The New Contract Explosion
McMahon, Chris, Modern Trader
Commodities are hot and an infusion of cash and investor interest is driving the creation of new products. Here's a quick look at several new products and insight from the people who created them.
More people in more diverse sectors are realizing the need for risk management and the benefit of futures as a risk management tool. One of the manifestations of this is the number of new contracts being launched. In 2005, 35 new futures contracts were listed as of March 5, compared with 83 in 2004 and 80 in 2003, according to the Commodities Futures Trading Commission (CFTC).
While more futures contracts are being introduced, the process is far more time consuming and complex than it used to be. "Ten years ago, you'd pick up the phone and say, 'Sparky, build me another pit.' Then you'd go down to the floor and you'd say, 'Joe, Tom, Henry, Sally, we need you in this pit here as liquidity providers," says Robert B. Ray, SVP of business development at the Chicago Board of Trade (CBOT). Most recently, Ray was responsible for the launch of the CBOT's South American soybean contract. In the age of electronic markets, things are vastly more complicated, he says.
Including operations and information technology professionals, 40 CBOT employees took part in the planning sessions, which started six months before the launch. In addition, 20 people from the Chicago Mercantile Exchange, the CBOT's clearing partner, and another 20 plus people from the ATOS Group, which powers the Liffe Connect platform, participated in the planning. "So now you've got 80 people sitting in the room," Ray says, and this is before discussions with back office processors, the independent software vendors, quote vendors or even the end users. Ray agrees electronic markets are efficient and drive productivity. "Once you're there, and if it's successful, yes it's very efficient. But getting there costs a hell of a lot more. The days of launching a contract or launching a lot of contracts and hoping that 10% stick are over."
New futures contracts, whether based on a commodity, a financial instrument or an event, are conceived to address an identified need or on the anticipation of a need, and all successful contracts are based on a value proposition that the marketplace recognizes, understands and embraces. But identifying and anticipating the need is just the beginning.
"When you start a commodity contract, you have to think about: Is it a global commodity? Is it interchangeable? Is it frequently traded? Can you find an easily standardized grade?" says Herwig Schmidt, manager of customer relations at Triland Metals Ltd. in London.
Schmidt has traded metals for 25 years and watched the launch of nickel, aluminum and most recently the plastics contracts at the London Metals Exchange (LME). Plastics have become primary raw materials, replacing materials such as metal, lumber and glass in many manufacturing processes and have achieved an annual market size of $120 billion, as much as nonferrous metals and growing faster, according to the LME. In addition, there is a great deal of volatility in plastics prices, influenced by supply and demand as well as the high and rising cost of petroleum, a primary ingredient in plastics. But until recently there was no way for manufacturers, converters and buyers to hedge or speculate on this important commodity.
"We look for an industry need and try to find a solution to that industry need," says Neil Banks, director of exchange development at the LME. Responsible for the launch of LME's plastics contracts in May, Banks says, for the plastics industry, the need was to manage price risk.
In the case of the New York Board of Trade's new pulp contract, "The industry came to us," says Eric Maine, manager of market development. "We saw some cracks in the armor," such as the exponential growth in over-the-counter pulp markets. Last year, the industry hedged 5 million tons of pulp in over-the-counter swaps, up from 350,000 tons in 1997. …