The role of commodity brokers and futures exchanges in commodity risk management

Part of the value of a good broker is that he will provide not only information about prices and deals, but snippets of gossip about who is doing what – and why. Traders are always focused on supply and demand aspects of physical commodities in which they trade and as well as the larger macro-economic picture, so it is important to assess what other competitors, are doing in the market. Some brokers are providing a lot of value-added service in providing not just price information – but offering lots of ideas – on the economic backdrop, current and future price trends, etc. Whether brokers are futures brokers or deal in physical transactions, the tendency has been for many of them to become principals. Traders can be skeptical about the information given by brokers, particularly if they feel it has been influenced by the broker’s own relationship with another position taker – either inside his own group, or elsewhere. However, since brokers are largely looking to commission as a way of earning money for the company – and their own commissions, this may be a somewhat churlish position to take. Nonetheless, brokers play a key role in augmenting price transparency alongside the international and domestic commodity exchanges.

The principle role of exchanges is to regulate and control futures and derivatives trading through a membership system. Commodity futures date back to the trading of rice futures in Japan in the 1600’s – but the underlying principles of commodity futures go back a long way further. Commodity markets have been around for some thousands of years and the degree of their formality has been dependent on the political, social and economic environment prevailing at the time.

The trading of futures is relied upon these days by producers, traders and speculators, and high volumes of transactions on the major exchanges illustrate both the size of their role and the level of influence they have on the market in general. Futures markets help overcome difficult challenges faced in balancing supply and demand and exchange products. Derivatives, futures and options provide several economic benefits, including primarily the provision to mitigate the inevitable risk of price volatility. Since the 1990’s, in an environment of liberalization and following the collapse of many commodity boards in Africa, the role of exchanges has been enhanced.

The presence of exchanges and the development of futures and options markets have influenced the development of the commodity swap market. At present, although the commodity swap market is very small in comparison with the currency swap market, it is growing. For comparison, there was an amount outstanding of 598 billion US$ for commodity derivates in December 2001 by comparison with 69 trillion US$ in the interest-rate and currency swap market at the end of the same period. Most of the commodity swap transactions were for OTC contracts – about 40% according to the Bank of International Settlements.

In recent years, we have seen the growth of existing exchanges and the emergence of new ones. There are major commodity futures exchanges in over 20 countries, including Australia, Brazil, France, Germany, Japan, Korea, Singapore, US and UK. A large number of new exchanges were created during the past decade in developing countries; not all of them have progressed to the level of futures trading, and many have rapidly disappeared again.