Commodities exchanges have a structured objective aimed at bringing the buyer and seller together to transact on a safe and secure platform. A well-established exchange can only complement the agribusiness sector by improving price discovery and introducing efficiencies in the market place that should ultimately reduce costs to the key stakeholders in the sector. 

The exchange therefore does not have the right to exist, but has to prove to the market participants the value it brings to the total ecosystem. Once you have an exchange that is able to cost-effectively facilitate buyer and seller trading, and is able to ensure that the seller receives his/her money for the commodity and buyer is assured of the product, then this is an exchange living up to its purpose, in my view.

Exchanges with a twist

It is also important to understand that there are spot exchanges and then derivative exchanges, all focused on commodities but with a slight twist. Although the text books would always indicate a country should first develop its spot market before introducing derivative contracts, we have seen countries where there is a well-established production base of commodities moving directly into a derivatives market. South Africa is a case in point.

There is the perception that if you have a spot commodity exchange, it would be easy for banks to offer inventory finance. This is possible, but banks would continue to heavily discount the transaction since, to cover their risk in the event of a default, they will still have to find a willing counterpart to take the stock they financed in the first place. This is where a commodity derivatives exchange such as the JSE Commodity Derivatives, really adds value. Banks through the use of either futures or options, can now offer clients 100% financing based on the level at which the bank secures a hedge on the derivatives market.

Transactioning in practice

Let’s explore this transaction a little further. A farmer produces 50 tons of commodity and takes it to a reputable storage operator. The same farmer requests a silo receipt to be issued and then has a choice: he can take this to a financial institution or even an asset manager who is willing to accept it and will provide financing in return for interest.

The financing party will then go to the commodity derivatives exchange and sell a futures contract for a date, either three or six months into the future, depending on the client’s term of finance. By selling a futures contract, they have managed to lock in a price for a future date, enabling them to extend financing to the same client at the full hedge value.

The big question is: why and how can the financier do this? Well, if they are comfortable with the commodity exchanges agreement and that the storage operators will honour the silo receipts they issued, and if they are comfortable with the clearing house of the exchange to guarantee the flow of funds, then in essence there is very little risk remaining for the financier. This is because, in the event their client defaults and does not settle the interest claim, they will be able to deliver their stock on the short futures position and receive the full cash value the next business day. This applied to markets such as the JSE that have a T+1 settlement cycle which most derivatives markets do.

Liquidity and robustness does the job

By having a liquid and robust derivatives market, the financier therefore does not have to be concerned about finding counterparties for the physical stock, should the client default in the spot market. In South Africa, where there is a liquid and active commodity derivatives market, access to finance for particularly grain products that have deliverable futures contract, has stiff competition. This competition is not only among local banks, but also from a number of foreign institutions. This results in financing rates being extremely competitive.

This works out really great, not only for farmers, but for traders and millers who have access to cash instead of holding all their funds tied up in physical stock. They are then able, in the same way, to approach financiers to fund the grain in the silos. – Dr Raphael Karuaihe, Head: Commodities, JSE Capital Markets

Dr Raphael Karuaihe is Head of Commodities at the JSE in South Africa. Should you want to reach out and comment on any of the points raised, please email raphaelk@jse.co.za