The dry freight derivatives business is only a small niche in the global commodity markets, yet it enjoys an unusual degree of competition in clearing.
Four years ago the clearing of dry freight derivatives was dominated by LCH, which benefitted from more than a decade of experience with these products and close connections to the London-based brokerage community. But lately its share of the cleared volume has fallen dramatically and this past July LCH announced that it will get out of the business by the end of 2017.
LCH’s departure came as a surprise to some analysts, but others said LCH’s shifting fortunes reflected the increasingly strong value propositions offered by its two main competitors--the Singapore Exchange and Nasdaq. According to recent public reports, SGX currently clears roughly 40% of the dry freight market and Nasdaq's clearinghouse in Stockholm handles an additional 30 to 40%.
The LCH announcement marked the end of a long-time commitment to dry freight that began in 2001. Interest in clearing grew in the post-crisis years, when concerns about counterparty credit risk made it difficult to continue with the old model of bilateral trading. Georgi Slavov, head of commodity research for Marex Spectron in London, said that the freight derivatives adopted clearing almost overnight. “The market went from almost entirely bilateral before the 2008 crash and is now almost completely cleared,” he said. “It was one of the fastest transitions I’ve seen in any market, if not the fastest.”
Dry freight derivatives are based on the price for transporting bulk commodities such as coal, iron ore and agricultural products. The cost of shipping these goods across the ocean can have a significant impact on the overall economics of a transaction, and derivatives such as forwards, futures, options and swaps are used to hedge volatility in shipping costs.
For SGX and Nasdaq, the key to gaining market share has been their ability to combine related positions in other parts of the commodity complex. That allows their clearinghouses to capture risk correlations and reduce the amount of margin required to clear these contracts. At SGX, for example, market participants can bundle freight with iron ore and coking coal. That gives customers the ability to lock in the prices on a "virtual steel mill" all on one platform, according to William Chin, head of commodities at SGX. “It is about providing margin and capital efficiencies for the trading of both cargo and freight,” he said.
In addition, SGX is benefitting from its £87 million ($113 million) acquisition last November of the Baltic Exchange, the 250+ year old membership organization for the maritime industry. The exchange is based in London and its members produce the benchmarks widely used for pricing freight derivatives. The deal gave SGX a network of connections in London's community of freight brokers, neutralizing LCH’s geographic advantage and leveraging global interest in China's commodity markets. Nasdaq's Scandinavian arm has roots in the freight derivatives business going back to 2012, when it bought NOS Clearing, a Norwegian clearinghouse that began clearing freight derivatives more than a decade ago.
Nasdaq currently offers dry freight contracts on seven routes in the Atlantic and Pacific as well as two sets of related products: fuel oil and tanker freight derivatives, also known as wet freight, which are based on the cost of moving liquid cargo such as crude oil.
Competition from Germany
While SGX and Nasdaq are well positioned to take over LCH's share of the clearing business, the London clearinghouse has given its stamp of approval to a different contender—the European Energy Exchange in Leipzig, Germany, and its clearinghouse, European Commodity Clearing.
In its notice to members announcing the shutdown of its freight clearing business, LCH said it had worked out an agreement with EEX to transfer open interest from one clearinghouse to the other in a "seamless transition." In effect, this will allow customers to move their positions without having to incur the cost of closing out positions at LCH and then reopening those positions at another clearinghouse. Twenty two clearing members of ECC are set up to process trades in freight futures and options, including large international banks such as ABN Amro, Barclays, BNP Paribas, Citi, Goldman Sachs, J.P. Morgan, Morgan Stanley, Societe Generale and UBS.
EEX, which is majority owned by Deutsche Boerse, is a relative newcomer to the freight business, but the move fits into a broader growth strategy. The exchange has a strong base in the continental European power and gas markets, and it moved into the freight business through its acquisition of Cleartrade, an electronic trading venue based in Singapore. Cleartrade was founded by Freight Investor Holdings, one of the leading brokers in the freight business, and offers trading in commodities such as iron ore, steel and fuel oil as well as freight.
“Bringing CLTX into the group and then launching our own cleared freight product is kind of one step toward that broader strategic goal of creating a global commodity exchange,” said Richard Heath, head of freight business development at EEX. “Part of our strategy to build a global commodity exchange is that we can offer services to customers in all jurisdictions in Asia, Europe or the United States,” he said. “You get the benefit of that single global clearinghouse but with local registry business at the front end.”
Growing the Market
SGX and Nasdaq are not going to let EEX take LCH’s dry freight business without a fight. Both exchanges have offered to waive their fees for a limited time to lure departing LCH customers and they are looking for ways to encourage market participants to migrate to their service.
SGX is also trying to expand the market through outreach to ship owners, cargo owners and other players in Asia to educate them about the advantages of using freight derivatives to manage their risk exposures. In June, SGX and the Baltic Exchange organized a seminar in Shanghai with experts from leading local brokers to discuss how to hedge freight rate volatility.
“Our focused goal right now is to grow the liquidity of FFAs [freight forward agreements] through a close partnership with the Baltic to promote the adoption of FFAs as a useful risk management tool," said Chin. "A more liquid FFA market benefits all participants. The focus of the competition is on growing the pie, not operating a fee war on shifting parts of the same pie. It is about adding real value to customers.”
Clearing Firm Perspective
Karen Taylor, head of institutional sales at ADM Investor Services International, said all three services are contenders for the LCH business. ADMISI, which provides hedging solutions for a wide range of commercial clients, is a member of LCH, SGX and Nasdaq and recently joined ECC, the clearinghouse operated by EEX. ADMISI is also a member of the Baltic Exchange and provides both execution and clearing of freight derivatives, typically in conjunction with trading in grains and other agricultural products.
Taylor said one factor in customer choice is regulation. Both EEX and Nasdaq are subject to EU rules, which is a plus for some customers and a challenge for others. Another factor is the type of cargo; SGX has a very active market for iron ore futures, so that may be a better match for companies active in the iron ore market. Still another factor is strength in particular products; Nasdaq has been clearing options longer than the others and tends to be favored for clearing that type of product, she said.
"The choice really depends on what the client is looking to hedge," Taylor said. "If they can hedge everything that factors into the price of the transaction, and then clear all of that on one clearinghouse, they get the benefit of the offsets."