Exchanges Involved In Commodity Market

8.1.Introduction to Derivatives Exchanges

A commodity exchange is an organized physical or virtual marketplace where various tradable securities, commodities and derivatives are sold and bought. Commodity derivatives exchanges are places where trading of commodity futures and options contracts are conducted.

What were the historical reasons behind setting up commodity exchanges worldwide?

Contrary to popular perception, commodity derivatives are not a new phenomenon. 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 rationale was reduction of transaction costs as well as organizing a marketplace where buyers and sellers could find a ready market.

8.2.How does a commodity derivatives exchange function

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.
• Providing a dispute settlement mechanism.
• Designing the standardized contract for trading which cannot be modified by either parties

Ideally, a commodity derivatives exchange needs to provide a seamless trading platform with a fair, transparent and financially secure trading environment in keeping with the robust risk management practices. It should have a suitable risk management mechanism, normally in the form of a clearing house 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 exchange should also maintain a Settlement Guarantee Fund (SGF) to ensure a high level of protection against the risk of default by a trader. Importantly, 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  in the form of cash or securities. The margin money fluctuates 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 asked to increase their margin amount (‘margin call’).

8.3.What is the role of exchange in future trade?

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 modified by the either party. The exchange then provides a seamless trading platform and competitive trading as well as facilities for clearing, settlement, and arbitration. Above all, the exchange guarantees a financially secure environment for risk management and guaranteed performance of contract

8.4.How are futures prices on the exchange determined?

In theory, the future prices are determined by the forces of demand and supply for a particular commodity in any market. The price rises if purchase volumes outnumber sales volumes, and vice versa. The bargaining 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, such as expectations about the quality of harvests, the trading by market players ,weather, consumption patterns and global macroeconomic or geo-political factors. The way exchange trading is conducted is also influenced by the domestic regulatory regime. In practice, futures prices can also be influenced by buying and selling by speculators when they engage in excessive speculative trading that is unrelated to the physical market

The actual bargaining and trading on an exchange can be conducted with traders meeting physically or through computerized communication. Open outcry is a vanishing method that involves verbal price offers as well as hand signals made by traders to convey trading information on the trading floors of the exchange building. A contract is made when one trader cries out that he wants to sell at a certain price and another trader responds that he will buy at that same price. Most exchanges now use electronic trading systems instead of open outcry, as it reduces costs and improves the speed of trade execution. Nowadays big traders use sophisticated tools such as algorithmic trading for trading in commodity futures, and individuals often use mobile phones for placing orders. As a result, trading in commodity futures around the globe has now become more sophisticated, convenient and quicker than in the past.