Commodity Trading
Commodity
Commodities, simply defined, are things of value and of uniform quality that are produced in large quantities by many different producers; different items from different producers are considered equivalent in quality.
Futures Contract
This is a contract between a buyer and seller, whereby the buyer is obligated to take delivery and the seller is obligated to provide future delivery of a fixed amount of a commodity at a predetermined price at a specified location and time. Futures contracts are most often liquidated prior to the delivery date and are more often used as a financial risk management and investment tool rather than for price hedging. These contracts are traded exclusively on regulated exchanges and are settled daily based on their current value in the marketplace. A contract traded off the exchange, also known as an over-the-counter transaction, is referred to as a forward contract. In contrast to a Forward contract, a futures contract requires initial margin to be paid by the buyer to the seller when a trade is executed. Specifications, such as quality and delivery date, for futures are standardised, while a forward contract can be unique for each contract based on the client’s requirement.
Physical vs. Financial Futures
Settlement is the official closing of a futures contract. It can be done in one of two ways, through physical delivery or cash settlement. When a contract expires and a cash payment is made based on the settlement price, that is cash settlement. Physical delivery is settled by the actual commodity, meaning the buyer will be able to pick up the commodity as specified in the futures contract.
Types of commodities
There are many types of commodities products available for trade in the market, both on-exchange and via OTC. These products include:
- Precious Metals – Gold, Silver, Platinum; Palladium
- Base Metals – Aluminium, Copper
- Energy – Petroleum products, Natural Gas, Electricity, Coal
- Plastics – polypropylene
- Environmental Commodities – Carbon Emission
- Agricultural Commodities – Sugar, Wheat, Corn, Cotton
Contract design
Product development
A well-planned contract will increase the liquidity of the commodity, particularly in the context when contracts currently available to market participants do not adequately address users’ risk and hedge exposure. HKMEx will introduce tailor-made contracts catering to end user demand that will enable traders, investors and industry to hedge commodities price risks in a fair and transparent manner. Product development is conducted in three phases: Origination, Analysis and Execution.
A. Product Concept Generation
Deep understanding of both commodities market trends and the needs of trading members is key to sourcing new products. The Product Development division is responsible for conducting detailed market analysis and collaborates with leading industry experts to identify potential underserved markets. The product team will continuously review the performance of existing products to analyze their strengths and weaknesses. To improve liquidity and volumes, we will perform extensive independent research and seek feedback from trading members to introduce or modify product features to enhance the attractiveness and liquidity of HKMEx contracts. This approach is critical, as some of the world’s deepest liquidity products require multiple iterations before becoming global benchmark contracts.
B. Product Analysis
To determine the viability and market potential of a new product, Product Development team reviews several key factors. These factors include the particular commodity demand in region, the existence and vitality of a spot/cash market and the existence and vitality of an OTC market. In general, gaps in any of the factors above may present a market opportunity. The product development team critically analyzes the overall market size, current and expected competition, demand level from members, key specifications, delivery points as required and projected revenue opportunity to determine the viability of any potential product.
C. Final Product Development
Once a product is determined to be attractive for launch, the product development team produces a detailed timetable for development which highlights the key milestones required to launch a new product. Product specifications are developed with end users in mind and require input from a focus group of key members who would likely be the most active traders of the new product.
D. Product Marketing
The completion of a product design is the beginning of its appearance to the financial market. The marketing division will produce a marketing plan to promote the product launch. These activities include, among others, face-to-face meetings with the financial community who will participate in the trading of this product; roadshows to introduce this product to different target audiences; meeting with major industry players to gauge their buy-in on this product; education tutorials and media activities to increase the exposure of this product to the financial community and public.
E. Post-Implementation Product Feedback
Further the marketing efforts, the Product Development team will gather feedback from users on the contract specifications and trading & delivery features, internal feedback via MIS and regulator reports and monitor market indicators through trading volume, open interest and so on. This information will help the Exchange to further polish its product offerings and services.
Market participants who trades futures
End Users: As the natural buyers and sellers of commodities products, end users are the ultimate drivers of commodities volumes. The trading of commodities and associated futures and options contracts are fundamental to the business operations of the end users. These groups may connect directly to an exchange but often execute transactions through agents such as investment banks or futures brokers. We are focused on developing products designed for the end user who will in turn drive trading volumes through the members of the Exchange.
Industrial Users: Industrial users are continuously subject to risk, as they are unable to produce their core products without commodities. Refineries are wholly dependent on the price and delivery of crude oil or fuel oil to produce petroleum products such as gasoline and diesel fuel. Airlines rely on jet fuel to operate, while shipping firms depend on bunker fuel. In addition, manufacturers such as technology companies often rely on a range of commodities including precious and semi-precious metals. Industrial users are a fundamental contributor to trading liquidity.
Professional Traders: Professional traders represent a broad range of asset managers including institutional investors, pension funds, university endowments, hedge funds and algorithmic traders. These asset managers employ a broad range of trading strategies in the commodities and futures markets to earn investment returns. Professional traders represent significant assets under management and are a major source of liquidity. There are many professional traders throughout Asia, and many are based in and operating in Hong Kong, China and Taiwan.
Swaps Traders: The swaps desks of investment banks use commodity prices to create structured products such as commodity swaps that are in turn marketed to commodity users and producers. Since most swaps are traded OTC, swaps traders have a natural demand to hedge OTC swaps using futures contracts traded on an exchange. HKMEx will establish benchmark commodities pricing in Asia which in turn will drive hedging demand in the swaps market.
Arbitrageurs: Arbitrage traders seek to identify price dislocations between multiple markets. Arbitrageurs will be attracted to execute transactions on HKMEx because of the price discovery of significant commodities throughout Asia. The easy currency convertibility of our US dollar-denominated products will be another attraction to these traders.
High Net Worth Individuals: High net worth individuals have significant investable assets and are generally clients of private banks and investment banks. Asia, in particular Hong Kong and China, is home to a large and fast-growing population of high net worth individuals who are seeking investment diversification.
Members
Potential members are drawn from the critical commodities and trading participants in the region and around the world. We are targeting a diverse group of membership segments: China Majors, Regional Brokers, International Majors, Global Futures Brokers, Global Financial Institutions, Physical Commodities Traders and Market Makers. Each segment brings unique trading styles and goals for participating on the Exchange, and we have already had multiple discussions with the majority of these potential members.
China Majors: Leading Chinese producers and users play a major role in the commodities markets. In general, China’s demand for commodities has led the China Majors to presently become net buyers of commodities. These firms do not have access to international price discovery with proximity to China and are required to hedge imperfectly on international exchanges. HKMEx will mitigate these issues faced by the China Majors by providing China tailored international price discovery to support an alternative hedging platform while minimizing counterparty risk.
Regional Brokers: Hong Kong has a vibrant trading community that is home to Regional Brokers serving the needs of local customers. Qualified local investors may have significant demand for investing in and trading of commodities and would conduct business through these Regional Brokers. These end users may employ a range of investment strategies from day trading to speculation. HKMEx will offer new products for Regional Brokers to market to qualified local customers while providing access to a new avenue for these local customers to diversify their investment portfolios.
International Majors: The leading international producers and users of commodities play a major role in these markets. In general, China’s demand for commodities has led the International Majors to presently become net sellers. As US dollar denominated exporters to China, the International Majors seek new avenues for effective hedging of currency risk. HKMEx will mitigate these issues faced by the International Majors by providing destination pricing to hedge transportation and price risks on an alternative hedging platform. In addition, an exchange alternative will minimise counterparty risk.
Global Futures Brokers: The leading Global Futures Brokers are consistently in the top 5 of liquidity providers on the world’s futures exchanges. Each generally operates with a strong presence in Asia but with access to countries and futures exchanges around the world. Their wide range of customers include financial institutions, industrial groups, hedge funds and other asset managers to professional traders and private/retail clients. These customers are a significant source of liquidity and represent the entire universe of trading styles. Several Global Futures Brokers have expressed a strong interest to connect to HKMEx for multiple reasons including the ability to sell new trading products to their customers and an open commodities exchange in the Asian time zone.
Global Financial Institutions: The major banks and investment banks have historically been and continue to be major liquidity providers on the global futures exchanges. They employ a broad range of investment strategies including speculation, internal risk management and structured product hedging. Moreover, investment banks have served as prime brokers to hedge fund and high net worth clients across a range of strategies. Several Global Financial Institutions are interested in HKMEx as a source of destination pricing and an alternative hedging platform to satisfy both internal and client driven trading demand. Given the recent turmoil amongst several Global Financial Institutions, counterparty risk is a significant issue driving more transactions onto exchange.
Physical Commodities Traders: There are multiple diversified commodities trading companies based in or with significant operations in Asia. These companies are typically involved with the origination and distribution of global commodities and therefore have significant exposure to pricing risk and transportation costs. These Physical Commodities Traders would typically utilise hedging and speculative trading strategies on exchange. The vertical business model typical of this segment also makes the Physical Commodities Traders natural buyers and sellers of the core commodities. HKMEx provides the Physical Commodities Traders with an alternative platform for the hedging of price and transportation costs in Asia. In addition, counterparty risk will be minimised on exchange.
Margins
The amount of money or collateral deposited by a customer with his broker, or deposited by a broker with a clearing member, or by a clearing member with the clearinghouse, for the purpose of insuring the broker or clearinghouse against adverse price movement on open futures contracts. The margin is not partial payment on a purchase.
- Initial margin is the minimum deposit per contract required when a futures position is opened. If a position involves an exchange-traded product, the amount or percentage of initial margin will be set by the exchange concerned.
- Clearing margin are safeguards enacted in order to ensure clearing brokers and corporations actually perform the open contracts of their customers. Individual buyers and sellers of futures and options contracts are required to deposit clearing margin with brokers.
- Customer margin is financial guarantees paid by both buyers and sellers of the futures contracts to ensure fulfilment of contract obligations. It is determined by market risk and contract value.
- Maintenance margin is a sum which must be maintained on deposit at all times. If the equity in a customers’ account drops to, or under, that level because of an adverse price movement, the clearing member must issue a margin call to restore the customers’ equity. Margins are set by the Exchange based on its analysis of price risk volatility in the market at that time.
Clearing
Clearing is important because the time required to trade is much faster than the process time for completing the underlying transaction. It refers to all activities from the transaction made until it is settled. Once a transaction is made at the exchange, the clearing house will act as the counterparty to each side of the transaction, assuming the counterparty risk involved when two parties (or members) trade. Trades executed on a regulated exchange are guaranteed by the clearing house, hence, minimized counterparty risks to traders. For any party to trade on the exchange, both buyer and seller, or their service provider, must be members of the exchange and the clearing house. The Hong Kong Mercantile Exchange works with LCH.Clearnet to provide clearing solution to its members.
Regulatory Structure
All futures transactions must be regulated by a regulator here in Hong Kong. The Hong Kong Mercantile Exchange is regulated by the Securities and Futures Commission (SFC) in Hong Kong. The SFC is the independent statutory body charged with regulating the securities and futures markets in Hong Kong. It is the main authority and supervision board for the security market in Hong Kong. Even though it is consider to be a branch of the government body, it run separate to the government itself. It consists of a CEO. To learn more about the SFC, please visit www.sfc.hk.