UNITED KINGDOM February 05 2015 2:36 PMTweet
SINGAPORE (Scrap Register): Singapore Exchange (SGX) and the CME Group together cleared almost 80 million tons of iron ore swaps, options and futures in January, making it the second highest trading volume month on record in spite of limited price volatility in the underlying physical market. As SGX celebrated another bumper month for traded volumes, the bourse also quietly reached another key liquidity milestone highlighting its central role in the burgeoning market for ferrous swaps, options and futures. Open interest across SGX’s iron ore contracts, arguably the key metric measuring depth of liquidity, finished the month above 100 million tons for the first time.
The exchange, which uses The Steel Index (TSI) price benchmark for 62% Fe iron ore fines shipped to China for cash settlement of its iron ore contracts, serves as the leading venue for price risk management for the global iron ore market. Since launch in 2009, the volume of derivatives traded on SGX and other offshore exchanges entering the market in later years, including the CME Group, has more than doubled annually. In 2014, almost 600 million tons of swaps, options and futures were cleared globally, equivalent to almost half of all seaborne physical trade worldwide, and two-thirds of Chinese imports.
The continued growth in this market has allayed early fears that liquidity may be insufficient to enable hedging on any large scale. Some had concerns that the arrival in 2013 on the scene of a physically-settled futures contract on China’s Dalian Commodities Exchange (DCE) would threaten liquidity on SGX. The new entrant was often portrayed in the media as a challenge to SGX’s market position, as vast pools of liquidity from domestic Chinese retail investors offered players the opportunity to hedge large positions without liquidity risk (albeit in Chinese yuan).
In reality, however, the two markets have existed - and indeed expanded - comfortably side-by-side, serving both distinct and sometimes overlapping client bases. Indeed, arbitrage opportunities between the two have been a boon to both markets.
Iron ore derivatives for hedging
Chinese iron ore imports of over 900 million tons per year are priced in US dollars, typically using price indices such as the TSI 62% Fe index CFR China port as used for SGX contract-settlement. This makes offshore exchanges like SGX the preferred choice for those offsetting US dollar risk for seaborne material – particularly when the same index is used in the physical pricing.
Unlike Chinese commodities futures, which tend to have extremely deep pools of liquidity centred on a limited number of tenors (contracts) reflecting seasons, liquidity on SGX and other offshore clearing venues is spread out along the forward curve as far as 2018. The deepest liquidity is found on the so-called “front months”, corresponding to the normal practice in the physical market of pricing off the index average of the month of cargo arrival – usually one or two months in the future.
Key to the usefulness of any derivative contract for hedging purposes is its convergence with the underlying market it represents. Whilst the iron ore futures traded in China on the Dalian Commodities Exchange (DCE) are settled by physical delivery, in practice only around 0.01% of all of these contracts go to settlement, sources familiar with the DCE contracts report. The overwhelming majority are closed out before expiry, as would be expected in a market with such a high degree of retail participation. Few participants on the Chinese exchanges have any corresponding physical exposure.
By contrast, trading on SGX is entirely by institutions and physical market users – a majority of which are also engaged in the physical iron ore market. SGX estimates that 60% of all participation is from Asian miners, mills and traders, and says around 15% of all contracts cleared by the Exchange are held by companies until the point of expiry. On DCE, despite the enormous volumes traded on a daily basis, open interest on its iron ore futures is relatively low and has actually been falling relative to that on SGX. In January 2015 SGX market share of total iron ore open interest increased to around 75%.
That is not, however, to doubt the relevance and success that DCE has had in shaping the global iron ore market. Growth on the contract has been extremely rapid, and daily traded volumes – even if liquidity is not “sticky” - are typically multiples of the physical market. Chinese buyers are also often exposed to positions on DCE, and the movement of these during the day can impact both sentiment and their buying behaviour in the spot market, as well as the offshore derivatives.
A vibrant secondary market also exists at China’s major ports where, once through customs, imported material is sold by traders in yuan with VAT applied, typically in smaller volumes supplied to mills on an ad-hoc basis. The DCE contract specification, also priced in yuan with added taxes, is often seen as better suited to this market. International iron ore traders able to access the Chinese market are also keen users of the DCE futures, but concede its use is largely limited to directional hedging.
In summary, off- and onshore derivatives, typified by the offerings of SGX and DCE, play largely different and complementary roles in the market – with SGX providing the key venue for hedging US$-denominated seaborne material and price formation, and carrying the majority of open interest, whilst DCE offers deep liquidity for intra-day trading and the opportunity to manage RMB-denominated port stocks price risk. After all, financial markets of this type are not a zero-sum game. There are, in theory, no limits to how large a derivatives market can grow and there is clearly still enormous potential in iron ore futures.