Getting off the Ground – Successful Commodities Futures Contracts
How do you launch a successful, liquid futures contract? Its nearly as difficult as launching a rocket. Every year, the big global exchanges launch a number, sometimes dozens, of new contracts. Out of these, approximately half fail to trade at all, and only a small number ever achieve meaningful liquidity. So, what are the factors that go into making a successful contract? Is there a way to predict success? What lessons can we learn from historical contract launches which have gone on to be the most liquid contracts in the world?
Liquidity – a futures contract is successful where there are a large number of buyers and sellers, willing to take both sides of the trade. Generally, this means having a deep pool of both hedgers and speculators. Speculators take risk, hedgers want to reduce or control risk. A core function of exchanges and futures products is risk transference. Speculators and hedgers often (but not always) take the opposite side of one another’s trades.
Hedging – almost all successful commodities futures contracts have arisen as a result of a commercial need to manage price risk. The soybean, wheat and corn futures which trade on the CME all began trading to reduce the risks born by both producers and wholesalers. Farmers got a price guarantee up front, and the cash to carry them through until the harvest. Wholesalers were assured of an adequate supply of the product they needed at a set price when they needed it. This became increasingly important as Chicago became a grain terminal and transport hub, and merchants had to manage price risk for their inventory. Metal futures started trading on the London Metal Exchange to manage the price risk incurred during the transportation of copper from Chile and tin from Malaya (each of which took three months, hence why the LME’s three-month contract is its most liquid). In oil, there was a gradual transition from long-term contracts to spot contracts during the 1970s. With economic uncertainty, the spot markets became volatile, and an economic need for hedging arose. The NYMEX responded with a suite of energy futures, starting with heating oil in 1978 (although deregulation was also an important factor in energy contracts – see below).
Speculating - speculators provide essential liquidity by trading, and trading frequently. It is nearly impossible to have a liquid and successful market without individuals willing to take risk. Chicago, for example, grew as a financial centre because it had a community of risk-takers which had grown up during the nineteenth century, initially because of land speculation and canal construction. This community deepened in the twentieth century as more commodities products became available for trading.
Reference prices – the most successful commodities contracts see a profound correlation between the physical and the financial. In some mature markets, the exchange’s reference price will be embedded in physical supply contracts, helping to ensure a highly efficient hedging mechanism. On the London Metal Exchange, for example, physical supply contracts generally incorporate the LME price; this is the core element of the price, and the parties to the supply contract will haggle over the “premium”, which is the element of the total price over and above the LME reference price, for a particular grade, location etc. A physical market participant, for example a mine, or an end user of metal such as a car company, can then hedge its exposure very efficiently on the LME. Steel markets, on the other hand, have historically used a fixed price in their contracts, inclusive of all fees, premiums, costs etc: this leaves them exposed to fluctuations in market conditions and achieves a less efficient hedge.
Lack of interference – a fully competitive market, free of governmental interference, is an essential precursor to futures trading. The natural gas market is relatively new to futures contract trading. In the US, from the 1930s until the late 1970s, the natural gas market was increasingly heavily regulated: the market was uncompetitive, and national governments effectively set the price. After this point, gradual de-regulation occurred, and by 1993, the markets, rather than governments or regulators, determined the price of gas at the wellhead. During the 1990s, the Henry Hub developed, and derivatives contracts were launched on NYMEX on the back of a liquid spot market. Today, 400,000 Henry Hub contracts are traded daily on CME (the owner of NYMEX), with 1.7M of open interest. Natural Gas is one of the largest physical commodities futures contracts in the world.
Changing behaviour – As noted above, oil saw a gradual change in behaviour from long term contracts to spot contracts during the 1970s, and energy futures arose on the back of this. There have been countless attempts through the years to change behaviour which have not been successful. For example, the LME launched polypropylene and linear low-density polyethylene plastics contracts in 2005. The plastics industry in 2005 was enormous, and to some, it seemed ripe for exchange-traded contracts. However, finding benchmark deliverable grades proved difficult, and the LME failed to persuade producers and consumers to change behaviour. Looking forward, it will be interesting to see whether the carbon steel industry achieves a transition to hedging. Historically, steel producers have been unwilling to hedge, relying instead on long-term fixed contracts or on the active spot market as an indication of where the market value is for a specific deal. Although steel contracts are available on a number of exchanges, including CME, LME, SGX and SHFE, volumes have generally been low relative to the size of the physical industry, and, where volumes have been higher, this has tended to be driven by speculative activity, particularly in China. This is due in part to the reluctance of steel industry participants to hedge, although it is also due to other factors, such as the many varying specifications of steel.
Regulation – an essential pre-requisite to the launch of a successful commodities contract is a safe, well-regulated jurisdiction which facilitates commerce, and respects the rule of law. Chicago, New York, Singapore and London all have this reputation. London’s reputation has recently been called into question by Brexit, and this may have long term consequences which are outside the scope of this article; for the moment, however, it remains the centre of European commodities trading. If a futures exchange does not have regulatory parity with another similar exchange, then it could lose market share. Since the turn of the millennium, there have at times been regulatory imbalances between the US, Europe and the UK. One of the reasons for ICE being able to attack Nymex in oil in 2006/7 was regulatory imbalance: on the ICE WTI contract, traders did not have to comply with the same CFTC-mandated position limits or position reporting requirements as on Nymex. This was rebalanced in 2008 when foreign boards of trade were required to comply with the same requirements as domestic exchanges (note ICE actually subjected itself to the same regulatory oversight as its NY-based counterpart before these requirements were formally introduced). A major concern for the European Union during the Brexit discussions with the UK was the potential for divergence between the regulatory requirements in the EU and the UK. A number of equivalence requirements exist in EU regulations; unjustly fearing a “race to the bottom” (or perhaps just to pressurise the UK), the EU has been reluctant to determine the UK as equivalent in any area to date.
Skills - it is no coincidence that Chicago, New York and London are thriving financial centres, and are all well served by excellent universities. Institutions such as the University of Chicago, Cornell, Columbia, Imperial etc (and other excellent centres of learning nearby, such as the Ivy League Universities and Oxford and Cambridge) have all had a tradition since at least the 1970s of training graduates in mathematical finance. Many graduates from these types of institutions go on to become traders at banks, proprietary trading firms, hedge funds etc. It is also worth noting that the Black-Scholes model, used to price options contracts, was developed by Myron Scholes and Fischer Black in 1973 at the University of Chicago.
Competition – the most liquid futures contracts have few or no major competitors. Roughly two thirds of all crude contracts around the world reference Brent crude (traded on ICE Futures Europe). The other major oil reference prices, WTI in the US and Dubai/Oman in the Asian market, are used as references primarily in specific regions and are for different grades. In metals, the London Metal Exchange is the global reference price for each of its most liquid contracts. Although there are metals contracts on CME and Shanghai, for many years these failed to get significant traction; even more recently where volumes have increased, such growth has, in the main, not been at the expense of LME volumes. The last twenty years have seen major consolidation in commodities exchanges: CME owns CBOT, Nymex and KCBT; ICE has acquired the IPE, the NYBOT, the WCE and NYSE Liffe. Unlike in other industries, such consolidation arguably has, on balance, pro-competitive effects. Users of services at large consolidated exchange groups get access to deep liquidity pools, economies of scale, and margin offsets at the clearing house.
Arrival of new competitors – Sometimes the arrival of a new competitor can be a reason why existing futures contracts fail. In 1998, trading on German Bund futures moved from Liffe (an open outcry exchange) to Eurex (an electronic exchange). Eurex was able to offer lower access costs due to operational efficiencies and benefit from volumes provided by the German banks which owned it. Seeing an opportunity to attack, Eurex lowered its fees and stole a large chunk of liquidity in a very short space of time. Liffe responded with a fee cut of its own three months later, but by then it was too late, and it had lost the liquidity. This shows that sometimes, when faced with a competitive threat, exchanges need to act swiftly. However, it is worth noting that many commodities contracts have barriers to entry for competitors (lack of clearing inter-operability, physical deliverability, embedded nature of reference price etc) that will make it more difficult for a rival to drain their liquidity pool as quickly as occurred with the Bund contract.
Level playing field – asymmetry of information will cause difficulties for a contract. Speculators will not be attracted to a futures market if commercial hedgers or traders have an advantage in predicting prices. In agricultural contracts like soybeans and corn (both traded on the CME, and two of the top five most liquid commodity futures), the primary uncertainty is the outcome of supply. Hedgers generally do not have an informational advantage over the speculators. Where it has been alleged that certain parties have an informational advantage, for example in relation to large movements of physical stock (e.g.in the oil or metals markets), this can cause participants to reduce their trading activity.
Interventions - generally, investors seek certainty, and dislike interventions. However, sometimes they are necessary, and markets can survive them, as long as they are not too severe. In 1980, the CFTC ordered the suspension of futures trading in corn, oats, wheat, soybean meal and soybean oil for four days. However, the suspension only had a relatively minor effect on futures trading. More recently, the LME suspended nickel trading for eight days, having concluded a disorderly market had arisen. The LME was subject to intense criticism from some sections of the market, and nickel volumes fell nearly 28% year-on-year (2021 to 2022). However, the contract still traded over 12m lots in 2022, and the fall in volume can be mainly attributed to speculators - funds - withholding business; hedging activity remains, in sufficient volume to suggest the contract will rebuild in time.
Incentives – exchanges with deep pockets increasingly pay large financial incentives to market makers in an attempt to build liquidity in new contracts. This can be a risky strategy, however, with no guarantee of return.
Conclusion
New contract launches for exchanges are increasingly difficult. Liquidity is sticky, and most of the “low hanging fruit” is gone. However, there are still opportunities for well-resourced exchange groups. For a new contract launch to be successful, an exchange needs to be nimble. It needs to be able to spot an opportunity, whether in a new market or through a rivals’ weakness, and target that opportunity relentlessly. This will be through financial means such as fee discounts and incentives, but also by having the ability to design a contract specification rapidly, and the technological flexibility to make the contract available for trading without delay.
Further Information
The author, Tom Hine, is a commodities trading expert and former Managing Director and General Counsel at the London Metal Exchange, with 17 years’ experience in commodities. His consulting company, Cambitas, can help with all aspects of new product launches, from strategy and product design to understanding the regulatory environment. If you would like further information, please contact Tom at tom.hine@cambitas.com.
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