Asia trade drives container freight derivatives

Container freight volumes have exploded during the past decade with trade flows to and from China a major driver of this growth. Up until this year, however, end-users had little ability to manage risks associated with movements in container freight prices. That may be set to change. Kathy Wang reports

Container transportation has emerged as one of the fastest-growing segments of the global freight industry during the past couple of decades, particularly trades to and from China. From the mid-1990s to 2008, container freight traffic tripled to 136 million 20-foot equivalent units (TEUs), valued at $137 billion, according to the Singapore Exchange (SGX). Asian container traffic is projected to account for 68% of the world container exports and 56% of world container imports by 2015, according to a study, Regional Shipping and Port Development, published by the United Nations Economic and Social Commission for Asia and the Pacific and the Korea Maritime Institute in 2007.

Container freight rates are also very volatile, with prices on major routes from Shanghai falling nearly 10% during the third quarter of this year, for example. And these price movements have a significant bearing on the ultimate profitability of goods bought and sold around the world.

End-users have had little option but to accept this price volatility. At least, this was the case until the Shanghai Shipping Exchange (SSE) – set up by China's Ministry of Transport and the Shanghai Municipal People's Government - established the Shanghai (Export) Containerized Freight Index (SCFI) last October. This index is a reference index for container market - equivalent to Baltic Index for global dry-bulk trades.

Not long after the index family was launched, the first container freight swap (CFS) deal was conducted as a hedge against the price movement of the index in January of this year. The first trade was done in London between Morgan Stanley and shipping company Delphis, with Clarkson Securities acting as broker. "Container derivatives will help transform container shipping, bringing price transparency and risk management into the industry," says Brian Nixon, London-based executive director of commodities at Morgan Stanley.

Container freight swaps are financial instruments that offer a similar hedging principle to freight swaps traded for dry bulk and tanker. They enable counterparties to manage their exposure to spot market volatility by allowing them to take a position on where freight rates will stand at a certain point in the future. Shippers are most likely to buy CFS when the freight prices are going up and the dynamic moves the other way when prices start to decline, with shipping lines most likely to consider hedging their risks.

Hedging for dry freight is nothing new, with the derivatives often traded against the Baltic Index to reduce risk exposure. The forward freight agreement (FFA) market for dry freight is now valued at $36 billion, or 40% of physical activity, according to market participants.

"The container market rates are volatile, affected by the amount of container suppliers and the demand for moving cargo around, and so far there is still very limited ability for the companies that have exposure to that market to protect themselves, so this derivative is to help manage that exposure more effectively." says Benjamin Gibson, London-based freight derivatives broker at Clarkson Securities.

The SCFI comprises freight rates from Shanghai to 15 mainline ports around the world giving US dollar TEU individual ocean freight rates for these shipping lanes. Lines serving Europe and the US West Coast account for 20% of the index, those shipping to the Mediterranean 10%, while the rest is accounted for by lines serving the US East Coast, Persian Gulf and Red Sea, Australia and New Zealand, East/West Africa, South Africa, South America, West/East Japan, Southeast Asia, South Korea, Taiwan and Hong Kong.

Gibson said up until now, the majority of trades have focused on the Shanghai-Europe route. "When you start a new derivatives product, it's very important to concentrate all the liquidity you have on one route; that's what we've been doing on the Shanghai-EU route. We are careful and grow it very slowly, so not to lose liquidity," he says.

While the SSE offers prices for 15 routes; clearing services introduced by the SGX in August cover just four container swap contracts: Shanghai-Europe, Shanghai-Mediterranean, Shanghai-US West Coast and Shanghai-US East Coast. The contracts are also based on the SCFI. In the third quarter, the SCFI slid nearly 10% from 1,576 to 1,420. During the same period, the China-Europe index price dropped 11.1% from 1,800 to 1,600, or $200/TEU; while the China-US West Coast index fell 14.3% from 2,800 to 2,400, or equal to $400/TEU.

To date, more than 30 companies globally have subscribed to weekly updates about the index, according to the SSE and more than 100 companies around the world have contacted the SSE for subscription to the SCFI. "Container derivatives have been trading with interest mainly on the Q4 2010 and 2011 markets with interest on the China to Europe and China to US West Coast routes," says Nixon.
Counterparties of CFS mainly include shipping lines, but equally important are retailers, logistic companies, cargo owners, manufacturers, freight forwarders, trading houses and financial institutions, including banks and hedge funds.

But activity in Asia has been muted so far. "It's not a fully liquid market yet, but there were a lot of good trades," says Arthur Worsley, a container freight derivative broker at Freight Investor Services (FIS) in London. "Companies from the EU and US are so far more actively involved in the market when compared with Asian companies."

Clarkson's Gibson says investment banks are also more active than shipping and logistic companies in the CFS as it's easier for investment banks to get the permission internally to trade new products given their understanding of the derivatives market. "That's why you see a lot of activities from them so far," says Gibson, noting it might take longer for the physical container shipping companies to get the internal permissions to be able to trade, as they may never have done any derivatives transaction before and need to fully understand how such products work.

"CFS is not a highly leveraged derivatives product in terms of sophistication level," says Worsley. "It just takes time to bridge the gap through market education, as container shipping users do not understand the derivatives market, while financial institutions that understand the derivatives are not familiar with container shipping."

Nixon believes it will take about five years for the CFS market to become a fully fledged derivatives market. "With the deregulation of the liner shipping markets, we will have more active shipping market participants who are keen to reduce their price risks going forward," Nixon adds.

And CSF liquidity is essential ahead of the introduction of other derivatives instruments, such as a container freight options. "At the moment, while we have people interested in the options, we need to concentrate on growing the swap market first, because the option pricing is based on the pricing of underlying swap. And at the moment, the prices we can give options came out too expensive," says Gibson.

But Morgan Stanley's Nixon says the potential for options among shippers and forwarders is "huge". "So far we have decided not to push the container options market yet, as we would like liquidity to improve first," says Nixon. "But the options market will become important."

Market backers expect container derivatives volumes to represent about 10% of trades done in the physical market five years from now. "It could actually be more should derivative growth occur exponentially, as has happened in other markets such as dry bulk shipping derivatives, the oil markets and iron ore trading, for example," says Nixon. "Based on experience from the dry-bulk FFA market, initial trading activity is expected to be slow while brokers and clearing members bring in more participants through educational and training engagements," adds Kenneth Ng, vice-president, commodities at SGX in Singapore.

While a lot of the container freight market is controlled by Europe and the US, Ng says a great deal of container swap end-users - such as large manufacturers, shipping lines and commodity traders - are based in Asia, adding that Asia is also home to the world's two biggest container ports, so volumes could soar.

However, some major shipping companies appear to have little interest in the container derivatives market yet. "The container freight swaps have been launched for some time... [and] trading volume of the product has yet to be very sizable, and the market is still at its initial stage," Sun Jiakang, vice-president of China Cosco, Asia's largest shipping company by market value, said in late August. "Our company has done some research on the product... we have not decided to enter into the market at this stage."

Moreover, Nixon concedes that regulation and legal structure in China is not favourable for derivatives trading. "Once that is improved, there is good potential growth in China," he says, "although Chinese companies are already relocating trading activities to Singapore to capture more favourable regulations with regards to derivatives trading. Should the legal framework improve in China and foreign exchange controls relax, then companies will be able to trade from China as well," he adds.

Container shipping first started in the late 1950s and the market started to expand dramatically in the 1970s. Historically, the container freight rates market has limited transparency, with average freight rates not accessible to the public market, and, until October last year, there was no index that could be used as a settlement mechanism for container derivatives.

But the creation of the FFA market may give a tailwind to container freight derivatives. "Unlike the FFA market, many of the potential users of container swaps are already familiar with freight derivatives and clearing," say Ng from SGX. "In fact, many of the potential users of container swaps who need this product to manage their finished products shipping risks are already active users of dry-bulk FFAs to hedge their raw material shipping risks. Therefore, we expect the learning curve for container swaps to be less steep for some players."