EXPERT VIEW: Reinterpreting physical delivery and market pricing after queues
The challenge of the past 10 years in warehousing metals has been what to do with excess supply; the challenge of the next 10 years will be what to do about the shortage of metals.
Sporadic queues - those currently in Korea, for example - will remain a feature of the market but the more important trend is towards lower stocks. Exchange stocks for aluminium are at their lowest since 2008; the trend is for further decline.
As long as metal was flowing into warehouses, it could be used in settlement against futures positions. But how does the market adapt not just to less metal but to metal being stored in the “wrong” warehouses? That is to say: excess metal is likely to be either in China or in non-exchange warehouses, making it inaccessible to Western futures markets.
Exchange warehouses will of course continue to play a major role in the market but we should expect to see non-exchange warehouses boost the scope of their activities. The challenge and opportunity lies in making available the metal stored in those warehouses to assist with futures trading and price discovery.
Warehouse companies will play a key part in this process. Some will continue to act as repositories for metal that is being financed but they will increasingly be seen as a more integral component of the global supply chain.
Not only do they have sheds in both the West and China but they have also been developing increasingly sophisticated electronic platforms to register and track metal moving through their premises. Earlier this month, for example, Metal Bulletin reported on the new platform being developed by warehouse company Steinweg to manage its customers’ metal flows.
Working closely with warehouse companies could enable different options around settlement. For example, warehouses could issue their own certificates that could be used to settle futures positions via an “exchange for physical” process. They could otherwise facilitate a move towards a delivery window for physical metal settlement, as is the case in other commodities.
Both options would preserve a link between the physical and futures market, capture more physical supply and keep costs lower for market users.
Widening the eligible means to settle trades should facilitate not just liquidity but also the accuracy of price discovery. It could also lead to a broadening of the scope of pricing in the market, which would have important - and positive - implications for trading.
The market is already exploring alternative ways of settling futures prices, including using prices determined by price reporting agencies (PRAs) such as Metal Bulletin, for products that were traditionally not put on exchange warrant. While exchange warrants become less important in the context of the overall metal available to the market, some prices will be collated and used differently.
In the future, we are likely to see a blend of methodologies used on exchanges, facilitated by new flows of not just metal but, crucially, information. A good example of this is the growing importance of metal premium contracts, which show how the futures and physical side of the market can come together to increase choices and liquidity.
Premiums gathered by PRAs are an established means to solving the problem of low physical availability, be it in certain grades or locations. Where exchanges do not have access to these liquidity pools, they will increasingly look to settle contracts using PRA price assessments. In what should become a virtuous circle, trading and price discovery along the futures curve facilitated by the exchanges should then feed back into decisions taken and information exchanged at the point of settlement.
Western exchanges and their regulators will perhaps look back on the recent years as a golden era when metal in their orbit could be transparently monitored and managed. The transition that has followed has not been smooth - in aluminium trading, for example, where lower stocks have distorted spreads and constrained liquidity.
The physical market has moved on, with competing liquidity pools, large and small, global and local. More than ever, for futures trading to remain relevant, it must adapt to the changes and innovations in the physical market.
Chris Evans is commercial director of NFEx Markets