The opening up of the iron ore contract on May 4 followed the announcement earlier this year by the International Energy Exchange (INE), a subsidiary of the Shanghai Futures Exchange, that it would allow non-Chinese companies to trade crude oil futures contracts.

At Iron Ore Week - taking place in Singapore all this week (21-25 May) - Metal Bulletin met up with William Chin, head of commodities at SGX, to discuss how the internationalization of the Chinese exchanges is affecting SGX business, especially iron ore derivatives.

SGX accounts for the bulk of the offshore iron ore derivatives market and offers various price risk management tools across different grades of iron ore products.

With the DCE opening up its iron ore futures to foreign investors, there is a perception in part of the market that the SGX might lose some volume as traders turn to the liquidity pool of the Chinese exchange.

Chin, who has been heading the commodities business at SGX since 2017, said that while a small number of investors might be drawn to DCE’s liquidity, the composition of investors on both the exchanges is very different and as such the prices reflect different fundamentals.

“On the DCE, 70-80% of the volumes are reportedly backed by retail investors while wholesale institutional investors account for bulk of the trading on SGX,” Chin said.

He highlighted how the “cost of access” will also have an impact on investors and traders choosing between an international and a Chinese exchange.

One of the “costs” may be the limited trading hours on the DCE, he said. 

The DCE is open for trading for six hours every day, split across morning, afternoon and night slots, and this “six-hour access might prevent traders who want to respond to news flows or news breaks that emerge outside those trading hours,” Chin said. 

“You would look to leverage on that deep liquidity, but ultimately you also want the ability to manage your own risks on an international exchange that provides ease of access in terms of timing, a range of instruments in futures and options as well as a suite of different iron ore grades,” he added.

There is the obvious requirement of managing currency risks as well, he added.

Win-win scenario
Chin emphasized that the interaction of deep liquidity provided by the DCE with the international accessibility of SGX is a very powerful catalyst that is likely to boost volumes for both exchanges.

“When the liquidity of DCE interacts with the informational quality of SGX, it will elevate the ecosystem of offshore and domestic price discovery,” Chin said, adding that the obvious advantage for investors with access to both exchanges would be the arbitrage opportunities.

He said the two seemingly similar products might appear to create a “winner-takes-all situation” but there were examples of positive interactions between products launched across geographies.

“The history of exchanges is peppered with examples of arbitrage opportunities across geographies, platforms and products. We are... history in the marking, and in all the excitement, the starting point is that DCE and SGX contracts for iron ore represent different demand-supply fundamentals, react differently to news flows and policy announcements,” he added.

Grade differentials
The widening grade differentials in iron ore prices, which have been identified as a structural change in the market by some of the world’s leading miners, has also not gone unnoticed by the SGX.

Metal Bulletin’s 62% Fe Iron Ore Index averaged $74.39 per tonne cfr China over the January-March period of this year, down 13% from $85.63 per tonne cfr over the same period last year.

Metal Bulletin’s 65% Fe Iron Ore Index averaged $90.30 per tonne cfr China in the first quarter of 2018, down 8.9% from $99.11 per tonne cfr a year earlier.

But Metal Bulletin’s daily index for 58% Fe iron ore averaged just $41.89 per tonne cfr in the first three months of this year, down 31% from $60.42 per tonne cfr in the same period last year.

“The market appears to have moved to a ‘new normal’ in the sense that environmental concerns have come to the fore, and those do not look like they will disappear quickly,” Chin said, referring to China’s efforts to step up environmental controls as part of its five-year plan for 2016-2020.

The grade differentials in iron ore are a function of robust profit margins for steel makers in China since last year amid the supply-side reforms and growing domestic consumption.

Steel production cuts introduced in the winter months last year to control pollution levels in China were also instrumental in driving higher margins.

Chin sees the potential in such a market for a high-grade derivative, “as long as you believe this is a new normal and the market will continue to see semi-permanent, wide and possibly volatile differentials, then yes the market may benefit from such a derivative.”

The exchange also continues to see its business across the ferrous value chain expanding in the coming years, as it looks to tap into new opportunities, especially in Asia.

One such opportunity lies in the downstream sector by way of steel derivatives.

Downstream derivatives
Metal Bulletin launched its fob China steel indices last year amid calls for more independent third-party references for the benchmarking of steel prices. 

But Chin warned that a lack of education among the downstream industry participants about the merits of price risk management and the structure of the steel market itself could be the main reasons why it may not be easy for steel derivatives to gain traction immediately.

“As knowledge of financial instruments improves with the new generation of steel producers and traders, a bigger component of the market will understand how managing price risks works and what tools are available,” Chin said.

He added that while iron ore derivatives were launched nearly 10 years ago, in the first few years their adoption was fairly muted as the market was learning about the benefits of using derivatives.

The availability of hedging options for steelmaking raw materials also alleviates the importance of hedging the downstream price, at least in the perception of some participants, Chin said.

“There might be a perception that if you can manage input costs then managing output costs may not be very important. However, participants who re-trade steel products might be able to benefit from derivatives,” he added.

Despite these challenges, SGX see the ferrous value chain as the area where it wants to continue expanding in the future, especially in Asia where it can tap on the geographical advantage of being close to China.

“For a client to be able to trade coking coal, iron ore, steel and freight markets on one platform is a powerful, capital-efficient tool,” Chin said.

SGX bought the Baltic Exchange in 2016.