IRON ORE WEEK: SGX says organic demand behind success of 65% derivative contract
Nearly 1,500 delegates will descend upon Singapore this week to attend the seventh edition of Singapore Exchange’s (SGX) annual Singapore Iron Ore Week.
Much of the conversation at last year’s event revolved around the need for suitable risk mitigation tools in the iron ore market amid wide and volatile grade differentials due to the Chinese government’s environmental protection policy and robust mills’ margins.
Today, the iron ore market has more tools to manage its risks than it did a year ago, with the SGX broadening its suite of derivative offerings through the launch of the 65% Fe iron ore derivative contract on December 3, 2018. The contract is settled against the Fastmarkets MB 65% Fe Iron Ore Index.
Interest in the contract is apparent given that it has seen about one million tonnes traded on average each month since its launch and with open interest already breaching one million tonnes.
Fastmarkets MB spoke with William Chin, head of commodities at SGX, on how the latest derivative contract has fared, what makes SGX’s iron ore derivative contracts tick and the exchange’s plans for derivative contracts in the near future.
Why is the 65% derivative contract successful?
Chin sees two key benefits of the 65% Fe iron ore derivative contract for physical iron ore players: transparency on the forward curve and a seamless risk-mitigation tool for those with exposure to the high-grade segment.
“One of the most important economic utilities of an exchange is to provide risk management tools to mitigate volatility,” Chin, who has worked in the commodities industry for nearly a decade, said.
“Before the contract was launched, there was lack of visibility on the forward curve and a translation of demand and supply outlook pertaining to the high-grade segment but the 65% derivative has brought that transparency and the ability to reduce basis risks for those with exposure to different ore grades,” he added.
Chin highlighted the need for such a risk management tool rose amid China’s structural shift to measured and sustainable growth and its correlation to steel mills’ choice of raw material as they decide on maximizing profits and productivity versus managing input costs.
The addition of the 65% derivative to SGX’s other successful iron ore contract – the 62% Fe iron ore derivative – has given clients the “ability to react faster and with certainty” to changes in the iron ore market, Chin explained.
He added that while the 65% contract has attracted physical participants, “it is also important to attract the financial players as they bring the added liquidity”.
“The contract allows participants who may not be in the physical world but may want to trade grade differentials as a way to express their views on anti-pollution measures on China, its macroeconomic activity or steel mills’ margins,” he said.
“We did not really have to push the market to use the 65% derivative, as people saw a natural reason to use it,” Chin said, when asked what has made the contract so successful.
That also explains the mix of participants who have used the contract so far – comprising predominantly steel mills and traders.
Chin also explained that for a contract to be successful, it is also important to work with the right partners.
“It was highly important to work with a fantastic partner like Fastmarkets with the right reach in the physical market. Also, the ability to work with a miner who is able to provide liquidity in terms of spot cargoes on an indexed basis was hugely important in driving adoption,” Chin said.
“With the 65% we had strong interest and people were lining up to trade on the day we launched it. The important question [for the success of a contract] is to figure out how do you build liquidity and bring liquidity providers to the market,” he added.
“The liquidity comes down to whether there is a core reason for a participant to trade the contract and the potential profitability in that trading decision to get involved in the contract,” Chin explained.
Synergy with 62% Fe iron ore derivative contract
The 65% contract has mostly been traded as a spread to the 62% Fe iron ore derivative contract, allaying any concerns among participants about the contract driving volumes away from the mid-grade contract that was launched nearly 10 years ago, Chin explained.
“As an exchange we have to figure out the right balance between price transparency for every single ore grade or type of impurity versus the ability for us to cater to a sufficient segment in the market that cannot rely on a single price reference and therefore needs to have some price discovery on other types of market indicators,” Chin said.
He further stressed that as the 65% iron ore market is sizable and a segment that could no longer rely on just one price reference for efficient price discovery, the launch of a high-grade derivative contract was warranted despite the existence of a successful 62% Fe iron ore derivative.
Iron ore as a proxy for China’s macroeconomic health
Much of the conversation with regard to iron ore demand from China, the world’s largest consumer of the material, is tied to the country’s macroeconomic health.
Many participants consider copper and iron ore as proxies to China’s macroeconomic conditions and outlook, however, volumes involving copper derivatives are a much bigger proportion of the physical market compared the ratios seen in iron ore.
Chin, who was a senior vice president at the London Metal Exchange for nearly four years before joining SGX in 2015, explained this was down to the difference in the structures of the two markets.
“The number of producers, consumers and importantly intermediaries in iron ore and copper is very different. Iron ore sees more bilateral trades, while in copper there is a lot more re-trading, facilitated by London Metal Exchange’s warrants, and that results in higher paper volumes over the physical volumes,” Chin said.
He also explained the transition in the way their clients are accessing the iron ore contracts is bringing a richer mix of participants trading the commodity.
“For a new product you need brokers who can marry trades between buyers and sellers. As the product evolves, you find that the ability for clients to go directly from an order book to trade becomes higher as there is more transparency around news flows and knowledge of what is happening in the physical world,” he explained.
He further said that while in the past, 100% of their clients accessed [iron ore contracts] through the brokers in over-the-counter market but now 15-20% of the volumes of a much larger market come in through the screen [trading directly on exchange].
“This has attracted a wider range of financial clients and that has been absolutely phenomenal and extremely positive development in terms of growing the overall liquidity pool,” he added.
“The transition in how the clients are accessing the contracts has also brought a richer and wider mix of participants trading SGX’s iron ore contracts, for example some of these participants traded copper or energy products and now they have brought liquidity to the [iron ore] market,” he explained.
Further explaining the differences between the iron ore and copper markets, Chin stressed on the multi-layered structure of the iron ore market through its grade and product-type differentials – such as pellets, lumps, fines, and so forth – that allows participants to use the structure to form a view on environment or economic policies in China.
SGX’s success and future
Emerging as the most successful offshore exchange for iron ore derivatives has been made possible through SGX’s approach of measuring any new initiatives through the lens of “what value it brings to the market”.
“It’s not about launching 50 products to see what works, it is about launching a particular product, supported by demand,” Chin said, when asked what has made its iron ore contracts work.
Chin acknowledges that it is important for exchanges to work with price reporting agencies to provide value-added products to the market by keeping a close eye on the changing physical market structures.
“What we have done right is to listen carefully to our clients, to understand changes in the structure of the market and then pulled the trigger at the right place at the right time,” he added.
In that light, Chin underlined the bourse’s commitment to continue researching and analyzing the market developments, and come up with products that meet requirements.
“At the moment the market thinks of steel mills in silos but bringing all of that together under a virtual steel mill – coking coal, iron ore, FFAs [forward freight agreements] – would be area for us to look at,” he said.
The exchange is looking at expanding its ferrous product offerings beyond steelmaking raw materials to products such as steel and ferrous scrap contracts
but has not made any firm plans yet.
Chin conceded that, as a whole, the notional volumes for ferrous derivatives outside of iron ore and coking coal was still small.
“Exchanges need to think about how do we incentivize adoption, grow visibility and it will take a number of participants to get the ferrous derivatives going and so we are keeping a close eye,” he added.
“We do want to figure out the pain points in the industry and then work in that direction in terms of what people want,” he added.