What is Commodity Exchange?
A commodity exchange is a market in which multiple buyers and sellers trade commodity-linked contracts on the basis of rules and procedures laid down by the exchange. In developed countries, and in an increasing number of developing countries, such exchanges typically act as a platform for trade in futures contracts, or for standardized contracts for future delivery. In other parts of the developing world, a commodity exchange may act in a broader range of ways, in order to stimulate trade in the commodity sector. This may be through the use of instruments other than futures, such as the cash or “spot” trade for immediate delivery, forward contracts on the basis of warehouse receipts, or the trade of farmers’ repurchase agreements for financing (known as “repos”). Alternatively, it may be through focusing on facilitative activities, rather than on the trade itself, as is the case in Turkey, where exchanges have served as centres for registering transactions for tax purposes.
The usefulness of a commodity exchange lies in its capacity to remove or reduce the high transaction costs often faced by entities along commodity supply chains in developing countries. A commodity exchange reduces transaction costs by offering services at lower cost than that which participants in the commodity sectors would incur if they were acting outside an institutional framework. These can include — but are not limited to — the costs associated with finding a suitable buyer or seller, negotiating the terms and conditions of a contract, securing finance to fund the transaction, managing credit, cash and product transfers, and arbitrating disputes between contractual counterparties. Therefore, by reducing the costs incurred by the parties to a potential transaction, a commodity exchange can stimulate trade. Moreover, properly functioning commodity exchanges can promote more efficient production, storage, marketing and agro-processing operations, and improved overall agriculture sector performance. It is precisely because of these benefits that transition and developing economies with large agricultural sectors have embraced commodity exchanges in recent years.
Specifically, a commodity exchange can perform one or more of a range of potential functions — exactly which functions will depend on the nature of the exchange and the local context in which it operates. For exchanges that offer spot trade or supporting activities, the institutional function is to facilitate trade — bringing together buyers and sellers of commodities, and then imposing a framework of rules that provides the confidence to transact. Robust procedures for overseeing these transactions can also trigger improvements in the efficiency and infrastructure of commodity cash markets — for example, through the upgrading of exchange-accredited warehousing and logistics infrastructure, the acceptance among market participants of exchange-defined product quality specifications, and the reduction of default levels, through intermediation by the exchange in the processing (or “clearing”) and settling of contracts.
Commodity exchanges offering trade in instruments such as forwards and futures contracts also provide sector participants with a means of managing exposure to commodity-price volatility. This is important, as world commodity prices are often highly volatile over short time periods — sometimes fluctuating by over 50 per cent within a year. These “hedging” instruments can bring producers greater certainty over the planting cycle, while enabling processors, traders and purchasers to lock in a margin that can secure them a positive return. This allows those active in the commodity sector to commit to investments that yield longer-term gains, and also makes it more viable for farmers to plant higher-risk but higher-revenue crops. Even in the face of a long-term decline in the prices of their commodity, the ability to hedge against shorter-term price movements provides farmers with a window in which to adjust cropping patterns and diversify their risk profile.
Finally, where spot, forwards and futures transactions take place on a commodity exchange, the price information that results from this trade — the so-called “price discovery” mechanism — also performs a vital economic function. As exchange prices come to reflect the information known about the market, they provide an accurate reflection of the actual supply/demand situation. This provides important signals that market participants can use to make informed production, purchasing and investment decisions. Furthermore, the availability of a neutral and authoritative price reference can overcome information asymmetries that have often disadvantaged smaller or less well-connected sector participants in the past.
Commodity-linked contracts
· Spot (or cash): Contracts for the purchase or sale of a commodity with immediate delivery (i.e. within a few days).
· Forwards: Contracts for the purchase or sale of a commodity with deferred delivery.
· Futures: Standardized forward contracts which represent an obligation to make or take delivery of a fixed quantity and quality of a commodity at a specific location. Contrary to forwards, futures contracts do not often result in physical delivery, as they can be offset by an equal and opposite contract before the delivery date.
· Options: Contracts giving the right, but not the obligation, to buy or sell a futures contract at a specified price or before a specified date. To obtain such a contract, the buyer needs to pay a premium — the maximum loss is limited to this premium. The seller of an option receives the premium, but the potential loss is theoretically unlimited.
Swaps: An exchange of specified future payment streams between two counterparties.
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