Commodity derivative markets are organized in two basic ways: exchange traded products and over the counter (OTC) products.
When you think of commodity derivative markets, you probably think of the CME Group, the London Metal Exchange, and the Intercontinental Exchange. These exchanges have a defined physical location and provide trading and risk management products around the world. These products vary but can include futures, options, and swaps. Several years ago, the exchanges provided price discovery in the form of trading pits where bids and offers were relayed to the trading floor and deals were executed. This still happens on a few exchanges, but the vast majority have moved to electronic platforms. When you place an order on an exchange, you are matched with a buyer or seller who is taking the opposite position you intend to execute. Your counterparty in this transaction is the exchange and is responsible to “live up” to their end of the deal. Exchanges aggregate market participants and allow for efficient price discovery. Exchange traded products are standardized and have set rules and regulations to participate.
Benefits of Exchange Traded Products
- Price Discovery Transparency – Exchanges provide transparent price discovery driven by buyers and sellers. Market participants have access to volumes, tenor, and price of bids and offers.
- Transparent Fees and Expenses – Exchanges post fee schedules by product. Fees and expenses are clearly labeled on account statements.
- Reduced Counterparty Risk – When the products traded are “cleared” or matched. The exchange becomes the counterparty to both sides of the trade. This can lower your counterparty risk of performance.
- Standardized Products – Quantity, tenor, product, and terms are all standardized based on product and underlying commodity.
Limitations of Exchange Traded Products
- Margin requirements must be met to transact. If the market moves adversely to your position, you must post additional margin or risk forfeiting your position.
- Standardized Products – If you are a bona fide hedger, chances are you transact in the physical market outside the scope of standardized quantities. Hedging on exchange generally requires you to be under or over hedged when your physical positions don’t match the financial product 1 to 1.
- Limits – The Futures Commission Merchant (FCM) that holds your account may impose boundaries and limits on tenor and size of positions held in your account based on exchange rules and internal policies.
- Liquidity – Generally, exchange traded commodity products offer excellent liquidity. However, in developing markets such as steel derivatives, sufficient liquidity may not exist to transact. This can sometimes be overcome by using an Interdealer Broker.
Over the Counter Markets
The Over the Counter Market (OTC) trades through a decentralized network of entities. Market participants work through a network of dealers to access products and negotiate price and terms. When working with an OTC counterparty, industrial participants generally work under two types of agreements, either a Terms of Business (TOB) agreement or an ISDA (International Swaps and Derivatives Association) Agreement. TOB’s are generally standardized agreements with very little room for negotiation. ISDA’s can be negotiated to meet the needs and structure of all participants. Trading OTC allows the buyer or seller to go beyond the standardized products offered by the exchanges to provide greater flexibility. However, they can be opaque, as details of the transaction are not generally required to be disclosed to other market participants.
Benefits of Over the Counter Products
- Customizable – Every feature of a product can be negotiated and customized to fit different risk profiles and business needs.
- Margin and Credit Financing – Depending on your company balance sheet, you may be able to take advantage of initial and variation margin financing.
- Lower Margin Requirements – For OTC products, dealers aren’t required to follow exchange rules for initial and variation margin. Depending on creditworthiness, industrials may be able to negotiate lower margin requirements.
- Liquidity – OTC dealers are free to extend products and positions beyond the limits of exchange rules on a case by case basis. Careful consideration should be made when deciding to enter into such a transaction, as you may be adding other risks you have not accounted for.
Limitations of Over the Counter Products
- Counterparty Risk – When you trade OTC, you are subject to the creditworthiness of your counterparty to fulfill the terms of the agreement. If the financial health of your counterparty or if the market, as a whole, come into question, market liquidity can disappear and lead to disorderly function of the market.
- Market Opaqueness – You generally have a less defined view of what you are paying in commission/mark-up, cost of credit, and other financial considerations in a transaction.
- Cost of Exiting a Position – Exiting an OTC position is usually defined in the OTC contract. However, if you need to exit a position at a different time than originally planned, you can be at the mercy of your counterparty to receive a fair price and terms.
About Nexidus Commodities, LLC
Nexidus Commodities provides commodity hedging, risk management, and analytical services to a large range of industries. Our mission is to provide clarity, direction, and strategy to better manage commodity price volatility that exists on an ongoing basis. We review our clients existing hedging strategies to identify gaps and improvements. Nexidus offers a full range of services including one-time consultations, analytics and reporting, risk management planning, as well as a fully outsourced hedging solution that executes on behalf of our client’s requirements and goals. www.nexidus.net
This communication is not a solicitation to buy or sell derivative instruments. The trading of derivatives such as futures, options, and swaps may not be suitable for all investors. Derivative trading involves substantial risk of loss, and you should fully understand those risks prior to trading. Past financial results are not necessarily indicative of future performance. Nexidus Commodities, LLC is a member of the National Futures Association (NFA) and registered with the Commodity Futures Trading Commission (CFTC) as a Commodity Trading Advisor. Certain Nexidus services are available only to individuals or firms who qualify under CFTC rules as a ‘Qualified Eligible Participant’ (QEP) and who have been accepted as customers of Nexidus.