Come to think of it, ferrous derivatives, in spite of their progress at more than one exchange, continue to evoke scepticism in some quarters. This, however, is understandable, for many in the long chain of steel industry are still going through the learning process to appreciate the benefits of new financial instruments especially designed for iron ore and steel products. What is not in doubt is that derivatives play, allowing participants to control risk and shield themselves against price volatility, is finding more and more converts. Confirmation of this is to be found in the gaining of popularity of ferrous derivatives since the introduction of futures in steel billets at the London Metal Exchange (LME) in 2008. Many new products have been launched since at LME and other exchanges, and the volume of business is rising.
To give one example, physically deliverable steel billet contracts at LME quadrupled in the first quarter of this year, compared with the same period in 2010. Price volatility on an unprecedented scale that happened in steel products and in steel-making raw materials like iron ore and coking coal since 2008 and the controversial migration of iron ore price fixing from an annual to quarterly basis, linked to indices, have further underpinned the imperativeness of covering risks. This is done by using derivatives now available in an increasing variety. The ways of settling contracts between parties are multiplying as these are fine-tuned to make them user friendly.
Responding to the growing use of ferrous derivatives in the form of options, swaps and futures, more and more exchanges are coming on board, from Chicago Mercantile Exchange Group to Dubai Gold & Commodity Exchange. In our country, the Multi Commodity Exchange (MCX) offers trading in physical delivery based futures contracts in steel ingot and billet. Moreover, MCX and Indian Commodity Exchange (ICEX), had launched in January, physically deliverable iron ore contracts to be settled by deliveries of ore fines of 62 per cent iron content. Both exchanges are working towards making their contracts globally accepted market-driven benchmarks for the mineral of which India is an exporter, particularly to China.
That China, which last year with production of 626.7 million tonnes had a share of 44.3 per cent of world steel production, is fast warming up to derivatives, is evident from risk mitigation offerings at Shanghai Futures Exchange (SHFE) and Shanghai Steel Exchange Centre covering items like rebar, wire rod and hot rolled coil. Metal Bulletin (MB) which has published a highly informative 'Guide to ferrous derivatives' says "of all the exchanges listing steel derivatives, SHEF has the highest liquidity, with daily trading volume for its steel futures often exceeding 30 million tonnes." At the same time, exchanges in Singapore offering ferrous derivatives must be drawing a lot of sustenance from players with stakes in China.
What will be watched with interest is the response the Singapore Mercantile Exchange (SMX) gets to its proposed iron ore futures market which will have a much bigger operational canvas than bilateral swaps to include "a greater range of players, such as the investment community." Giving an idea of what the new contract is going to be like, SMX CEO Thomas McMahon told MB that it is "designed to be open to international market participants, providing a price model for China, Japan, Korea and other east Asian markets, while creating a new price benchmark structure for the export markets in Brazil, Australia and India." Some of our leading ore exporters are hoping that the SMX contract will usher in discipline in ore trade now riven with differences between miners and steelmakers.
An issue with the exchanges is that not all miners are sold on derivatives. MB has given the example of Rio Tinto, which remains indifferent to paper markets and derivatives. Sam Walsh who leads the company's iron ore division says "our policy is not to hedge. We leave it to others." On the other hand, BHP Billiton is championing the cause of derivatives as is evident from CEO Marius Kloppers' opinion that "we would like to see deep and liquid swaps markets – or derivatives markets in raw materials, as well as in output products." For steelmakers without linkages to mines, the big concern is price volatility of iron ore. Arguably, the best way of negotiating the risk is by hedging. The challenge is to lock in prices at a future date.
This is why every constituent in the steel chain from miners to steelmakers to stockists to service centres to ultimate users of the metal has started seeing virtues in hedging. And the participation of financial institution in ferrous derivatives is boosting liquidity of hedging operations. MB has made the pertinent observation that the "bond" between the steel community and financial fraternity is "steadily strengthening as an increasing number of people in the steel industry are won over and the volume of trade in derivatives grows. After all, if as an iron ore miner, scrap supplier, steelmaker, mill or stockist you were offered a method of shielding your business from most of the risks of price volatility, why wouldn't you want to use it?"
