Bridging the gap

Asia's regional commodity exchanges are expanding but the emergence of an Asian exchange champion to challenge Western platforms looks a long way off. Georgina Lee reports

The global economic slowdown is hurting heavy industry and manufacturers around the world. But a slew of government-backed capital expenditure programmes on infrastructure projects in Asia is resuscitating the region's voracious demand for raw materials. And this new demand for commodities comes on top of an annual $180 billion spent on infrastructure projects in Asia - an amount required annually just to cope with infrastructure needs to support the region's population growth, according to estimates by the World Bank.

Meanwhile, concern about the financial viability of many Western financial institutions has resulted in hedgers reappraising their counterparts for future hedging solutions. This concern comes after Asian shipping companies, airlines and oil companies lost billions of US dollars from failed hedges. The result is that risk managers are increasingly seeking more transparent and secure avenues to hedge their risks - at least that's the view of officials at many of the region's commodity exchanges.

Exchanges believe the current conditions represent a major opportunity for them to play a bigger role in the commodity derivatives markets by offering listed instruments as an alternative to over-the-counter (OTC) transactions. And politicians and regulators are giving them a tailwind amid efforts to tighten supervision of what many parties view as the opaque OTC market.

The growth of commodity contracts in certain areas also appears to be strong. Trading in non-precious metals derivatives grew by 64.5% to 175.79 million contracts and those on agricultural products increased 38.7% to 888.83 million contracts in 2008, according to statistics released in March by the Futures Industry Association (FIA). The FIA collected data from 69 exchanges located in Asia, Europe, Africa, Latin America and North America.

Asia itself is likely to see the addition of at least two new commodity exchanges this year. The Singapore Mercantile Exchange (SMX) and the Hong Kong Mercantile Exchange (HKMEx) both say they are on track to start trading by the end of 2009. The HKMEx, for example, is reportedly looking to offer contracts in gold, silver, black pepper, WTI crude oil and fuel oil. But it is already behind schedule with its trading launch, which was due in the first quarter.

John Mathias, chief business officer at SMX in Singapore, says his exchange plans to create a pan-Asian exchange out of Singapore. "SMX was conceived out of a need for a sophisticated trading and clearing exchange in Singapore, particularly due to its proximity to major commodity trading centres in the region and high liquidity in a broad spectrum of commodities," says Mathias. "Our ultimate vision is to network our exchanges within the Financial Technologies Group."

India's Financial Technologies has set up and manages seven exchanges, five of which operate out of India, including the Mercantile Commodity Exchange (MCX), together with the Dubai Gold and Commodities Exchange (DGCX) and the Global Board of Trade (GBOT) in Mauritius.

According to sources close to the SMX, the exchange plans to launch a variety of products, including futures contracts in gold, silver, copper, raw sugar, coffee, WTI crude oil and black pepper. The proposed product suite will also consist of Australian dollar/US dollar and euro/US dollar currency futures and MCX Comdex Index futures.

Indeed, a number of market participants believe the establishment of SMX is part of an effort by Financial Technologies to create an exchange where international investors, who are restricted by the Indian government from trading on Indian commodity exchanges, can freely access products already traded on MCX.

The backers of both HKMEx and SMX believe Asia-based exchanges offer future users the advantage of trading during Asian business hours to base their transactions on prices set within the region while being able to offset positions against those held elsewhere in the world. "Our trading schedule will bridge the current gap in the 24-hour day between the European and North American trading sessions, allowing the maximum flexibility and minimum volatility for trading activities to take place," says Barry Cheung, chairman of HKMEx in Hong Kong. "It's a quite clear and obvious hole in the trading day."

Asian exchanges are clearly instrumental in allowing local participants to hedge risks caused by changing global commodity prices in local markets. This is particularly the case in certain jurisdictions, such as India, that have regulatory constraints hindering hedgers from accessing foreign exchanges due to currency controls. "This is the typical corporate audience for commodity exchanges such as the National Commodity and Derivatives Exchange (NCDEX)," says Madan Sabnavis, chief economist at NCDEX in Mumbai, which handles a high percentage of agricultural product trades on Indian exchanges.

But derivatives traders, corporate treasurers, commodity brokers and bankers say they are sceptical about whether or not Asian exchanges can provide a wider role as major international sources of liquidity on a scale to rival peers such as the CME Group and the IntercontinentalExchange (ICE).

The CME Group, which includes the Chicago Board of Trade, the Chicago Mercantile Exchange (CME) and the New York Mercantile Exchange (Nymex), was the leading commodity derivatives exchange in the world in 2008 in terms of futures and options contracts traded and/or cleared, according to the FIA. In the energy area, ICE Futures Europe, the London-based futures exchange, ranked second and third in Brent crude oil futures and WTI crude oil futures respectively last year.

The dominance of international exchanges when it comes to global benchmarks makes it difficult for Asian exchanges, at least in the short term, to recreate their own version of a crude benchmark, for example. The most obvious route, therefore, is for local exchanges to offer global benchmark products to local clients in the form of a commercial tie.

MCX, for example, has a licensing agreement with the CME so that investors settle their contracts referencing the CME's WTI crude benchmark prices. In return CME gets a per trade licensing fee from MCX. Such tie-ups are increasingly common across the region.

While this licensing model may work well in large countries such as India, which have deep levels of demand from domestic clientele, it may not necessarily represent the way forward for exchanges targeting a bigger audience than their own market. Indeed some parties believe offering contracts that reference a global benchmark is an unappealing selling point for the Asian region.

"WTI is a US crude benchmark. Why would (SMX) want to launch a WTI (contract) when the CME is already trading that 24 hours a day?" asks a Singapore-based senior executive at an energy broker that is a clearing member of a variety of regional exchanges. "These new exchanges are not offering anything new to the market. I'm sceptical of whole thing working."

Meanwhile, Oral Dawe, chief executive of Asia Pacific commodities at JP Morgan in Singapore, says the fragmented nature of the market in Asia represents a fundamental structural flaw. While there are a lot of regional markets - from Dubai, Singapore, Shanghai, Tokyo and Sydney through to exchanges in China and India - Asia lacks a central hub. This means Asia tends to look to the West for price setting.

"For Asia, it is a structural issue that needs to be addressed if it is to realise its full potential from a commodity trading point of view," says Dawe. "It needs an Asian centre of liquidity."

International exchanges have gone through their own evolutionary path of trial and error, with many contracts failing in the past decade. And they also face issues when trying to offer contracts that appeal to Asian hedgers. The London Metal Exchange (LME), Dubai Mercantile Exchange and Nymex, for example, have all attempted to launch a steel futures contract but are seeing limited success.

The LME launched its steel billet contract in April last year, made up of two regional pricing references - Far East steel billet and Mediterranean steel billet. The exchange believes the two contracts are necessary to reflect the different regional market fundamentals in the global billet market of 512 million metric tonnes annually.

But the LME Far East reference is rarely traded. The LME says during the past full year of trading of the steel billet contracts, Mediterranean contracts represented almost all the total volume of 1.53 million tonnes. And this has led to calls from some parties for the LME to close the Far East contract altogether.

The reason for the illiquidity of the LME Far East contract is that there are very few companies that have their physical steel contract referenced to this particular futures contract price, according to Sean Mulhearn, global head of commodities sales at Standard Chartered in Singapore. "In comparison to the major base metals (copper, aluminium, lead, nickel and zinc) where physical contracts reference the respective LME contract, the same physical link does not apply to the LME steel contract," says Mulhearn. "Very few commercial contracts in Asia reference the LME Far East contract and that is one of the shortfalls of this contract. To attract liquidity you need have the link to physical activity, otherwise you are limiting your target audience."

Physical delivery plays an important role in creating price convergence as it ensures that the price of near-expired futures contracts moves towards the cash price of the underlying commodity, so limiting basis risk. If the exchange contract price appears too high or too low, market participants may see a favourable pricing opportunity and make use of the delivery mechanism to exploit this. This means delivery has the result of ensuring that the exchange traded price is in line with the physical price.

Asian steel producers typically make flat rolled products such as hot rolled coil, meaning very few Asian producers and traders would establish commercial contracts using the LME Far East reference as it tracks long products such as reinforcing steel bars (rebar) and rods, which are in a different category of finished steel.

Russell Norton, head of Asia Pacific commodities sales at Barclays Capital in Tokyo, says while physical settlement is very important for maintaining pricing relevance, it must also be supported by the participation of a broad range of participants. He believes if there are only a select number of parties dominating the market it would deter participation from smaller investors.

For domestic contracts that are financially settled, Norton sees value from a reference to international physical benchmarks and cites the Tokyo Commodity Exchange (Tocom) crude oil contract, which effectively references benchmarks in the Middle East. "So although it is a financially settled contract, it does reference the physical market," says Norton.

Mitsuhiro Onosato, executive officer at Tocom in Tokyo, meanwhile, says the exchange recognises there is still room for improvement with its Middle East crude oil (the average value of Dubai and Oman crude, which acts as the benchmark price of Middle East crude oil) contracts. One obvious limitation is that Tocom's crude oil futures are only denominated in yen.

Tocom is also seeking more institutional participation. "We target ... oil companies, metal refiners, air carriers and truck companies," says Onosato. "Recent high volatility of the crude oil price has made these companies more aware of the benefits of hedging. Therefore we shall provide sufficient information to commercials (commercial entities) that have traded only in overseas commodity markets or have never traded commodity futures at all."

Going local

In March, the Shanghai Futures Exchange (SHFE) became the world's fifth exchange to trade steel futures and the SHFE remains the only metals futures exchange in China as well as the only exchange to offer fuel oil contracts in China. China's three commodity futures exchanges, which also include agricultural product-focused Dalian Commodity Exchange (DCE) and the smaller Zhengzhou Commodity Futures Exchange, currently offer products that are largely exclusive to themselves.

Their specialisation contrasts with exchanges in India, such as NCDEX and MCX, which each offer a wider spectrum of products than the three exchanges in China but at the same time offer contracts that cover the same underlying.

But that does not mean Chinese commodity exchanges are unaware of the need to be innovative to stay competitive, even if they are only planning to serve the local market for now. The DCE, which according to the FIA was the 10th biggest derivatives exchange last year by contract volumes, says it is studying new products such as crude oil futures, weather indexes, pork and charcoal in its bid to diversify its product range.

"For 13 years since our inception (in 1993) we had focused on agricultural products, banking on Dalian's advantageous position in China's foodstuff market, but since 2006 we have taken a conscious decision to develop our exchange into an integrated exchange," says Dalian-based Liu Yan, a researcher at the DCE. "Our product innovation has since diversified away from only agricultural to also include manufacturing raw materials, index products ... We have just obtained the regulatory approval to launch PVC."

China's metal futures market also remains largely a domestic affair due in part to restrictions on physical delivery into the country. For example, a 17% value added tax is imposed on imported copper. To qualify for trading, a participant must also be a locally incorporate entity. Meanwhile, the lack of renminbi convertibility also limits participation by foreign investors.

Despite the restriction, bankers say the Shanghai metal contracts are still very relevant to the market and there are trading strategies that seek to arbitrage between base metal prices differentials between the SHFE and LME in the physical market.

Chinese companies, for example, account for 35% of global aluminium smelting and are the biggest consumers of copper in the world - making their domestic pricing relevant to the wider metals markets. "If you don't know what's going on in China, you don't know what's going on for the entire (base metal) market," says a Hong Kong-based commodities banker at a European bank.

Indeed, Jennifer Ilkiw, ICE's Asia Pacific director, based in Singapore, says some international exchanges do not necessarily view Asian exchanges as competitors. "With more exchanges developing in Asia and listing commodity futures contracts, trading activity during Asian hours may increase, both for Asian and non-Asian exchanges," says Ilkiv. "Traders may be interested in trading similar products listed on different exchanges as - due to the relationship between two respective contracts - they may find arbitrage opportunities or determine profitable trading strategies."

Similar views were echoed by Onosato at Tocom, who says while the Japanese exchange aims to attract participants from outside the country, this does not necessarily mean Tocom intends to draw from existing volumes on overseas exchanges. "What we have in the forefront of our minds is to respond to the arbitrage needs of traders in other parts of the world. We want to expand commodity futures trading as a whole, and create a win-win situation for exchanges around the world," Onosato says, adding that in recent months about 18% of Tocom's trading volume had come from non-Japan based commodity users.

Ultimately, however, liquidity will be the key differentiator between what strategies will work and those efforts that are destined to fail.