Question marks surround Dalian iron ore futures contract ahead of launch

Although the market is excited about the new contract’s possibilities, uncertainties remain over physical delivery capabilities and liquidity levels

iron-ore-assay

Guaranteeing iron ore quality in the physical delivery and ensuring domestic industrial player participation are two of the concerns raised by market players for the Dalian Commodity Exchange’s (DCE) iron ore futures contract due to start trading on Friday.

DCE, the third largest futures exchange by volume on the mainland, received official approval from the China Securities Regulatory Commission on October 9 to list the iron ore contract after more than two years of discussions and development.

The contract will be the world’s first physically delivered iron ore derivative contract – Chinese exchanges use physically delivered contracts in the belief this will keep the futures markets tied closer to physical market fundamentals. In contrast the Singapore Exchange’s futures contract and swap contracts cleared by the SGX and CME Group are cash-settled against The Steel Index (TSI) price.

The trading unit of the contract will be 100 tonnes per lot, with the delivery standard quality at 62% iron grade ore, with a minimum concentrate of 60% permitted for delivery. However this aspect is causing concern among market players, with the sheer size of iron ore shipments making such guarantees awkward.

One trader points out the differences between delivering easily standardised copper and iron ore. Copper has standardised types with a benchmark-approved quality and quantity.

“With iron ore, it’s totally different. Depending on where the supply is coming from, the quality can change dramatically and on top of that you don’t know about the moisture or arsenic content etc. Even in one ship, there will be various loads in it and there is a concept with iron ore to create blends. The delivery process setup is going to be challenging and the market’s not 100% sure how that is going to work,” says the offshore iron ore trader.

The trader says the situation is similar with regard to warehousing iron ore.

“With copper, you’ve got exchange-deliverable locations, it’s easy to move around and move it on and off the exchange. For iron ore, it arrives and is bulldozed into a great big mountain and how the exchange warehousing process works is not yet clear,” says the trader.

Helen Lau, Hong Kong-based senior commodities analyst with UOB Kay Hian, agrees that guaranteeing delivery quality and punctuality does raise issues but that there are ways around the problem.

“The quality varies and is not consistent in the shipments and there are a lot of different contaminations in the ore concentrates. But I don’t think physical delivery cannot be done,” she says.

“Not all iron ore producers would be qualified to be members on the futures market. So in order to become a member, your iron ore must be of a certain standard, which is one way to speed up the inspection process. So if DCE accepts, say, only 10 producers, either domestic or international, they must produce a certain specification of iron ore, which would shorten the settlement time. It’s the same for gold and silver. Not every gold producer can sell their products on the Shanghai Futures Exchange, for instance – you have to be accepted,” she adds.

The DCE could not be reached for comment but had previously pointed to its record in guaranteeing quality and delivery punctuality in its coal contracts in a July release as proof of its ability to handle physical delivery of bulk products.

Another issue, which will soon be established on Friday, is whether the contract will garner sufficient liquidity and breadth of participants to become successful. As with all futures contracts on Chinese exchanges, the iron ore derivative will be only available to market participants registered on the mainland. But UOB’s Lau says there is the possibility that in the short term, many industry players won’t use the contract.

“This is because Chinese steel producers are still not accustomed to the concept of hedging future trade flows. What they know is they buy iron ore from certain suppliers and have never hedged their raw material,” she says.

Richard Fu, London-based director, Asian commodities trading with Newedge, says there is a risk that trading is dominated by speculators.

“One important factor towards the success of the Dalian contract is breadth of participants. If only speculators are involved, the contract would lack authenticity in the industry as a pricing tool. Without involvement from the industry, volume pick-up will be very slow,” he says.

In spite of the reservations, market players including SGX remain upbeat about the contract’s future, especially the arbitrage opportunities it will present against the swap contracts and SGX’s futures contract.

“Our view is that the two products are complementary [i.e. not substitutable], and that onshore retail/speculative liquidity will be a welcome boost to offshore institutional/hedging liquidity,” says Michael Syn, Singapore-based head of derivatives at the SGX.

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