Such bourses can bridge the gap commodity futures are unable to fill

The decade that went by saw increased interest in commodities as an asset class. Most of these investments were made in liquid exchange-listed derivatives. We witnessed the blossoming of new exchanges and product listings from South Africa to Sao Paulo. All of these exchanges have vied singularly for a greater transactional flow that has prompted them to launch newer products. The conventional belief is that futures and cash markets converge on expiry of the contract; hence a futures exchange should in theory reflect the cash fundamentals of the listed commodity. This is seldom true, and more often speculator interest (with or without empirical evidence) is blamed to be the cause of a convergence distortion.

The difference between the cash price and futures price of a commodity is referred to as Basis. To illustrate, let us take a simple example of gasoil (diesel) contract. Let us assume that the price of March gasoil futures of gasoil is $900/tonne in New York and the March cash price of gasoil in Osaka is $940/t; then Osaka’s basis would be +40 (cash price less futures price), with respect to New York Gasoil Futures prices. We know many of these commodities are produced and consumed at different locations around the world and such distances cause prices to be different. (Price differences arise from logistics, foreign exchange rates, time value, and duties among many other variables).

I believe that there is a strong need for a basis exchange, which can fill the aforementioned gap left by futures exchanges in commodities. I shall focus on the needs for basis exchanges.

The first reason is lower capital allocation for trading/hedging. A basis exchange will list just the basis price and not the underlying commodity price. Taking the example of gasoil from above, if the contract (assuming the contract size of 100 tonnes) was traded in Osaka on a basis exchange, the capital allocation would be 100x40 = $4,000 instead of 100x940 = $94,000.) Thus from a working capital standpoint, a basis exchange benefits the participants on the exchange. Only upon the fixing of the price, the principal of $94,000 needs to get allocated.

The second reason is lower volatility exposure for the exchange participants. Basis is usually less volatile than the underlying commodity price itself. This will ensure that participants are not subject to large margin requirements by the exchange. The exchange will also benefit from a great transaction flow as participants would be entering and exiting trades in tandem with their physical/cash businesses.

The third reason is lower market and credit risk. The commodity market generally trades in basis. Most of the long-term sale/purchase agreements and financing are done on basis. This ensures that while the volume agreements are in place, counterparties do not take on additional credit risk on their books. A basis hedge will remove the smallest market risk associated with such long-term deals. To give an example, assume a Firm A buys commodity on a basis agreement from Firm B, price to be fixed in 12 months from now, and then sells the same basis risk back on the exchange. In such an instance, the only risk Firm A has on its books will be the credit risk differential between the Firm B and the exchange, which will be much smaller than the credit risk associated with a normal purchase agreement between Firm A and Firm B.

Finally, a basis exchange benefits market participants from the around the world and reflects their needs. Currently, the futures exchanges cater to participants either with a location advantage or a capital advantage. A basis exchange caters to a greater number of participants and drives out some of the information advantages (or disadvantages) pre existent in the current commodity markets. This would help match the basis risk of a producer from Sao Paulo with a consumer in Shanghai.

The writer is based in New York and is the founder and Managing Director of Opalcrest

(This article was published on February 5, 2014)
XThese are links to The Hindu Business Line suggested by Outbrain, which may or may not be relevant to the other content on this page. You can read Outbrain's privacy and cookie policy here.