Dalian iron ore futures contract trading volume falls away as question marks linger

Strong volumes on the first day of trading tailed off over the week although players deem it early days for determining the contract's success

Hopes were high in the run-up to the launch of the Dalian Commodity Exchange's iron ore futures contract both from players based on the Chinese mainland and from the offshore market. Indeed, when the contract went live on October 18, the first-day volume was a staggering 338,700 lots, or around 34 million tonnes. Comparatively, the Singapore Exchange (SGX) cleared 20.5 million tonnes equivalent in iron ore swaps for the whole of September.

However, by October 29, volume had tumbled by more than 50% to 108,908 lots, doing little to dispel fears that liquidity might not be wide or deep enough to rival the raging success of the Shanghai Futures Exchange's steel rebar futures contract, which trades close to 1.5 million times every day.

Players have been excited by the contract's opportunities, both in tapping into potentially huge domestic demand as well as providing an arbitrage opportunity against the offshore iron ore swaps contracts.

A key facet is its physical delivery from ports and warehouses in China. Physical delivery was not previously available with SGX's futures contract or swap contracts cleared by SGX and CME Group, all cash-settled against The Steel Index (TSI) 62% iron content cost and freight China price. Chinese exchanges use physically delivered contracts in the belief this will keep the futures markets tied closer to physical market fundamentals.

Judy Zhu, Shanghai-based metals analyst at Standard Chartered, says that although volume has fallen away, it is too early to judge whether the contract will succeed or fail.

"It is a solid start but we've also seen the trading volume declining. It takes time for people to get familiar with the new onshore investment tool they have. There is no doubt that many people here are very excited and interested at least in taking a look, if not immediately trade, in the market because they know if they don't trade the iron ore [contract] they will be exposed to market risks. It takes time to see how the contract will succeed," she says.

Dalian's downtown district

Indeed, when the Dalian Commodity Exchange launched a coking coal futures contract in March, the first-day volume was a spectacular 1 million trades, hitting 1.2 million a week later, but has since slumped to half that.

As with all Chinese exchanges' futures contracts, the iron ore derivative will be only available to market participants registered on the mainland. Helen Lau, Hong Kong-based senior commodities analyst with UOB KayHian, says there is a risk that in the short term, many industry players won't use the contract.

"At the initial stage of the launch, there is the possibility there may not be many participants trading the contract 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.

It's just speculation

Then there is the possibility the contract could be dominated by speculators - the first-day boon followed by the falling-off in volumes raising questions about who exactly was trading the contract, says one iron ore trader.

"There was a huge amount of turnover but the main question is what's behind that turnover? Is that real supply and demand going through, or is there a speculative aspect to that?" says the trader.

The Chinese explicitly stated their hopes for increased pricing power over iron ore through the contract but if the contract doesn't attract enough industry players and remains a plaything for speculators, it will struggle to gain credence as a pricing tool.

Without the market's acceptance that the contract suitably reflects fundamentals, volumes won't gain ground, says Richard Fu, London-based director, Asian commodities trading with Newedge.

"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.

Guaranteeing iron ore quality in the physical delivery remains a significant barrier to entry for industry buyers. 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 and 4% level for impurities. But the sheer size of iron ore shipments renders such guarantees awkward.

One trader points out the differences between delivering copper and iron ore. For copper, there is an easily standardised process with 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 actual delivery process setup is probably going to be quite challenging and the market's not 100% sure how that is going to work," says the trader.

The Dalian Commodity Exchange 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.

However this aspect will continue to cause concern among market players until the first physical exchanges are made in March and the market can see how the exchange handles the process. "Ultimately the focus is going to be on the delivery. The real thing is the first delivery date. If this thing comes through and is delivered properly and comes through against the TSI, everyone is going to feel a lot more comfortable in trading it," says the trader.

A positive that has emerged through the contract's first week of trading has been the arbitrage against swap contracts priced against the TSI. Prior to the launch, SGX's head of derivatives Michael Syn told Asia Risk the contract would boost liquidity in the offshore market as well.

"Our view is that the two products are complementary, i.e. not substitutable, and that onshore retail and speculative liquidity will be a welcome boost to offshore institutional and hedging liquidity," Syn says.

The May contract contains almost all of the liquidity and since the product launch, it has maintained a significant premium over the offshore equivalent once the onshore 17% VAT cost has been factored in. On October 29, the Dalian contract closed at 922 yuan, or 788 yuan ($129/tonne) minus the VAT, compared with $118/tonne on the SGX's iron ore futures May contract.

With most domestic traders unable to access the offshore market and vice versa, those select traders with the capability to trade both on and offshore would look for opportunities similar to those that exist between the London Metal Exchange and SHFE's copper contracts. As such, the iron ore trader says the arbitrage should remain in the future.

"The arbitrage is here to stay. It will open and narrow in the way that the arbitrage between the LME and SHFE copper contracts does. There is always this onshore/offshore activity," says the trader.