Commodity Derivatives Exchanges

Enrich Broking: Functions Of Commodity Exchange

A commodity exchange (also called bourse) is an organized physical or virtual marketplace where various tradable securities, commodities and derivatives are sold and bought. 

They appeared much before financial derivatives in the world.

Clay tablets appeared in Mesopotamia around 2000 BC as contracts for future delivery of agricultural goods.

The story of Thales of Miletus (624-547 BC) in Aristotle’s writings is considered as the first account of an option trade whereby the price of the spring olive from the oil presses was negotiated in winter without an obligation to buy the oil.

The idea was to offset the price risk and maintain a year-round supply of seasonal agricultural crops in the markets.

During the 12th century, merchants began making commitments to buy or sell goods even before they were physically available to reduce the risk of looting while traveling along dangerous routes. 

The central function of these contracts, later called derivatives, was to guarantee a future price and avoid the risks of unexpected higher or lower prices.

The late 19th century witnessed a spurt in commodity futures trading with the creation of exchanges. 

The main focus was reduction of transaction costs. 

Organizing a marketplace where buyers and sellers could find a ready market. 

Chicago emerged as a major commercial hub where derivatives were traded and harvest could be delivered, with the best of rail, road and telegraph line connections to attract wheat producers, dealers and distributors. 

The prices on the Chicago Board of Trade, e.g. for wheat futures, are still important price references and price indicators used worldwide. 

Some commodity exchanges were established in the rest of the world. 

Set up in 1854, Buenos Aires Grain Exchange in Argentina is an example of one such old exchange in the world. 

After the liberalization of agricultural trade in the 20th century, many countries withdrew support to agricultural producers and prices became more volatile. 

Commodity exchanges helped the price discovery and hedging function and facilitate physical trading. 

Initially, these exchanges were located mainly in developed countries but soon the developing countries followed. 

The key functions of the commodity derivatives exchanges include:

Providing and enforcing rules and regulations for uniform and fair trading practice.

Facilitating trading in a transparent manner

Recording trading transactions, including circulating price movements and market news, to the participating members

Ensuring execution of contracts

Providing a system of protection against default of payment (clearing)

Providing a dispute settlement mechanism

Designing the standardized contract for trading which cannot be modified by either party.

It should have a suitable risk management mechanism, normally in the form of a clearing house (owned by the exchange or by another operator) that ascertains the credit-worthiness of the parties of a contract and ensures the execution of contracts. 

It especially serves as a legal counter-party between each buyer and each seller of a derivatives contract on the exchange and, therefore, is called a central counter party (CCP). 

The exchanges should also maintain a Settlement Guarantee Fund (SGF) to ensure a high level of protection against the risk of default by a trader. 

The clearing house (the CCP), or the SGF of the exchange has to be used in case of default by a buyer or a seller to pay the other party. 

In order to guarantee that the parties will execute the contract and to maintain reserves to deal with default, the clearing house or SGF requests the parties to provide collateral (called margin) in the form of cash or securities. 

The margin money changes daily with the change in prices of the contracts on which traders have taken positions. 

In an event of adverse price movements, the traders are requested to increase their margin amount (‘margin call’).

Modern electronic commodity exchanges offer fast, secure, transparent and regulated platforms for transactions along with public display of prices and trading. 

The exchange designs the standardized contract for trading which cannot be altered by the either party.

The exchange provides a seamless trading platform and competitive trading as well as facilities for clearing, settlement, and arbitration. 

Most importantly, the exchange guarantees a financially secure environment for risk management and guaranteed performance of contract.

The price rises if purchase volumes outnumber sales volumes, and vice versa. 

The bargaining (bids and offers) for commodity derivatives contracts converge at the trading floor on the expectations of different stakeholders about prices of a particular commodity on the specified maturity date in the future. 

The prices in a futures market are determined from the bargaining, namely the interaction of buy and sell ‘quotes’ from different participants having different expectations from the physical and financial markets. 

Buying and selling by speculators when they engage in excessive speculative trading that is unrelated to the physical market influences the futures prices.