What Makes Commodity Exchanges Successful? A View From the Enabling Environment
Last month, the Feed the Future Enabling Environment for Food Security (EEFS) project produced a four-part series exploring several mechanisms for enabling safe, nutritious food trade. This month, EEFS explores the enabling environment for structured trade, specifically commodity exchanges and the preconditions in the enabling environment for their success.
What is a Commodity Exchange?
A commodity exchange is a rules-based platform where buyers and sellers interact to trade commodity-based contracts. There are varying models for commodity exchanges and different levels of sophistication dependent upon objectives, institutional capacity, and the operating context. For a background on different types of commodity exchange models and contract types, check out this EEFS study.
What are the Benefits and Limitations of a Commodity Exchange?
A commodity exchange has several potential market-wide benefits as well as clear limitations. Regarding the latter, a commodity exchange is fundamentally incapable of providing order to an agricultural market system on its own. It is simply a mechanism for exchange that, in many ways, reflects the prevailing conditions — formal and informal — in a market system.
Where the appropriate conditions are in place, however, a commodity exchange can facilitate price discovery, price risk management, and more efficient physical trade — all of which are critical to transform market systems for greater inclusiveness and private sector engagement.
Price discovery is the process of determining a market price through the interaction of buyers and sellers. When the breadth and volume of transactions on the exchange reflect the breadth and volume of transactions in the physical market, exchange participants may then arrive at a price over time that represents the underlying supply and demand of a commodity. When this occurs, market actors from producers all the way through to retailers are more capable of making informed investment decisions.
Price risk management occurs on an exchange where market actors can trade in futures and/or options contracts. Essentially, a future or option contract allows a market actor with price risk exposure to insure against downside risk. For instance, a producer that invests in inputs today is doing so with an anticipated output price at harvest. If the price at harvest is lower than the producer initially anticipated — due to fundamental changes in supply and/or demand or short-term speculative price volatility — he/she can lose a lot of money and potentially be less willing or able to invest in the next production cycle. By trading futures and/or options contracts, however, a producer can hedge against that downside risk.
A well-functioning commodity exchange can improve efficiency of physical trade in the marketplace by lowering transaction costs, including the costs associated with identifying a buyer/seller, negotiating terms, ensuring product quality, and managing counterparty risk (the risk that your trading partner will not pay or not deliver what has been agreed). Additionally, trading on an exchange relies on a well-functioning system of grades and standards. Therefore, where there are benefits to participation on the exchange, producers and warehouse operators have an incentive to improve their quality assurance systems, so that they may participate on the exchange.
What are the Conditions for Successful Commodity Exchanges?
Generally, the conditions for commodity exchange success fall into three distinct but interrelated categories. The first two are governance and market conditions, both of which are external to the exchange itself. The third category consists of operational design conditions, which are internal to the exchange itself.
One of the most important governance conditions for a successful commodity exchange is the level of government interference in commodity market prices. If a government controls prices — for example by unpredictably restricting exports or releasing grain stocks, both of which moderate prices for the benefit of net food consumers at the expense of net food producers — then there is a disincentive for market actors to participate on the exchange. In such a scenario, only well-connected actors may have inside information on government intentions that would influence prices.
The formal legal/regulatory environment also matters. Since commodity exchanges trade commodity-backed contracts, commodity exchanges naturally will be less successful where contract enforcement is weak. Additionally, it is necessary to have a clear legal framework and strong institutional capacity for regulatory enforcement related to warehouse, brokerage, and clearinghouse operations.
As previously mentioned, it is also necessary to have an effectively administered system of grades and standards in place that is clear and well understood by actors across the system. This may also be considered the so-called soft infrastructure in a market system, but for simplicity this piece will discuss the matter in the context of market system rules. Commodity-based contracts are based on a mutually understood quality designation. Therefore, without clear, well understood, and enforceable grades and standards for commodity quality, disputes are more likely to occur, and exchange-based trade becomes less likely to form.
Several commodity market conditions must be assessed and understood before investing in (establishing or supporting) a commodity exchange should take place. First, a viable commodity exchange requires a high volume of trade among a large number of traders to achieve price discovery. If the market is thinly traded, meaning only a few dominant market actors are participating, then a commodity exchange is unlikely to generate sufficient transactions to cover operational costs. The commodity exchange is also more susceptible to manipulation by a small number of bad actors. It is therefore crucial to generate buy-in from a large number of actors within the market to ensure an appropriate breadth of trade on an exchange.
Additionally, if a commodity exchange intends to facilitate a warehouse receipt system or price risk management through futures contracts, then the commodity market must be characterized by sufficient intra-year price variability. Otherwise, there will be limited demand for — and negative returns on — these services. While a commodity may exhibit inter-annual price variability, it is intra-annual price variability that is more important here, since warehouse storage periods as well as futures/options contract expiration dates are generally less than one year in duration.
Finally, if financial service providers, such as lenders, brokerage firms, clearinghouses, are not active in a particular commodity market, or if they are present but uninterested in participating on the exchange or providing services to exchange participants, then it also becomes less likely that a full-service exchange can succeed.
In addition to all of these contextual considerations, it is also important to understand the exchange-specific operational design conditions (e.g., the business model and organizational structure of the exchange) that may lead to success or failure.
Generally, the more services that an exchange provides directly, the higher the operational cost. To cover operational cost, an exchange needs to generate sufficient volumes of transactions to maintain profitability, otherwise it must increase the costs of transacting on the exchange. As the costs of transacting on the exchange rise, the value added relative to the physical marketplace becomes less clear for market actors.
For instance, while not an exhaustive list, the following services must be in place for a well-functioning commodity exchange. The necessary operational design determination is whether the exchange itself should provide these services directly, or whether it makes more sense from an operational cost perspective for third party service providers to deliver these services:
- Certified warehouse management and/or insurance services to ensuring quality of delivery
- Clearing and settlement services to manage counterparty risk
- Market information services for disseminating bid/ask prices, lot sizes, grades, and settlement prices
- Dispute resolution services in the event of breach of contract
Lastly, the structure for ownership and membership within the exchange also matters. There is no right model; exchanges may be private for-profit, private not-for-profit, government-run, or public/private arrangements. The important factor here is good organizational governance, which ensures services are delivered effectively and efficiently in a way that generates deep and wide market actor buy-in. Without this element, like any business, the exchange is unlikely to succeed over time.
While commodity exchanges have led to market system transformations across many developed countries, their success has proven more elusive in sub-Saharan Africa. If USAID and implementing partners are to consider supporting investments in commodity exchanges going forward, it is increasingly necessary to understand the underlying conditions for success, including conditions external to the exchange, such as governance and market conditions, as well as those internal to the exchange, such as operational design conditions.
Commodity exchanges will not create an environment where transformational market and governance conditions emerge. Instead, these are preconditions that should be in place prior to investments in commodity exchanges, and feasibility assessments are needed to identify whether these conditions are in place to inform USAID and its implementing partners on the likelihood of success.
To access customized analytical services of the enabling environment for structured trade, please contact EEFS’ Chief of Party, Adam Keatts, at [email protected].