The long-term trends in soft and agricultural commodities will provide some of the most exciting trading and investment opportunities across all asset classes in the next decade. NYSE Liffe has already experienced remarkable growth in the trading of these commodities and has embarked on a development programme to provide market participants with the necessary products and trading infrastructure to take full advantage of the opportunities still to come.

Introduction

Faced with a crisis that has brought the banking system to its knees and plunged the global economy into a synchronized recession, the focus of attention is understandably on restoring the financial system to health and ensuring past mistakes are not repeated. Exchanges, such as NYSE Liffe, are an integral part of the process through which trading in financial products will in future be more efficient, more transparent and above all safer. Moreover, derivatives exchanges, like NYSE Liffe, will continue to play an important role in enabling the exchange of risk in an uncertain world. 

But when all eyes are on crisis management, it is easy to lose sight of longer-term underlying economic trends. Perhaps the greatest of these is the impact of economic development in China and other emerging countries on the global supply and demand balances of commodities and natural resources. 

Ensuring the world’s growing population has enough to eat is the challenge facing politicians in both the developing and developed world and the need to address that problem will ensure that commodities will be one of the most important asset classes of the next decade. 

More than a cycle

Undoubtedly there was a traditional cyclical element to rising agricultural prices between 2006-08. The surge in US wheat prices, for example, owed much to adverse weather conditions that damaged crops in Canada, the EU and Australia at a time when wheat inventory levels in the US were at their lowest levels in 60 years. The influx of financial investors, some of whom trade based on the markets’ momentum as much as the supply and demand balances, has in turn prompted debate as to whether their involvement may accentuate price movements in the short-term. In the United States, for example, the CFTC believes there is a connection, but this view is not shared by other regulators, governments and opinion formers around the world.

Agricultural commodity prices have fallen following the global economic downturn and memories of food riots in 2007-08 in a range of countries from Mexico to Morocco are fading. But underlying secular changes to both global supply and demand have made the future course of world food prices highly uncertain. It is likely that prices will not resume the long-term downward trend in real terms that prevailed from 1975-2005. 

Demand outstripping supply

Population growth is the key determinant of demand for food grains. In August 2009, the Department for the Environment, Food and Rural Affairs (Defra), launched a review of the UK’s food security in which it stated that world population is expected to reach 9bn by 2050, requiring a 70 per cent rise in food production to prevent widespread hunger. Consumption patterns, too, are changing. As real incomes rise, particularly from very low levels of per capita income, so does daily calorie intake. Moreover, the proportion consumed as protein, particularly meat, increases. This has a leveraged effect, because meat production requires proportionally more grains. For example, seven kilogrammes of feedstock grains are needed to produce one kilogramme of beef.

A desire for energy security, borne out of high oil prices, has led to the increased production of biofuels, such as ethanol and biodiesel. This has added to the long-term demand pressure on agricultural commodities. As farmers switch acreage into feedstock grains for biofuel production the knock-on effect ripples through the supply balance of other food grains such as wheat.

These demand trends need not lead to higher agricultural prices if supply can keep pace with the expansion in demand. Growth in supply is the result of a combination of acreage expansion and increases in yields. According to the Food and Agriculture Organisation (FAO) of the United Nations, growth in yields is slowing. Over the past 45 years, average annual growth in global cereal yields has been 2 per cent a year, but over the past 20 years it has slowed to 1.3 per cent. This falls far short of the pace required to match the expected increase in demand from the combination of population growth, dietary change and increased biofuels usage. 

This puts the onus of increasing supply on acreage expansion. But according to the FAO, over the last five decades global cultivated acreage has expanded by just less than 15 per cent, primarily through growth in South America and Africa. There is scope for additional significant acreage expansion in South America, Indonesia and the former Soviet Union. But much of this land is remote and will require considerable investment in infrastructure that can take years, or even decades, to build. Climate change, too, could play its part in the supply of suitable land for cultivation. Projected increases in temperatures through the impact of global warming are expected to have a dramatic impact on agricultural production in areas vulnerable to a reduction in water. The overall picture, therefore, is one of considerable uncertainty.

Building the infrastructure for success

Encompassing broad trends from climate change to energy security, the commodities story will be difficult to ignore in coming years. But the provision of suitable products must develop in line with the evolving needs of existing market participants as well as providing a market infrastructure that addresses the concerns of new entrants.

NYSE Liffe has an established portfolio of central order book exchange listed contracts in soft and agricultural commodities – cocoa, coffee, sugar, wheat, rapeseed and corn – all of which provide benchmark prices for the underlying physical markets. The next stage in the evolution of the NYSE Liffe product offering is to leverage the exchange’s position in exchange-traded commodities with the award-winning Bclear service for over-the-counter (OTC) derivatives. The expansion of Bclear is designed to offer users of the OTC commodity markets greater security than they currently have. 

“Putting commodities onto Bclear is an initiative that has been on our agenda for some time,” says Ian Dudden, Director Commodity Derivatives at NYSE Liffe. “We brought the first phase to market at the end of March 2009, starting with futures and options based on the cocoa, coffee and sugar contracts, and will be following that up with a number of subsequent phases, in line with the continued development of Bclear.”

“While they have existed for years in the energy markets, OTC swaps in soft and agricultural commodities still represent a relatively small part of overall trading activity,” explains Aaron Gill, Head of Business Development, Commodity Derivatives at NYSE Liffe. The term ‘swap’ in the commodities markets differs in usage from the fixed income markets. An OTC commodity swap references a particular future or option but has a slightly different schedule or particular structure, compared with the standardized products listed on exchanges. There is an active daily market in OTC swaps between banks and also between banks and end users of commodities, designed to permit additional flexibility – for example by matching hedging needs to a specific production schedule. 

Risk mitigation

NYSE Liffe’s plan – to take vanilla OTC instruments that reference the central order book price and provide users with the security of automated trade administration and clearing through a central clearing counterparty – is designed to win business that is currently taking place in the bilateral OTC market. The clearing-house structure eliminates counterparty credit risk and, significantly for commodity market participants, it also removes delivery risk. “For the hedge fund community that can be a very important distinction,” says Gill. “The contracts on Bclear are cash settled which allows direct exposure to the volatility and price movement of the underlying physical asset, but without the delivery risk.”

“Many of our customers who trade in financial assets want exposure to commodities, but without the risks associated with dealing with the physical product,” says Nick Jacob, senior broker in soft and agricultural commodities at Tullett Prebon. “Bclear allows them to mitigate those risks, and therefore encourages new counterparties to contribute to these markets.”

Bclear settles the OTC instrument, for example coffee, using the daily settlement price of the coffee future. For margining purposes the client is getting direct access to actual market prices. “As a hedge fund I know that if I get involved in an OTC cleared commodity trade my mark to market is independent – it’s an exchange traded price,” says Dudden. “There is no concern about how my book is being valued relative to my counterparty’s book, nor about counterparty credit risk or delivery risk.” 

The Bclear service offers users the ability to either report trades or remain anonymous – benefiting from the transparency inherent in a central order book market without revealing too much about their own activity. Bclear also provides a way for market participants to put part of their vanilla business into the cleared space thereby freeing up credit lines for more exotic or esoteric business with higher margins.

Bclear has additional advantages compared with other clearing solutions available in the market. “One of the attractions of Bclear for the hedge fund community is the ability to leverage the distribution already in the system,” says Gill. “Because Bclear has been around since 2005 and is used by the majority of the buy-side and the sell-side in the equity space its not just a niche product for commodities.”

Constant evolution

The evolution of the equity offering on Bclear shows how its structure allows NYSE Liffe to continually add additional value for customers and more closely match their trading requirements. In equities the service has moved from single stock options and an initial set of futures and options on indices to single stock futures and an even broader range of index contracts. The latter now encompass a set of MSCI index futures contracts referencing Emerging Markets, Latin America and the BRIC countries amongst others. Volumes processed have grown by an average 51 per cent a year since the launch of the service in October 2005. 

Similarly, the commodity products launched on Bclear so far – vanilla swaps on NYSE Liffe’s listed soft commodities – and the next phase of development, which will offer the Exchange’s wheat, rapeseed and corn contracts as well as greater flexibility of expiry dates, are the first building blocks in a service that will continually develop. “As equities have shown there is a constant flow of new products onto the service,” says Dudden. “In commodities, this is just the beginning, we are just getting the channels open. There are many other products and trading strategy types which could potentially be listed on Bclear.”

“As investor business starts to return to the markets and risk appetite increases, we are seeing a broadening interest in a growing range of commodities and the need for new products and infrastructure to satisfy that demand,” says Tullett Prebon’s Jacob.

The milling wheat futures and options contracts, for example, have grown from trading 1,500 contracts a day in 2006 to almost 10,000 contracts a day now, as a direct result of NYSE Liffe providing the market with a product they required to hedge their physical price risk. “From a Bclear perspective, we know that there is activity in the OTC space which references pricing in the milling wheat futures, a benchmark we created and own,” says Gill. Beyond the logical next step of clearing vanilla agricultural contracts that mirror the exchange-listed products, there is also scope for further development. NYSE Liffe’s Paris-based wheat contract, for example, is based on Western European wheat deliveries, but Black Sea wheat trades at a price differential. Swaps could be developed based on specific regions that relate back to NYSE Liffe’s central order book contracts.

As well as adapting to the needs of participants in established areas of the commodity markets, OTC cleared derivatives have an important place in facilitating trade in new markets created by evolving global trends. “What you are seeing now is the evolution of those products into new areas,” says Gill. “For example take biodiesel. We have a rapeseed contract actively traded by companies in that sector of the energy business, not only by those in the agricultural space.” Similarly NYSE Liffe has a core white sugar business, which is closely related to the cane sugar industry that provides the feedstock used for ethanol production. Ethanol and sugar prices are closely correlated and many of NYSE Liffe’s sugar customers come from that sector of the energy industry.

Building blocks

Commodity markets have not escaped unscathed from the financial crisis. Activity this year in the bilateral OTC markets in soft and agricultural commodities has slowed. Credit is an issue. The sugar market, for example, is heavily reliant on Brazil for sugar and ethanol exports. But in reaction to the turmoil in the financial markets in the last quarter of 2008, some of the major investment banks have either severely restricted, or in some cases withdrawn, credit facilities in Brazil, which has impacted OTC activity. Also with the extreme volatility seen in commodity markets a lot of participants are trading on much shorter time horizons.

But a crisis also provides an ideal opportunity to look ahead and prepare for the future. It will take time for the wider market to refocus on the potential from the long-term trends in the soft and agricultural commodities markets, but NYSE Liffe is creating tomorrow’s infrastructure today. “Bclear allows you to take what you have and evolve it, but also to look at how it works in a growing space – whether it is inter-related to other exchanges or inter-related to other products that are emerging, such as biodiesel or ethanol,” says Dudden. “With the Bclear service we want to be positioned to have the appropriate building blocks to capture that development and the enhancement of those market trends.” 


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