The Role of Commodities Exchanges in Economic Development

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Friday, July 05, 2019   11:00AM  / AFEX Nigeria  / Header Image Credit: AFEX Nigeria

 

The first image that usually comes to mind when you think of an exchange is a group of brokers standing in a large circle in their suits and shouting commands at each other. If you have ever visited an exchange or seen “The Wolf of Wall Street”, you have probably wondered what all the fuss was about. 

Behind all the chaos both imagined and sometimes very, very real is a very rational, efficient and orderly process that is responsible for setting global benchmark prices for the world’s most important commodities. These prices established in the exchanges have a direct impact on our lives – from the price we pay to fill our cars to how much we pay for a bag of rice.

 

Let’s go down memory lane

Commodity markets are as old as civilization. Sumer (modern day Iraq) is thought to be the world’s oldest civilization and commodities market were said to be founded in Sumer in 4500 and 4000 BCE. Citizens would use clay tokens sealed in a clay vessel as a medium of exchange for goats and the like. Clay writing tablets then indicated the number of clay tokens inside each sealed vessels and the merchant would deliver the specified number of goats to the citizen making the exchange. The clay tablets included the amount, time and date, which tells us that they were the earliest form of what is now known as commodity futures contracts. 

U.S. investors have been trading in the commodities markets for more than 150 years, and reports show that commodity trading began more than a thousand years ago in Japan. The long and short of this trip down memory lane is that the commodity markets were one of the oldest forms of civilized transactions known to man. 

Commodity exchanges are commodity markets. Traders from all over the world come to a commodities exchange for a stable, regulated, transparent and liquid venue to trade commodities. These exchanges were born on the streets of Chicago (the world’s oldest commodity exchange is the Chicago Board of Trade CBOT), eventually moving indoors to the pits we’ve come to associate with the concept of trading.

 

And now….

Today’s exchanges on the other hand are almost completely electronic, performing millions of trades per second and offering market participants around-the-clock access to the global markets. 

The purpose of the exchanges that exist today are to provide a consolidated market place where commodity producers can sell their commodities to those that wish to use them for production or consumption.  The beauty of a commodity exchange is that a maize farmer can lock in a price for his crops months before they are harvested.

 

Why do we have Commodities Exchanges?

If you are an individual looking to hedge commodity prices for the future or an investor interested in capturing price inconsistencies and oscillations in the market, the commodity exchange will help achieve your goals. 

Commodities exchanges offer investors and traders opportunities to invest in commodities by trading future contracts, options on futures and other derivatives. Though independent traders can and do trade the futures market, the majority of players in the futures markets are large commercial players who use the futures market for price hedging purposes. For example, Diageo Plc a multinational alcoholic beverages company, is an active participant in sorghum futures because it wants to hedge against the price risk of sorghum, a primary input for making beers. 

Commodity exchanges play a very significant role in establishing worldwide standard prices for vital commodities such as crude oil, gold, copper, orange juice, coffee, maize, rice. The exchanges are essential for both producers and consumers of commodities.  Producers, who use commodities as inputs to create finished goods, want to shelter themselves from the daily fluctuations of prices. In the same way, traders may use the commodity exchange to profit from these fluctuations. 

So, whether you are an individual seeking to hedge commodity prices for the future or an investor interested in capturing price discrepancies and fluctuations in commodity markets, the commodity exchange will help you achieve your goals.  

Commodity exchanges are under strict oversight in order to protect all market participants and to ensure transparency in the exchanges. The main regulatory organization that has oversight of commodity exchanges in Nigeria is the Security and Exchange Commission (SEC). SEC is the main regulatory institution of the Nigerian capital market. It is supervised by the Federal Ministry of Finance and the Commission’s main purpose is to regulate the capital markets and to protect all market participants from fraud, manipulation and abusive practices. Any exchange that conducts business with the public must be registered with the SEC.

 

The Constituents of an Operational Commodities Exchange

In the broadest sense, there are four key components that make a commodities exchange tick.

 

Futures Traders: Hedgers and Speculators

These two types of market players go hand in hand, guaranteeing the flow of trades to and fro and bringing balance to the market.

 

Trading Technology: The Nerve Center

Electronic trading platforms allow exchanges to function on a global scale, providing a balanced level of speed, access and transparency for everyone.

 

Clearing: The Integrity Behind Every Trade

Clearing houses stand at the focal point of every trade, acting as the buyer for every seller and the seller for every buyer, guaranteeing that each player can make good on the terms of the trade and keeping the integrity of the market.

 

Liquidity: The More, The Better

Liquidity is the ability for every buyer to find a seller, and every seller to find a buyer, so that trading activity can remain consistent and reliable.

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The Sphere of Commodity Traders

All kinds of people come to the commodity exchange to buy and sell. They may work for corporations, banks, governments, investment managers, farmers or food processors. The list is endless.  Whoever they are, wherever they come from, these traders are interested in two types of trading: Hedging and Speculating. 

Hedgers and Speculators go simultaneously. One cannot exist without the other. Hedgers transfer risk and speculators absorb that risk.



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All set? Invest!!

When you decide you are ready to start trading exchange-traded products, you have to choose the most suitable way for you to do so. Unless you are a member of an exchange or have a seat on the exchange floor, you have to open a trading account with a commodity broker who is licensed to conduct trade on behalf of clients at the exchange. 

After you select a commodity brokerage firm you are comfortable with, it is time to open an account and start trading.  You can choose from a number of different brokerage accounts. If you feel confident about your trading abilities, then a self-directed account (you can do this using this link, comx.afexnigeria.com/afexebiz) where you call the shots is the most suitable account for you. If you do not feel comfortable calling the shots, then having a professional make the trading decisions for you through a managed account is a better choice.

 

Placing Your Order

Your trading account is your connection to the commodity exchange. The broker’s trading platform gives you access to the exchange’s main products such as future contracts, options on futures and other derivative products.

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Tracking Your Order

Once the order is received by the trading system, it is recorded in the Order Management System (OMS) database and also recorded on a transaction log file.  The OMS is in charge of maintaining the state of the order. At this time, the order state is “Pending New”, the order has been received by the broker but not yet sent to the exchange. Before the trade is submitted to the exchange the system needs to check to see if the order meets approved sizing controls.  If the order passes all necessary checks, it is sent to the exchange’s matching engine to be processed. 

The exchange matching engine is the electronic market place where buyers Bid for a price and sellers Ask for a price. The exchange will take Bid and Ask orders and match them appropriately. Orders that are not immediately matched are held in the matching engine as part of the book of open orders. They wait until a new order arrives that will match the same price. 

The OMS is responsible for communicating the fill to the originating trader. This communication happens as soon as possible. If the trader is online, then the fill would be reported immediately, if not the trader would be notified of the fill as soon as he or she is connected.

 

Where would we be without Commodity Exchanges?

Some people wonder if the commodity exchanges actually serve a useful purpose. Do they enrich the economy, or are they just a handful of people performing meaningless activity? 

The truth is that a standardized price for a commodity would be difficult to establish. without the marketplace of commodity exchanges. In such a case, producers would be dependent on individually finding buyers and sellers causing a lot of price volatility and fluctuations. A lot of producers and processors would also face the likelihood of going bankrupt without the ability to hedge their operations with the use of a commodity exchange. All this would in turn likely lead to higher prices for commodities and higher operational costs around the globe.

 

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