1. Forward markets for agricultural commodities - and how they can stimulate agricultural development Lamon Rutten Chief, Finance and Energy, Commodities Branch United Nations Conference on Trade and Development Centre for Banking Studies, Central Bank of Sri Lanka, Colombo 17 October 2002

2. Overview Forward contracts vs. futures Forward contracts vs. a forward exchange The structure/management of an exchange What services can an exchange provide? Designing a forward contract Conditions for a viable forward exchange Conclusion

3. Spot, forward and futures contracts Spot sales: at the moment that the production decisions are made, the producer does not yet know whether he will find a buyer, and if so, at what price. And processors may have to sell processed products for delivery in x months, without knowing what price they will have to pay for the raw materials. Forward contracts: the producer finds a buyer, and may, or may not, know the price at which he will be selling. Futures contracts: the producer eliminates most of the price risk for his crop.

4. Problems solved and created by forward contracts  facilitate planning and marketing  make it possible to lock in forward prices  can be used to secure a processing margin BUT: there are potential problems: It may be difficult to revert one’s initial position Major counterparty risk Possibility to profit from favourable spot market developments is lost pricing is often not transparent. BUT: there are potential problems: It may be difficult to revert one’s initial position Major counterparty risk Possibility to profit from favourable spot market developments is lost pricing is often not transparent. Spot markets leave producers, processors and traders with terrible uncertainties, forcing them to make speculative decisions. On the other hand, forward contracts: This, in turn, can make it easier to obtain bank finance. Futures contracts are designed to overcome most of these problems

5. Should one plan to evolve from forward to futures contracts? Not necessarily. It may not be possible. And there may be no need. And with the advent of Internet trading, there are hybrid forms that can work much better than “pure” futures.

6. Sufficiently large supply and demand for the commodity Sufficiently free determination of prices (little likelihood of price manipulation) Reasonably well-standardized commodity, and accepted grades Sufficiently large price fluctuations to warrant hedging Reasonably well-functioning spot market Support from commercial interests for the futures market Sufficiently large group of speculators Sufficiently well-developed infrastructure (grading, storage, etc.) and supportive legal and regulatory framework. Properly time the start-up of the exchange Conditions for a viable futures contract are rather strict

7. On the other hand: the risk of a forward exchange A forward exchange can collapse, taking down much of the agro-processing industry with it, in case of a large production shortfall. Start of season News of poor production starts In run-up to delivery period Delivery period Forwards Farmers enter into fixed-price forwards News is slow in being spread Farmers start trying to negotiate contracts with buyers Massive default by farmers, with risk of contamination/domino effect Futures Farmers sell futures Some farmers start closing out their positions / buy futures (prices up) High margin calls for farmers. Those without sufficient collateral or cash have to close out positions (buy futures). Only those with product or sufficient cash still have open positions: orderly market

8. A forward exchange versus forward contracts Forward contracts are always possible - and may work well in the context of contract farming because there is a strong incentive not to default on contractual obligations. Also, in fair trade, where farmers can receive high premiums if they do not default, forward contracts can work well in isolation. But in most other situations, forward contracts come with a large risk of default, leading to price discounts for farmers; having them traded on an exchange can then help, as the exchange can improve contract performance.

9. Functions of a commodity exchange Transparency in prices Everybody can know at what price is each product sold Avoid manipulation, provide a benchmark price for transaction Reduces transaction costs Everybody is in the same place, no need to look for buyer or seller Provides price discovery What will be the price of onions next month? Sorry, I only deal with love affairs, look at the commodity exchange

10. The roots of commodity exchanges Successful commodity exchanges have been set up as tools for physical trade. Not as tools of government policy. Not for the purpose of creating a place for gambling (partial exception: China). Throughout tumultuous decades, surviving wars, government interventions and the advent of “destructive technologies”, commodity exchanges have survived, because they have continued providing valuable services to commodity players.

11. How can a forward exchange be structured? Exchange “club” As a closed “club”As an open forum Central market place Liberalization generally leads to a new for more efficient markets. One element of this is the creation of new liquidity, meaning that one has to bring in physical market players from outside the “club” (e.g., farmers, supermarkets), and even speculators. An exchange can be set up as a relatively closed club of which the members knew each other well. This reduces the need for reputation-building, clearing, tight oversight, etc. But it also keeps volume at a low, albeit possibly sustainable level.

12. Managing a commodity exchange Ownership and management are different things. Owners need to appoint competent managers, but should not interfere in the day-to-day management of the exchange. The manager should be of high integrity, with a private sector background and strong experience in one or more of the business areas of the exchange (e.g., the commodity or the commodity finance sector). He should be able to withstand pressures from the board, the members and outside groups (e.g., government). It helps if the manager is, to some extent, an industry outsider (fresh views, independent reputation). To the extent possible, management decisions should be rule- based, and these rules should be spelled out.

13. Forms of commodity exchanges As a tool for physical trading, a commodity exchange should focus on the weaknesses and inefficiencies of the physical market. This implies that contracts and the focus of the exchange should be adapted to the particular needs of the economy. And its organization should reflect the needs and possibilities of its users as well as the economic environment. Just copying a foreign model is a recipe for failure. There can thus be different forms of commodity exchanges: - trading different kinds of contracts, - using different trading modalities.

14. Alternative kinds of commodity contracts An exchange is not limited to offering trade in forward or futures contracts. In an inefficient market, there are many other valuable services that a commodity exchange can offer. In particular:  An exchange could facilitate physical trade by guaranteeing parts of a commodity chain, supervising warehousing or inspection functions.  It could provide a trading forum where buyers and sellers can meet.  The latter function can be enhanced by the exchange by, for example, the provision of a guarantee on the logistics of trade; or by the facilitation of financing for the transaction  The exchange can play a role in the financing of agriculture. It should play this role automatically by its approval of warehouses, but it can also play a more active role, by trading warehouse receipts as underlying elements for financing deals (as part of repo transactions).

15. What services can a forward exchange provide? Some possibilities The exchange as meeting place SellerBuyer Contract Exchange Information on contract price Information on market prices Price transparency is already a major gain - farmers know how to use information.

16. What services can a forward exchange provide? Some possibilities The exchange as vetting mechanism (e.g., eBay) SellerBuyer Contract Exchange Information on contract price Information on market prices Database on reputable buyers and sellers Blacklist of unreliable counterparties Information on contract performance

17. EXCHANGE What services can a forward exchange provide? Some possibilities The exchange as regulatory framework, using contract law SellerBuyer Contract Membership requirements Rules and bye- laws Agreed quality standards Arbitration panel Note that banks can also become a member of the exchange and thus benefit of the same contract-based legal protection as other members - allowing them to provide finance without having to rely mostly on the country’s legal and regulatory framework. Some level of contract standardization

18. Any exchange should help to develop industry standards, arbitration panels, information systems and the like: Being one of the exchange members should be seen as a “mark of quality” by the industry - so, set up rules so that only “quality companies” can become member, agree on good “rules of behaviour”, and set up procedures to punish members who don’t follow these rules. The exchange members can then become an “island of excellence” in an otherwise difficult environment. E.g., banks could find it attractive to finance members because these have to adhere to the exchange bylaws, and in case of problems the bank has recourse to an industry arbitration panel and industry rules, rather than to the legal system. The exchange could even develop and help guarantee a warehouse receipt finance system. Particularly if exchange members can benefit of certain privileges (e.g., information bulletins, extension services, financing services) the risk of contract default is strongly reduced. The “regulatory framework” role can be an important one

19. What services can a forward exchange provide? Some possibilities The exchange as an auction place Seller Buyer Exchange- provided bidding floor (physical, electronic) Bids Buyer offer Order-matching Requires significant logistical skills

20. What services can a forward exchange provide? Some possibilities The exchange can reduce contract default risk SellerBuyer Contract Exchange 10% deposit If contract performance is fully satisfactory, the exchange pays back the deposits (the exchange, or an agent bank, can also handle the payment for the ultimate delivery). If there is a problem with contract performance, the exchange would investigate, and pay the security deposit of the “guilty party” to the other party. Problem: given the volatility of commodity prices, is 10% enough? Would 25% be? Given the costs of finance in the country, would this not make use of the exchange too expensive?

21. What services can a forward exchange provide? Some possibilities The exchange as clearing house to all transactions SellerBuyer 1. Agreement on contract Exchange clearing house The clearing house system guarantees that all traders will honor their obligations, as the clearing house adopts the role of buyer to every seller and seller to every buyer, thus eliminating the problem of trust. The clearing house acts like the central bank in the clearing of checks in a normal banking system. The clearing house therefore helps in boosting the depth of the market. 2. Exchange clearing house becomes automatically buyer of commodities 3. Exchange clearing house becomes automatically seller of commodities

22. The exchange as clearing house to all transactions (2) The clearing house, or department, manages its financial risks towards seller and buyer through margining. When the contract is initiated, both seller and buyer pay a margin deposit. SellerBuyer Clearing house Sale Margin deposit

23. The exchange as clearing house to all transactions (3) The clearing house then dynamically manages the margin accounts. Both buyer and seller need to maintain a certain margin, but this is adjusted as a function of the profitability of their position. E.g., if prices increase: SellerBuyer Clearing house Sale Margin deposit Additional margin payment Payment

24. The exchange as clearing house to all transactions (4) In practice, the clearing house collects margins from (and distributes margins to) clearing members (e.g., brokers), who in their turn manage customer margins. Broker Clearing house Sale Margin deposit Buyer Seller order Margin arrangement

25. What services can a forward exchange provide? Some possibilities The exchange as a facilitator of finance (1) A bank will consider that the likelihood of reimbursement of a loan is a function of: - the likelihood of the borrower producing > volume A. - the likelihood of the borrower realizing > price B - the likelihood that the borrower will use the money received to reimburse the loan. Contract farming Forward contracts Forward exchange

26. What services can a forward exchange provide? Some possibilities The exchange as a facilitator of finance (2) Seller Exchange- controlled warehouse 1. Seller deposits (part of) physical commodities into warehouse Exchange Bank 3. Finance 2. Assignment of collateral The finance package can remain in place until the seller sells the physical commodities; then, the financing could be transferred to the buyer - in other words, as long as the goods stay in an exchange- controlled warehouse, financing is automatic.

27. What services can a forward exchange provide? Some possibilities The exchange as a facilitator of finance (3) SellerBuyer 3. Sale (through exchange) 1. Instruction to use future receivables with priority for reimbursement of debt. Exchange Bank 2. Finance 5. Debt reimbursement 4. Payment This system has been implemented in an Asian B2B exchange. A seller puts his products into a warehouse approved by the B2B exchange. The offer is put on the web. The buyer, if successful, pays 20% of the value, and if he wishes, a bank that cooperates with the B2B exchange finances the remaining 80%, so that the seller can be paid at once. As long as the goods are in the warehouse, the finance remains in place. The bank relies on the creditworthiness of the B2B exchange and its clearinghouse - there is less work and less credit risk than when lending through individual loans to individual traders.

28. What services can a forward exchange provide? Some possibilities The exchange as a facilitator of finance (4) Agricultural or agro-industrial firm Recognized warehouse 1. Deposit of goods 2. Issuance of warehouse warrants Broker 3. Transfer of warrant, with the agreement to buy it back after a certain period National Agricultural Exchange Investor/bank 4. Warrant is given in custody of Exchange 5. Open outcry bids on the interest rate for loans secured by the warrant 6. Credit

29. What services can a forward exchange provide? Some possibilities The exchange as a facilitator of finance (5) Cattlemen BNA (exchange) Centralized Securities Deposit Trust Bank Investors Insurance US$ 150,000 bank guarantee (only for first issue, June 2000) Insurance against larceny and terrorism. Insurance value increases in line with price increase of animals. Assigned responsibility, as agents for the trust, for fattening of cattle, for 11 months. Transfer of ownership of young cattle and of pasture rights. Issuance of securities up to 75% of value of the cattle Selection of the regions, ranches and cattlemen suitable for inclusion in the securitization (security conditions, cattle experience, infrastructure, etc.) Technical supervisor Guarantee in case cattle fails to reach anticipated weight gain. Extension services Registration of the securities (which enables public trade) Marketing agent Sale of animals Buyers of fattened cattle Sales proceeds Fattened cattle

30. Why trade a forward contract? A farmer, processor or trader may sell a forward contract through an exchange for two different reasons: 1. He may want to be sure of having a buyer for a commodity that he thinks he will have at some time in the future. 2. He wants to manage his price risk between the moment of the sale of the forward contract, and the moment that he has the commodities available for delivery. He does not expect to deliver against the forward contract. It is crucial to know which of these two will form the main reasons for using the forward exchange, as it has important implications for the design of the exchange and its contracts.

31. Choices to be made when designing a forward contract Major choice: who is it for? Reality: a market which is just for one group (say, producers) will not work. Balance between different users is essential. Factors: size/quantity security deposits and margining specificity of contract qualities (wide/narrow range - reputation vs. inclusion) delivery rules.

32. Requirements for a viable forward exchange: 1. A network SellerBuyer Exchange Intermediary Information Order flow

33. Requirements for a viable forward exchange: 2. Rules & regulations SellerBuyer Exchange Intermediary Obligations with respect to mode of interaction with clients Access criteria and enforcement Arbitration panel Ability to impose financial sanctions and expel members All parties involved take a contractual obligation to follow exchange rules

34. Commodity exchanges trade individual contracts for specific quantities of physical or financial products. The contract can eventually be converted into physical product. There is no fixed number of contracts in circulation - each contract is created by a willing seller finding a willing buyer. Regulation of the two markets is therefore completely different. Some differences: - the ability to convert the contract into physical product to a large extent ensures fair contract pricing. Regulators therefore pay much attention to the proposed contract specifications for new contracts. - insider trading is legal in commodity markets. - the financial integrity of the exchange clearing house/department is of key importance, as it has to stand behind each contract. Government regulation: a commodity exchange is not a stock exchange

35. Conclusion An exchange is a tool to tackle the major weaknesses in the market. The exchange itself influences these weaknesses. Thus, an exchange has to reinvent itself continuously in order to remain relevant. There is a wide array of possible “value-added” functions of an exchange. Which ones would work depends on country conditions - an exchange and its contracts needs to be tailored to local conditions.