In the introductory article the overall approach to commissioning a delivery system for a futures exchange was outlined, and at the end, it was suggested that the place to start an analysis was with the warehouse. The assumption being that the point of delivery in the international physical trade of the goods represented by the futures contract occurs in a warehouse. Note that for some products this is not the point of delivery in the international physical or cash contracts; for example, sugar is traded on the shipment term free on board (FOB), so for the sake of ease, commodities commonly using such shipment terms in the physical contracts are not considered here.
Strictly speaking, ‘warehouse’ is the wrong term, more correctly it should be ‘storage facility’ as this would cover all forms of goods being housed; including warehouses, grain silos, oil tanks etc. By the same token the role of warehousekeeper should more correctly be termed ‘storage operator’; however, for the sake of simplicity in this article the terms ‘warehouse’ and ‘warehousekeeper’ will be synonyms for those terms.
Terms of Delivery
By starting the analysis at the warehouse for commodities traded on storage terms it is possible to understand the nature of the business being undertaken, particularly the issues concerning delivery. As mentioned in the first article, the terms of the delivery underwrite the value of the goods. Clarity and robustness in the delivery terms provide the best valuation for any goods on offer – to a point. The joke of the ship’s steward asking the captain that, if he knew where the ship’s silver cutlery were, had he lost them? ‘No’, replied the captain. ‘Good’, said the steward, ‘Because I tripped and lost them over the side. They are now at the bottom of the sea’. That brings clarity on the point of delivery (admittedly the sea-bed is a wide option) but no help in either making delivery or costing it. If a potential receiver has any doubt about the terms of delivery the price on offer will not be optimal; the steward’s silver at the bottom of the sea is valueless as the cost of finding and retrieval are prohibitive.
Markets transitioning from domestic to international
So in the analysis, an early question is: what are the terms of delivery used in the physical or cash market? This is a basic question that many assume requires little reflection, however a slight variation at this point can result in an unworkable product. For example, an exchange may think that because a product that has success with the contract allowing only deliveries in a particular domestic market, that the route to increased volumes lies in adding delivery points outside the country. This is tempting, the idea being that such additional ports would attract more international market participants thereby increasing volumes, a vital source of revenue to an exchange. There are instances when such additions have been made without reflecting any of the differences that occur between a domestic contract and one made on an international terms. Surprisingly, this still occurs, and results in confusion to the potential traders but also the existing participants, which means they will find it difficult to use the product. For example, the domestic contract would make no reference to export tax or whether the goods are lying in bond. The inclusion of a delivery location without clear understanding of the affect on potential trade terms may at worst invalidate the trade of that product and at best be suboptimal.
In the next example, the domestic issues concerning delivery were addressed in a contract transitioning to international delivery, but arguably a more important legacy issue was not properly addressed.
The effect of legacy issues
At 11 o’clock on Monday, 21th May 1928 the cocoa futures market opened for the first time in London. The terms of delivery were ex-store London; delivery in Liverpool (which, you may be surprised to learn, had its own cocoa futures market at the time) was specifically excluded, as noted in the minutes of the 30th March 1928 of the newly formed London Cocoa Terminal Market Association. From this start with a single delivery point, the cocoa futures market in London developed, while other cocoa futures in Europe at Liverpool, Paris, Hamburg and Amsterdam faded for various reasons over time. For a long while the London market continued with delivery against a futures position only possible within the UK. It should be understood that business in the UK, a country deeply involved in trading, traditionally have all contracts of sale for stored goods on an ex-store basis; in other words, the company that choses the warehousekeeper to store the goods also pays for them to be picked up by the eventual receiver at the warehouse door, i.e. free of any charge by the warehousekeeper on the owner and is true of all goods stored in the UK. This is because the party storing the goods in the first place pays the ‘RH&D’, the Receiving, Handling and Delivery cost. Such charges let a third party take delivery of the goods free from any potential charges by the warehousekeeper, thereby allowing the new owner of the goods to negotiate on an even basis with the warehousekeeper, even though they may not have known each other. If negotiations fail, the owner can remove the goods at no charge.
With a successful cocoa futures contract during the 1960s and 1970s a growing amount of business, mostly for hedging purposes, emanated from companies on the European continent so pressure built up to include delivery points at the major cocoa trading points at the time, namely Amsterdam and Hamburg. Suitable changes to the contract were made for international trade and new, continental ports were included for delivery. However, trade on the continent was on an in-store basis, meaning that the RH&D did not have to be paid by the party storing the cocoa. The owner taking delivery had to pay the warehousekeeper the charges thought fit to remove the goods. The result was that storage on the continent was inherently cheaper than in the UK, irrespective of any foreign exchange movements. This, coupled with the fact that the continental market was much larger than that in the UK meant that there was not only pressure to standardise the delivery terms which up to that point was split between in- and ex-store depending on the location, but that the majority of business was now on in-store basis. This split was naturally untenable and needed to be standardised, which finally occurred in the September 1994 delivery onwards.
Unfortunately, the wrong direction was taken by making the basis of the contracts in-store and not ex-store, or Free on Truck.
The reasons why this direction was chosen will not be dwelt upon here; but a lack of foresight in understanding where this leads results in a potential blight on the contracts involved by placing the warehousekeepers in a potential position of power against third party owners by the exchange’s or clearing house’s allocation algorithm randomly matching issuers and receivers at the time of a delivery. An unprepared receiver in such a market may find that he is the owner of stock lying with a warehousekeeper with whom he has no relationship. The new owner may find that the cost of removing the goods from the warehouse vastly exceeds the cost of the work itself as well as the time at which a delivery may be made is at the warehousekeeper’s option. Nor does he have any control over the rent rate that may be levied. Now, a potential receiver should never go to delivery unless he is prepared and has worked out the consequences, but that reduces the number of potential participants able to take advantage of this integral and important aspect of the market as a receiver may have to deal with potentially fifty or more warehousekeepers. Sadly the biggest loss is that instore deliveries to unknown buyers does not reflect what occurs in the physical business, meaning that the futures market does not provide a proper hedge as doubt is cast on the cost and time of delivery so affecting the published price of what is trying to be an open market.
Markets caught by this and unable or unwilling to change the basis of the contracts have sought inelegantly to cap the rates chargeable by warehousekeepers and to stipulate by when deliveries have to be made. As one wag described: ‘It is like putting a sticking plaster on a wooden leg’. Some have seen fit to open a market on how soon the material is available, the premium market, allowing cynics to add that they appear to be now selling the sticking plasters for the wooden leg.
This example shows how seemingly small changes, perhaps made unintentionally, have consequences that have an enormous effect. The argument that it only affects a small number of specialist players, mostly based in the first world, fails to understand the role of some of these international markets in setting published benchmark prices that are used throughout the world by farmers, co-operatives, exporters and the like, and that consequently these prices can affect the livelihoods of millions.
In fairness to the warehousekeepers in this situation, they are only acting under pressure from their clients. Their clients, those providing stock for storage, want cheaper services and the warehousekeepers have obliged by calculating how long the goods need to remain in store in order to recoup the costs of the offers of the initial storage. The issue is that there is no natural market limit to what may be offered, in one case a warehousekeeper offered to ship the commodity from the other side of the world, land, sample, weigh and store the goods for free, as well as offering a free month’s rent. Who pays for these services? The owner and final receiver, when he can take delivery. This cost is understood by the market and the market price, which may be used throughout the world as a benchmark, is reduced accordingly. The elegant solution espoused here is to have a market that is based on terms tested in the physical market to ensure that the receiver has free and quiet access to his goods without the needless intervention of exchange regulations.
Security is important, and covers three main areas. Security of the business, premises, and goods are dealt with in turn below.
Security of the business means not only that the warehousekeeper is running a sound commercial enterprise but also that the ownership of the company is clearly understood. Some commodities, the grain business come to mind, allow the warehousekeeper to also be the owner of the goods; with others, for example the soft commodities of cocoa and coffee, this can represent a conflict of interest as a potential trading competitor may access to private information on others rates and even intentions. Protests that the information is not divulged by warehousekeepers to their owners have to be considered, but understood that it occurs in effectively unregulated conditions.
Security of the premises has to be sound, but the specifics of this is not the subject of this article, only to say that a properly functioning contract must allow for suitable inspections of the storage facilities and should include proper fire risk assessments.
It is often assumed that the security of the goods may be handed over to the warehousekeeper as they are responsible for the eventual delivery of the stock. While for most warehousekeepers this may be done without issue, it is not necessarily true for all. Should it emerge that an exchange delivery is questionable, the effect is that the market will value that into the price traded. It may be that the effect is small and local so have a limited effect, but if the market considers there is something systemic, the price will fall as the participants seek to value the goods with this new information. It is essential for the exchange not only to ensure proper conduct but also to show that it is occurring. So a prudent exchange will seek to ensure that systems are in place to preserve the identity of the commodity.
The final element to be assessed at the storage facility level concerns the supervision of the goods. Frequently passed over and not properly considered this element can be a key-stone between the owner and warehousekeeper. It can provide the sought after credence that what occurs in the warehouse may be relied upon and therefore valued by the market. It is essential that those operating as supervisors are independent, free from both ownership of the goods and connection with the warehousekeeper. For some commodities the role of the supervisor is limited while for others it can be critical. In particular those goods that require to be sampled for quality purposes it should (but sometimes is not) be conducted or overseen by an independent third party. It may seem obvious that no supervisory role should be made by entities that are warehousekeepers, yet that seems to be allowed in some commodities, one even sanctioned at the physical market level by the body that issues contract terms and arbitration facilities. So if that is the case the prudent exchange intending to offer a futures contract for such a commodity should devise its own guidelines and ensure that independence occurs for this important function.
An exchange looking to introduce new products for stored goods should start their analysis at the warehouse level as this provides the kernel on which the delivery system needs to be built. In particular, the system needs to reflect what occurs in the physical market with adequate security and supervision, not only occurring but being seen to be effective. There will be a number of issues that will occur that make the future market an imperfect hedge but they need to be over matters such as the allowances, (quality or brand, age, origin, location etc.) not integral items that may, and should, stimulate the gaze of a regulator.
About the author
Robin Dand is now in the fifth decade of working in the commodities market. He specialised in the cocoa market and softs in general but also oversaw the administration of a LME Ring Dealing member. In softs, he has experience in cocoa, robusta coffee and sugar, both as an independent supervisor and in the contract development department at NYSE Liffe. His specific expertise lies with the physical delivery of soft commodities, including the quality issues of those goods. He also devised a system to offer Exchange clients Pre-Shipment Grading for coffee in Vietnam. As an independent authority on Cocoa and Robusta Coffee he runs Robin Dand Commodities Ltd. and has recently been working as Registrar for the Chicago Mercantile Exchange Europe, overseeing the quality assessment and delivery of their cocoa futures.
Robin Dand has written two books on commodities; “Cocoa: a Shipper’s Guide” and “The International Cocoa Trade” first published in 1991 and now in its third edition; as well as contributing to magazine articles. He is also a member of the Technical Committee of Cocoa Research UK. Apart from his family and soft commodities, his passions are Cricket and Olympic Trap Shooting at which he has represented England five times.