank. One of the surprising issues to consider is that unused thresholds within CSAs (i.e., the difference between a company's actual exposure and its collateral threshold levels) are considered to be a form of credit facility that can get included in some of the MSP test calculations. (The MSP tests can also be calculated under an alternative methodology that excludes these unused thresholds, but this alternative methodology has some of its own issues, which will be discussed further in a subsequent article.) There are five methods set by the CFTC for meeting financial obligations within a board resolution under Dodd-Frank: (1) a written credit support agreement (this could be the CSA attached to the ISDA); (2) pledged or segregated assets (including posting or receiving margin pursuant to a credit support agreement or otherwise); (3) a written third-party guarantee; (4) the electing counterparty's available financial resources (this is an alternative to the CSA route); or (5) means other than those described. Who Has the Reporting Obligation? In general, if a transaction is concluded on an exchange, no further reporting is required. For off-exchange (OTC) transactions, one of the two parties to a swap must report the transaction to an SDR. If a Category 3 entity (i.e., an end-user) does a swap transaction with a Category 1 entity (swap dealers and MSPs) or a Category 2 entity (a financial entity), then the Category 1 or Category 2 counterparty has the reporting obligation (and not the end-user). The question arises: what happens when two end-users do a swap with each other? The answer is that if one of the end-users is a "U.S. entity" (as that term is defined under Dodd- Frank) and the other is not a U.S. entity, then the end-user that is a U.S. entity has the reporting obligation. A second question naturally arises: what happens when both are U.S. entities or both are not U.S. entities? The answer is that the parties have to agree on who will do the reporting. The main point to keep in mind is that for all swaps, someone has to do the reporting to the SDR. There is no free lunch.
When is the Reporting Required? Originally, all swaps were subject to reporting requirements that were to have begun on 4/10/13. This included "pre-enactment" swaps (swaps that were in effect on 7/21/10, when Dodd-Frank was enacted) and "transition" swaps (swaps that were executed after 7/21/10 but before 4/10/13). This original schedule was revised for non-financial counterparties (i.e., end-users) under a "noaction" letter issued by the CFTC during early April 2013 (Letter No. 13-10). The revised Dodd-Frank reporting schedule for end-users is now as follows (please note that the Dodd-Frank standard for reporting transaction data is generally in "real time," but this term is defined differently for different types of swap participants): Credit/interest rate swaps entered into after 7/21/13: subject to Dodd-Frank standards Credit/interest rate swaps entered into from 4/10/13 to 7/21/13: 8/1/13 Equity/FX/ commodity swaps entered into after 8/19/13: subject to Dodd-Frank standards Equity/FX/ commodity swaps entered into from 4/10/13 to 8/19/13: 9/19/13 All historical swaps that were in existence from 7/21/10 to 4/10/13: 10/31/13 Dodd-Frank Recordkeeping for End-Users End-users must keep full, complete and systematic records of all their swap transactions. The recordkeeping requirements apply to pre-enactment, transition and post-4/10/13 records. Records should be kept in electronic format unless they were originally created in paper format and have been maintained as such. Records must be kept for five years from the termination date of the swap, with the exception of audio records, which must be kept for one year from termination date. Please note that these same recordkeeping requirements apply to certain related physical transactions. Specifically, these are the physical transactions that are the hedged items for which hedge treatment is being claimed with respect to an end-user's hedging swaps. Final Issues and Parting Thoughts End-users should obtain legal entity identifiers (LEIs or CICIs) for each corporate entity that trades in swaps. End-users should also consider possible adherence to the August 2012 ISDA protocol. Though this article has discussed many of the more common issues that have arisen for endusers trying to comply with the new Dodd-Frank requirements, inevitably there will be some important issues that have not been covered. There will also inevitably be additional "no-action" letters and further changes in the Dodd-Frank regulatory structure before all is said and done. For this reason, this article is intended only as the first in a series of similar articles dealing with additional specific Dodd-Frank issues.
Dodd-Frank s Impact on Financial Entities, Financial Activities and Treasury Affiliates Swaps compliance requirements are complex 2013-10-23, by Gordon E. Goodman The compliance requirements for the Dodd-Frank Act (DFA) are complex. On one end of the spectrum, we have DFA "end users" that are not subject to the act's mandatory clearing rules, but are subject to certain reporting and record-keeping requirements. On the opposite end, there are swap dealers, major swap participants and "financial entities" -- three categories of companies that are subject to mandatory clearing, along with much more rigorous reporting and record-keeping requirements. The financial entities category is perhaps the most intriguing, partly because it is the least discussed of the types of companies under the DFA that cannot seek exceptions from the mandatory clearing requirement. Mandatory clearing is the obligation to clear swaps at a regulated entity (like an exchange or derivatives clearing organization (DCO)) and post full collateral. Financial entities also have the obligation to report swaps to swap data repositories (SDRs) when they are trading with end-users and other non-financial entities. In the DFA, a "financial entity" is described by Congress as any company that is " predominantly engaged in activities that are financial in nature, as defined in the Bank Holding Company Act of 1956." The DFA, in turn, requires the Board of Governors of the Federal Reserve System (the Board) to establish the requirements for determining whether a company is "predominantly engaged in financial activities." Given the broadness of the Board's definition of "financial activities," the financial entities category may actually include more companies than the two more widely-discussed DFA categories of swap dealers and major swap participants. Moreover, for many purposes, being labeled a "financial entity" under the DFA may be burdensome -- especially for companies that do not particularly consider themselves to be "financial" companies. Surprisingly, a significant number of subsidiary companies that centrally execute financial instruments for large diversified corporations may be considered financial entities under the DFA, but they may also qualify for an exception under the CFTC's recent noaction letter on "treasury affiliates." What is a Financial Entity? Under the DFA, just like swap dealers and major swap participants, financial entities (most of them, at least) are excluded from making an election that is otherwise available to end-users to be exempt from the DFA's mandatory clearing requirements.
The broader term "financial company" within the DFA includes not only financial entities but also bank holding companies and certain non-bank financial companies that are supervised by the Board. Very large (or significant) non-bank financial companies can also be determined to be systemically important under the DFA. As a result, they can become subject to additional regulation, like the Orderly Liquidation Act (OLA). What are Financial Activities? In its final rule on the definition of "Predominantly Engaged in Financial Activities," issued in April 2013, the Board determined that certain investing and trading activities should be considered activities that are financial in nature under the Bank Holding Company Act. Since the Board's definition of financial activities also covers activities that are not regulated under the DFA (e.g., trading in forward contracts), it is not yet clear how these two sets of related regulations (i.e., the Board's rules on financial activities and the CFTC's rules on the exception from clearing) will be interpreted. For example, should trading in forward contracts be included or excluded from the "predominantly engaged" tests that are described below? The DFA provides that a company will be considered to be predominantly engaged in financial activities if more than 85% of its annual gross revenues or if more than 85% of its consolidated assets are financial in nature. For companies that do not have a centralized subsidiary used for their corporate hedging activities, the two 85% tests may not be a problem, but a review should be conducted for all corporations that trade in swaps. What are Captive Finance Companies and Treasury Affiliates? In its so-called final rule for the "End-User Exception to the Clearing Requirement for Swaps," the DFA provides a potential exception for captive finance companies that have been deemed financial entities. That rule states that a financial entity does not include any company whose "primary business is providing financing." In order to qualify for this fairly limited exception for captive finance companies, a company must use derivatives for the purpose of hedging its underlying commercial risks related to interest rate or foreign exchange exposures. In addition, 90% or more of these risks must arise from financing that facilitates the purchase or lease of products manufactured by the parent company or a subsidiary of the parent company. More importantly for many diversified companies, in June 2013, the CFTC's Division of Clearing and Risk issued a no-action relief letter for certain treasury affiliates. If not for this letter, these affiliates might have been categorized as financial entities, and would therefore have been ineligible for an exception from the mandatory clearing requirement.
The no-action letter basically expands the existing exception within DFA that originally only covered treasury affiliates that act as agents for related subsidiaries. It includes treasury affiliates that act as principals when executing swaps for related subsidiaries. In order to claim the exception from mandatory clearing for treasury affiliates, a company must comply with all the requirements described in the no-action letter and also make the necessary filings with an SDR (similar to the annual filings that are required of end-users). A final exception to consider for certain cooperatives is one that the CFTC announced in August 2013. The CFTC, in its "Final Rule on the Clearing Exemption for Certain Swaps Entered Into by Cooperatives," determined that a cooperative whose members were all end-users would not be deemed a financial entity only because of the swaps that it executed for its member companies (even when acting as a principal). Closing Thoughts The definition of financial entities is the least well understood of the three categories of companies (swap dealers, major swap participants and financial entities) that are the most heavily regulated under the DFA. But for the CFTC's recent no-action letter on treasury affiliates, many diversified companies with centralized subsidiaries that execute financial instruments would have been subject to the DFA restrictions placed on financial entities. Companies should carefully review their use of swaps to determine whether they will be considered financial entities, as well as whether they may qualify for the treasury affiliate exception. Gordon E. Goodman is currently a consultant with the Alliance Risk Group. He previously held senior positions at both E.I. DuPont de Nemours & Co., where he served as president of its DuPont Power Marketing subsidiary, and at Occidental Petroleum Corporation, where he served as the trading control officer for its Occidental Energy Marketing subsidiary. He was the founding chairman of the American Petroleum Institute's (API's) Risk Control Committee, and he also served on the API's General Committee on Finance. He was a member of the Financial Accounting Standards Board's (FASB's) Valuation Resource Group (VRG) and earlier was a member of its Energy Trading Working Group (ETWG). He is currently on GARP's Energy Oversight Committee, which administers the Energy Risk Professional (ERP) certificate. His prior contributions to GARP's "Risk Review," "Risk Professional," and "Risk News & Resources" publications have included the following articles: "Dodd Frank Memories" (2013); "The Liquidity Risk Sweepstakes" (2012); "The Ethics of Business" (2012); "How to Value Guarantees" (2008); and "Credit Risk: Will the Bubble Burst?" (2007).