ComTech

The democratization of commodity hedging

By Tom Lawrence, Director, Flow&Ebb and Fraser McDonald, Commodity Risk Consultant, Flow&Ebb

Financial service’s automation revolution has not left the rolling fields of wheat and the deep mines of the commodities industry alone. Automated trading has been rapidly taking over markets . Mining companies are trying out autonomous trucks. Farmers in developing economies are getting access to digital selling solutions for the first time . Trust in the diamond supply chain is being bolstered by blockchains.

These first tentative steps are showing us just what is possible when we apply technology being developed elsewhere to commodities. Automation of both trading and the supply chain, the use of blockchains to bolster trust and replace traditional paperwork, and artificial intelligence systems to manage a company’s commodity buying and selling will transform how commodities flow globally.

This technological revolution focuses on making the commodities industry more efficient and secure. Indirectly this will benefit all of us. However, the focus is on the companies that are already connected to the commodities trade.

A major element that is missing from current commodities technology innovations is how to make the benefits of hedging against commodity price risk available to a much wider circle of businesses; businesses that in today’s world cannot hedge, but in the future world can.

This affects us all. Movements in commodity market prices affect us all. The processing of primary commodities like crude oil and cotton masks their prices to companies down the supply chain and end-consumers. But the price of these commodities has a substantial impact on the prices we pay for finished goods. Commodity prices will be a major or primary driver behind the cost of any manufactured good, food or transport service.

In a few exceptional cases — such as energy providers offering flexible pricing contracts — companies and end-consumers have the capability to hedge commodity prices. But in most commodity markets end-consumers and companies have no power to control commodity prices. Because of multiple barriers preventing these entities from engaging in commodity price risk management they are at the whim of market movements.

Price Risk Management Industry

There is a sophisticated, well-integrated and vast price control and risk management industry for commodities. One of the primary services that commodity exchanges offer is risk management. The London Metal Exchange, Shanghai Futures Exchange, Mumbai Commodities Exchange and Kansas City Board of Trade amongst many others allow companies with forward commodity needs to price fix those future requirements. This allows businesses a way to manage commodity prices independently of their suppliers (or customers).

As it currently stands there are two types of organizations that use these price risk tools. 1) Companies directly involved in the commodities trade like farmers, smelters, or refineries. 2) Very large corporations that are one or two steps away from the commodities trade, have very large indirect commodities consumption and can afford the costs associated with these tools.

Other companies can — and in certain industries do — use other options to manage price risk such as long-term supply contracts, non-standardized forward contracts or pass through agreements. However, in general the further away companies are from the primary production of commodities the less control they will have over commodity prices.

The more oligopolistic a stage in a supply chain is the less likely that companies further down the supply chain will be managing commodity prices through their suppliers. The more obfuscated commodity prices are as processing takes place the less likely companies that buy these processed goods will manage commodity prices. The smaller an end-user is the less likely they will be of engaging in independent commodity hedging on exchanges. The less funds a company can outlay to manage its commodities risk the less likely it will be of using futures or options to hedge.

Barriers

To understand the barriers organizations face when they look to manage commodity risk lets first look at the barriers faced from passing on commodity prices.

Let’s take a company that makes canned cold brew coffee for distribution in the UK. We’ll call them Cold ‘n Trendy. They are a new start-up and sell around 10,000 350ml cans a month to trendy coffee shops in and around London. The cold brew coffee trend has swept the UK and Cold ‘n Trendy is one of many start-ups selling cold brew coffee in a can. They buy aluminum and crude oil (for distribution) indirectly and coffee directly.

• For the aluminum cans they buy, their supplier is one of a few aluminum can rollers in Western Europe and they supply to thousands of small companies. Each month the can roller increases or decreases the cost of aluminum cans based on London Metal Exchange aluminum price changes. Cold ‘n Trendy cannot pass this change onto their customers

• For the distribution of their cold brew they pay for all the fuel a local delivery company uses. The delivery company allows Cold ‘n Trendy to fix the price for their fuel at a p/litre rate but only for 3 months ahead and only for the full fuel volume. This gives Cold ‘n Trendy some breathing room, but their costs are still at the mercy of crude oil markets. Cold ‘n Trendy cannot pass this change onto their customers.

• For their coffee Cold ‘n Trendy only buys Robusta coffee beans from Guatemala and Panama. Their supplier assures them that price changes are due to local supply and demand in Central America. Cold ‘n Trendy’s coffee buyer thinks the price they pay is influenced by the Robusta Coffee Futures market on the Intercontinental Exchange.

But their supplier does not break down their sales price to show what is driven by the futures market and what is driven by Central American coffee farming. Cold ‘n Trendy’s coffee supplier does not offer any price fixing service. Cold ‘n Trendy again cannot pass increases in coffee prices onto their customers.

The commodity futures exchange industry seemingly offers a solution for Cold ‘n Trendy. The company could forecast how much aluminum, crude oil and coffee it needs for the next few years and purchase commodity futures contracts to guarantee prices. Any losses it made on those futures contracts would cancel out to the gains it made from paying less for those commodities, and vice versa. This would provide Cold ‘n Trendy with a clear hedge. By doing this it would bypass trying to get better commodity price management tools from its suppliers.

Yet, when Cold ‘n Trendy tries to do just this it hits informational and access barriers:

  • Lack of access to commodity market prices
  • Lack of access to strategies and techniques on timing commodity market hedging
  • Lack of understanding of precise exposure to commodity markets
  • Forecast volumes too small for futures contract sizes
  • The business is too small for brokerages to deal with
  • Margin requirements too high
  • Specialist accounting practises needed

To better understand these barriers, we must understand that commodity exchanges are not geared to serve as many clients as possible. They developed and are structured to serve the interests of large scale commodity users.

This is not necessarily a conspiracy to keep out the greater public. Rather, prior to the information age only those companies which urgently needed to engage with the risk management functions of the exchanges invested the capital and time to do so. Wheat farmers have more reason to hedge annual crops than small bakers do to hedge their flour purchases for Halloween. A baker adds value and can absorb some market price fluctuation; the farmer produces the raw commodity and is totally exposed to market prices. As such, the way futures contracts were written and standardized was geared towards the legitimate users of the exchanges, not necessarily to serve the interests of all companies faced with commodity price risk.

Alongside this, the commodity futures exchanges fought a long battle with something called bucket shops in the second half of the 19th century and early 20th century. The result of this battle was acceptance of commodity futures exchanges as integral parts of the commodity trade via clientele discrimination. A purity test was needed to allow a company to trade futures which led to the restrictive commodity futures exchange ecosystem of brokerage firms and exchange members. Exclusivity legitimized the commodity futures trade as a necessary risk management tool, and delegitimized the more democratic bucket shop trade as mere gambling.

With the digitization of commodity markets — the movement on to electronic trading platforms — and the ease of accessing information there are no longer any physical barriers to people who want to engage in these markets. The above baker is now able to hedge and keep abreast of daily trading from the comfort of their own home. However, the structure of futures contracts and access to the exchanges remain mostly geared towards traditional market participants. And that makes hedging impossible for the smaller participants. So, let us further break down these barriers in more detail.

Lack of access to commodity market prices
Commodity markets are full of jargon. For someone outside of the field understanding this jargon and understanding what commodity prices they should look at is time consuming. With that knowledge they then need to seek out commodity market prices and other information about commodity markets. This in turn requires specialist knowledge.

Lack of access to strategies and techniques on timing commodity market hedging
Even with access to commodity market prices, timing commodity market hedging correctly is difficult. Someone who brews coffee for a living and deals with sales may not have the time or the training to do this properly.

Lack of understanding of exposure to commodity markets
There is a disconnect between the prices Cold ‘n Trendy pays for aluminium cans, delivery services and specialty coffee beans, and the prices for aluminum ingots, crude oil and commodity grade Robusta coffee. This disconnect creates confusion about exactly how the daily fluctuations of commodity markets impacts on a company’s costs. Larger businesses employ specialist staff to provide insight into these impacts.

The business is too small for brokerages to deal with
Companies access futures markets through brokerages. These brokerages are members of the commodity exchanges and earn income from trading commissions. To earn these commissions, they need their clients to pass through sufficient trading activity to warrant engaging with them. A small cold brew coffee is not going to have sufficient trading needs to warrant a brokerage opening an account with them.

Forecast volumes too small for futures contract sizes
Assuming Cold ‘n Trendy managed to gain an independent view on markets, became comfortable with timing hedges, gained a good understanding of their exposure and found a brokerage that would deal with them, their hedging requirements would be too small to fit current futures contracts. The company would use roughly 5.5 tonnes of coffee and 1.8 tonnes of aluminum a year. A single aluminum futures contract on the London Metal Exchange is 25 tonnes, one Robusta Coffee future is 10 tonnes. There is the option of Cold ‘n Trendy approaching a bank to create a special forward contract for less volume but the commission from this would be too small to warrant a bank’s interest. If Cold ‘n Trendy purchased a futures contract for 25 tonnes of aluminum to hedge 5.5 tonnes of aluminum it would leave itself open to a major financial loss if the aluminum market went the wrong way.

Margin requirements too high
For Cold ‘n Trendy to start purchasing futures contracts they’ll either need to buy them outright or buy them on margin. Almost always a company like Cold ‘n Trendy would buy futures on margin wherein they borrow money from a broker to buy the futures with the futures sitting as collateral. The purchaser pays a set amount defined by the commodity exchanges and the broker pays the remainder. On the one hand these margin requirements will tie up a large amount of Cold ‘n Trendy’s capital which may be in short supply being a small business. On the other hand, brokerages may not see Cold ‘n Trendy as being creditworthy enough to offer them capital for a margin.

Specialist accounting practises
If Cold ‘n Trendy purchased futures it will need to account for these futures on its books. It could either use normal accounting practises and make repeated general ledger entries accounting for the daily price fluctuations of the markets it has bought futures for. Or it could use a specialist accounting technique called hedge accounting. Both techniques require sufficiently more time and effort than the run-of-the-mill accounting practises a start-up would employ, and the latter requires specialist accounting skills.

Technological solutions
To bring the ease of hedging commodities on commodity exchanges to our cold brew coffee company we need to solve these problems.

These companies need tools to allow them to understand their exposure to commodity markets, to help them manage futures and options, and to choose the best time to hedge. The brokerage and commodity exchange ecosystem need to start seeing this wider pool of companies as a source of clients. That ecosystem needs help in making its processes more efficient and lowering its costs to do so.

From the perspective of companies looking to manage their commodity risk through hedging, technology can help them through software that does this. The software doesn’t need to be complex, but a few basic elements could provide companies with dramatically better clarity on their positions than they currently have. They could also provide companies with the specialist accounting and regulatory reporting tools:

• Build cost models that extract the commodity portion of their inputs
• Value that commodity portion against market prices
• Planning based on forecast and forward prices
• Track any hedges the company takes out
• Manage the lifecycle of those hedges
• Conduct hedge accounting processes
• Report on derivatives ownership to regulators

Currently legacy software exists in this space, but these were developed specifically for the commodity trading industry. They are also too expensive for smaller companies running at $100,000 to $500,000+ annually.

What would be more suitable is a cloud based system like the Sage or Xero accounting suites — they are designed for mass consumption and are priced accordingly. Small and medium sized companies need platforms that, whilst unlikely to be as cheap as Sage or Xero, are at a fraction of the of today’s commodity trading platforms.

This software would be built not for someone who specializes in the commodity trade, but for someone who runs a small to medium sized company’s books. A software package that comes with low cost of ownership but gives these companies the tools needed to manage their commodity risk is needed. What is not necessarily needed is the additional features of manage the storage and distribution of physical commodities which the more expensive legacy systems can do.

Forget about timing, or get a robot to do it for you
One of the most daunting aspects of commodity markets is timing them. The industry is rife with stories of panicked hedgers who locked out near the top of markets or indecisive hedgers who did not lock in at multi-year lows. This happens to professional commodity people, people who are employed to watch these markets daily. One of the services larger commodity brokerages have traditionally provided is a hedging recommendation to their clients. Even with a good understanding of what their exposure to commodity markets is, a small to medium sized company will find the task of hedging intimidating.

This raises the question of whether these companies should be looking to minimize their commodity input costs through timing the markets, or if they should be using markets to provide price certainty. Should they worry about buying at lows or should they be concerned with reducing the risks to their margins of large price movements of which commodities are prone?

If a company is looking to go do the former, then there needs to be a solution to the problem of not having the right skills and not having enough time to time the markets. Access to professional hedging recommendations services is relatively expensive. Small pieces of analysis on single commodity markets can run at thousands of dollars per month and still require expertise in deciphering them before they can be actioned upon.

What these companies need is a lower cost and more direct source of hedging recommendations. Developments in the artificial intelligence space look promising in this regard. We are starting to see AI being used by hedge funds . Algorithmic trading is already widespread throughout foreign exchange and commodity markets . It’s a natural next step for the hedging recommendation services of commodity brokerages and independent commodity analyst firms to be done more cheaply through machine learning.

The people who advise companies on when best to hedge tend to use industry standardized techniques such as the commodities supply and demand balance, inflow of investment into the commodities complex, geopolitical events and technical analysis. While not a simple task, it may be possible to develop machine learning systems which can offer analysis on these markets at a fraction of the cost of human analysts.

If a company was looking to do the latter, then the Sage or Xero like software packages mentioned above could be used to do so. As a core element of what that software did it would provide a forward planning tool for these companies to forecast their future costs at market prices.

Make hedging cheaper
The most difficult part of democratizing commodity risk management — thereby offering a solution to the small to medium companies like Cold ‘n Trendy — is amending the way commodity exchanges offer price risk management services to companies.

Making these changes will require a combination of desire to do so by the exchanges and provision of tools to do so through technology. Part of this process will be providing these companies with a clear understanding of their exposure via the previously mentioned technologies even if they do not immediately have a way to manage it, thereby increasing their demand for changes to commodity exchange offerings.

The increased demand from these companies for hedging tools from exchanges would go a long way to showing there is sufficient liquidity to support hedging tools aimed at a wider audience.

We’ll discuss here how technology can improve how the exchanges provide risk management services, but not how technology can change the exchanges desire to expand their clientele base. However, given that traditional commodity exchanges in Europe and North America are being threatened by new exchanges in India and China, which offer lower contract sizes and reduced commission rates, it’s likely that the traditional exchanges will move this way in time.

As mentioned there are three challenges for small to medium companies accessing these markets. Firstly, is the contract or lot sizes of futures contracts, secondly is the access to brokerage services, and thirdly is the margin requirements for holding these derivatives.

The first and second challenges are interrelated. The capital companies need to put up for the purchase of derivatives increases the larger the lot or contract sizes of those derivatives. Margin requirements are set as a percentage of owning a single contract, which is more expensive the higher the lot sizes. The larger lot sizes are, the easier they are for the exchanges to clear. It’s a simpler task to clear one ‘5,000 bushel’ futures contract than to clear fifty ‘100 bushel’ futures contracts. The exchanges are not against offering smaller sized futures contracts. Indeed mini-futures contracts are offered for some commodities, but they are not widely traded. Whilst the contracts are currently cleared electronically it remains easier for the exchanges to deal with fewer, larger contracts than smaller, more numerous contracts.

A potential technological solution to this would be the implementation of automated smart contracts in the futures markets. The cost of processing futures contracts may be significantly reduced and made more secure via the use of smart contract technology . This may allow exchanges to implement reduced futures contract sizes but they would need to implement the technology using the existing contract sizes first to become comfortable with them.

The second challenge comes down to changing the commodity brokerage system. This can be partly achieved via technology lowering brokerages costs, but it must be partly achieved by commodity exchanges adjusting the way they work with brokerages and approve of how brokerage services are offered. In other asset classes, like equities and foreign exchange, brokerage costs have been steadily eroded in recent years as the role of brokers changes from providing a face-to-face service to providing a digital route to market.

The commodity brokerage fields need to ultimately move towards a digitization and automation of their services. This will help a wider range of companies to manage their price risk, but it may also be necessary for the industry to survive given falling revenues and competition from exchanges in developing markets.

This change can be done easily by implementing existing technologies developed in the equities and foreign exchange brokerage fields. There are, however, a unique types of commodity brokerage services, such as the exchange-for-physical process, that need to be implemented digitally, but this is not a technically impossible process. Making services digital would lower running costs and increase security. If — or rather when — commodity futures contracts go onto the blockchain, commodity brokerage services may simply end up being private blockchains talking to public exchange blockchains.

This does leave the pressing question of smaller to medium sized companies not being sufficiently creditworthy enough to open accounts with these brokers. Again, here technology can help. If these brokerages continue to offer credit to these new, smaller clients with lower trading volumes then they would essentially be entering the world of microfinance. FinTech technologies can provide these brokerages with better, and cheaper ways of understanding the creditworthiness of their clients . This is if other offer solutions to the problem of creditworthiness checks for brokerages are not developed through FinTech.

Final Thoughts

In a few years we could exist in a world where technological change has fundamentally altered how small to medium sized companies manage their commodity risk. Relatively low-cost software systems will allow them to fully understand their exposure and build cost models. The software will also track their hedging activity securely. It will autonomously conduct all necessary accounting and regulatory reporting. Indeed, having this software would be as natural to these companies as having a subscription to Sage or Microsoft Office.

These companies would have cost effective ways of managing their commodity risk through granular futures contracts offered by exchanges. They would do so digitally through low cost commodity brokerages, which in turn run private blockchains and are securely and efficiently linked into global commodity exchange blockchains. Those commodity exchanges will be able to clear vast quantities of micro futures and options contracts using automated smart contracts.

This process could integrate seamlessly into a primary commodities industry which operates using AI trading systems, autonomous farming and mining operations and distributed trustless blockchains, tracking each bushel of corn or shovel full of iron ore from field or mine through the processing chain to delivery at a consumer’s door.

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