Commodity derivatives listed on various exchanges around the world are mostly denominated in the national currency of the exchange’s location. The relative lack of non-native currency denominated commodity derivatives creates an unfulfilled demand, forcing consumers and producers to turn to financial intermediaries, such as banks, for their services. The transaction support provided by these banks results in a greater cost that is passed on to the consumer. In such a scenario the financial intermediary arguably bears the least amount of risk with the greatest return and creates a drain on consumer surplus. I would like to make a case for how the exchanges themselves could innovatively preserve this surplus.

The Problem To illustrate the dilemma, let us focus on two exchanges and one single product. Consider the case of soyabean listed on both the Chicago Board of Trade (hereafter called CBOT) in the US and the Dalian Commodity Exchange (hereafter called DCE) in China. China is a large importer of soyabean, while the US is a large exporter of the bean. In a typical contract of sale of soyabean from the US to China, the pricing is fixed in $. Once soyabean consignments arrive in China, they are processed and revenues are collected in Chinese yuan. Thus, importers in China by the nature of its business are long yuan and short $. To add realistic complexity to the case, the importer hedges purchases on CBOT (short futures) and hedges sales in China on DCE (long futures).

Now, consider a case where the soyabean market goes up, such as this year, and the importer incurs a margin call on CBOT and has margin excess on DCE (given that CBOT and DCE have positive correlation they have the same directional move). In such a situation, the importer not only cannot offset the cash position but also has to increase the working capital needs in $, increasing funding costs. For the sake of simplicity, I am ignoring certain additional risks associated with the interest rate differential, which could potentially affect the cash position as well.

Current Solution To overcome the above common problem, the importer can either dig into his/her $ wallet (assuming, again, he/she has a long cash position) or reach out to a financial intermediary and pay a spread to overcome mismatch of funding and currency risk associated with the business. The resulting increased cost of business eventually is borne by the consumer (or reduced shareholder value of the firm), creating a drain on consumer surplus.

Exchange-Based Solution My prognosis of this problem can be addressed by the commodity exchange itself. An exchange already has a mechanism to settle cash positions everyday. If the exchange can offer instruments in different (non-native) currencies, then a market participant can choose to avoid some or all of the transaction costs discussed above. In this particular case, DCE could theoretically offer a look-alike product of CBOT, settled in dollar. This type of product would help the importer to fix prices of purchases, while avoiding funding issues and transactional costs. DCE can settle both the yuan and the $ listed products in yuan at the end of the day. The importer would thus be enabled to have a single cash position in his/her home currency of yuan despite having purchases made in $ and revenues earned in yuan.

The benefits of this solution are multi-fold: lower transaction costs for the market participant; lesser documentation; centralised operations and regulations at the exchange level; greater integration between currency and commodity pricing and improved transparency in pricing of commodities in non-native currencies.

If more exchanges can provide the ability to price commodities in non-native currencies, I think a big burden currently borne by the treasury departments of large commodity trading firms will be lifted.

The writer is based in New York and is the founder and Managing Director of Opalcrest (www.opalcrest.com).

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