On commodity derivatives and the Norwegian initiatives to create a fish derivatives market.

• Author: Gronvik, Gunnvald
• Position: Company overview

Hedging against future price movements can be important both for those producing goods and for those buying them. Commodity derivatives may be employed as a hedge against price risk, and this is one of the reasons behind several initiatives to establish fish derivatives markets in Norway. This article discusses the general terms for establishing commodity derivatives markets. There is seldom more than one derivatives market for a commodity. The success of a Norwegian fish derivatives market will depend on global competition between such marketplaces, and this competition will determine whether and what type of initiative that will succeed.

Norwegian (and European) legislation for commodity derivatives appears to be adequate. The markets are well organised and Norwegian legislation ensures that transactions involving standardised products are settled in a clearing house and that netting rules apply. This contributes to ensuring financial security in the commodity derivatives markets. The market positions held by financial institutions are otherwise too small to threaten general financial stability.

1. Introduction

   During the past decade, power and freight derivatives markets have developed in Norway and efforts are currently underway to establish a salmon derivatives market. All of these markets are based on the participation of buyers and sellers in many countries. Authorities worldwide are increasingly focusing attention on commodity derivatives markets. In the 1997 Tokyo Communique, supervisory bodies from 18 countries recommended standards for the regulation and supervision of commodity derivatives markets. The Markets in Financial Instruments Directive (1) provided the EEA countries with a common standard for regulating these markets (which is in accordance with the Tokyo Communique). In Norway, the Directive was implemented through a new Act on securities trading which came into effect in the latter part of 2007. As a basis for discussing such markets, it may be useful to explain how these markets function.

   A derivative is a contract to buy and/or sell an asset at a predetermined date at a price determined at the contract date. The asset to be delivered is called the under(ring asset for the derivative or simply the underlying. Goods and services are the assets underlying commodity derivatives, whereas other financial instruments or foreign currency are the assets underlying financial derivatives. In principle, the derivative's underlying asset should be delivered, but most derivatives markets today only involve a financial settlement. In cases where physical settlement of the underlying asset is required, the market usually provides a delivery facility so that purely financial investors can also participate in the market for the purpose of hedging price risk or speculation.

   In derivatives markets, the most common types of forward contracts are futures and forwards. The most important difference between futures and forwards is how the contracts are settled. Both contracts involve a future purchase where the price, quantity and quality of goods and the time and place of delivery are predetermined. The value of a futures contract is set daily at market value and buyers and sellers are credited or debited daily in relation to the changes in value. In a forward contract, the entire settlement takes place when the contract matures.

   We also differentiate between derivatives that are traded directly in an organised market (exchange traded) and over-the-counter (OTC) derivatives. When derivatives are traded in organised markets, the product is fully specified. The contracts traded are the same size, the maturity date is the same, and counterparty risk is eliminated since all transactions go through a clearing house which is the central counterparty, etc. This may be compared to the purchase of off-the-shelf items in a supermarket (e.g. 1 kg of sugar). With an OTC transaction, the product can be specially adapted just as the grocer can customise a product to our wishes when we go to the cheese counter and ask for a centre-cut, medium-sized piece of Gouda. The market participants offering OTC contracts are usually brokers, and trading directly in the organised market where they can reduce the risk of their OTC transactions is often an element of their risk management. Therefore, successful marketplaces for commodity derivatives often live in symbiosis with brokers dealing in OTC contracts.

   When a clearing house participates in a transaction as central counterparty, it acts as an intermediary between the buyer and seller. Both parties sign contracts with the central counterparty rather than with each other. In this way, all market participants only have counterparty risk in relation to the clearing house. The clearing house performs this service for a small fee but also demands collateral for its activities either in the form of a daily margin payment in accordance with the contract's daily price movements or a guarantee which covers the maximum loss on the portfolio of contracts held by the market participant.

   Central banks focus most heavily on financial derivatives and in particular exchange rate and interest rate derivatives. These are clearly the largest derivatives markets and are also the markets that can have the most substantial impact on central bank activities in the areas of monetary policy and financial stability. Nevertheless, there is also considerable activity in the area of equity derivatives and credit derivatives. The standard of good practice for central counterparties involved in securities trading, which has been developed by central banks, the Basel Committee on Banking Supervision and supervisory authorities, also applies to clearing houses involved in commodity derivatives trading, cf. CPSS (2004).

   Internationally, there is a large group of derivatives whose underlying assets are commodity prices. Contracts similar to today's commodity derivatives contracts were first traded in the 1100s. The first organised derivatives markets where the underlying assets were agricultural products appeared around 1850. The market participants included farmers and their sales cooperatives (future sellers) and the food and canning industry (future buyers). For both parties, security surrounding future prices had an independent value - the farmers increased the security of payment for seed grain and fertilizer while the canning industry increased the security of its pricing strategy and sales efforts. Commodity derivatives markets provide a hedge against unfavourable price movements and this has an independent value for both parties. Consequently, the transaction is more than a zero-sum game. The value of this hedge depends on the extent of the commodity's price fluctuations.

   Markets have developed in pace with demand, and at present there are global commodity derivatives markets with a range of underlying commodities. One large group of underlying commodities is agricultural products (grain, coffee, beef, food oil, orange juice, etc). Another group is metal and semi-finished goods (aluminium, copper, rubber, etc,). The group of underlying that receives most attention in Norway is energy products (crude oil, electricity). A number of indices (credit risk, equity indices, freight indices in shipping) are also used as the underlying. Some of these index products are naturally classified together with financial derivatives.

2. On the development of new commodity derivatives markets

   In addition to the traditional commodity derivatives markets, new markets are also being developed. There was little knowledge of commodity derivatives markets in Norway before the liberalisation of the electricity markets through a new Energy Act. In 1995, Nord Pool established a financial market for derivatives based on wholesale electricity prices. The market for hedging energy price risk (2) is now well established and is regulated by changes made in the Securities Trading Act in 2001. (3) A Norwegian marketplace for shipping freight derivatives, Imarex, was established in 2000.

   Both of these markets have experienced dramatic events.

   * There was a dramatic increase in electricity forward contracts, considerable need for hedging and particularly extensive trading on Nord Pool at the end of April 1999. Because price movements were abnormally volatile, Nord Pool increased margin requirements and accepted wider deviations between the market makers' bid and offer prices. Nevertheless, one of the market makers reneged on his obligations. The others continued their activity and thus the market continued to function so that it was still possible to hedge price risk. (4)

   * A Greek market participant with substantial positions on Imarex went bankrupt and could not meet his obligations to NOS Clearing in June/July 2004. The loss amounted to nearly NOK 60 million and led to a critical situation for NOS. The Financial Supervisory Authority of Norway (hereafter FSA Norway) demanded the introduction of measures to improve financial strength. The owners also recognised the need to improve the company's capital backing. Early in 2005, a new share issue raised nearly NOK 65 million. Subsequently, the activities of Imarex and NOS Clearing ASA could continue. (5)

   It appears now that both Nord Pool's power derivatives market and Imarex's shipping freight derivatives market are securely established.

   At present, there are several initiatives to establish a...