Vosbor Blog

A watershed year for the commodity trade

Fri, 30 Dec 2022 00:00:00 GMT

As we're closing out 2022, let's look at one of the most significant events in commodity markets this year. In March, Chinese nickel producer Tsingshan Holdings Group had to cover a massive short position at a loss, causing a meltdown at the London Metals Exchange (or LME). The resulting short squeeze highlights how the traditional derivatives exchange model can actually add systemic risk, instead of limiting it. I’ll explain here why the existing system — in place since 1865 when CBOT launched futures — is due for an update and why digitalising the physical commodity markets is crucial.

Futures exchanges manage risk through brokers, also known as Futures Commission Merchants (FCMs). These brokers request performance bonds or margin balances to ensure traders can meet their financial obligations. Traders must post cash collateral, called the initial margin, when buying or selling futures. FCMs make money from collecting fees and interest on customer cash balances. Most traders are customers of a broker that is a clearing member of the exchange, which guarantees the trader's obligations to the exchange and provides additional protections against default. When a clearinghouse — the party between buyers and sellers — experiences a default, the risk is usually shared by all clearing members through a guaranty fund.

Nickel Pig Iron

In March, Chinese nickel producer Tsingshan Holdings Group had to cover a massive short position at a loss and caused a dramatic intervention at LME. Tsingshan is a private Chinese stainless steel producer who through innovation in metallurgy, became a steel powerhouse and the world's largest nickel producer. Nickel is used primarily in alloys such as stainless steel and increasingly in batteries. It is sold in various forms, with the purest being high-grade (Class 1) nickel traded on the LME and stored in their warehouses worldwide.

But many end-users don’t need such refined nickel. Stainless steel production accounts for over two thirds of nickel demand, up from one-third in the past three decades. Buyers who use nickel in ferroalloys like stainless steel smelt it with iron. Thus a product consisting of 25-35% nickel and 65-75% iron will work fine. Tsingshan pioneered a process called Rotary Kiln Electric Furnace (RKEF) to produce low-cost nickel pig iron (NPI) using nickel ore from laterite, rather than the refined nickel sold on the LME. This NPI contains 10-12% nickel mixed with iron, making it attractive for stainless steel producers who can pay the same price (or slightly less) for NPI as they would for traditional nickel, while also getting a bonus of iron. The innovation revolutionized the stainless steel industry and the mines that produced laterite. Laterite production in Indonesia — who have the largest nickel reserves in the world — went from 130,000 tonnes in 2015 to an estimated one million tonnes in 2021.

NPI weighed the nickel price down in the 2010s, but the market picked up again in 2018 as the markets priced in the need for nickel in EV manufacturing. Now NPI is good for stainless steel, but it’s of no use for modern battery cathodes, whose production requires the type of refined nickel sold on LME. In March of 2021 however, Tsingshan announced a deal to sell 100,000 tonnes of nickel matte (essentially smelted nickel ore with lower iron content) to two large Chinese battery makers. The company managed to further refine the NPI they’d been producing from Indonesian laterite into a product with a 75% nickel concentrate, making it suitable for battery usage. The announcement caused an 8% drop in the nickel price.

The London Metals Exchange

Most of the world’s nickel — even refined concentrate — isn’t sold on LME. It’s a futures exchange where traders trade six ton lots of nickel that they have no intention of producing or receiving. This creates a benchmark for private parties to use when making deals for the delivery of nickel and other metals. The LME, which is over 145 years old, is somewhat of an old-boys club and benefits from its monopoly status in certain markets like nickel. When I started working in M&A in London in 2009, I received a tour on LME and remember how small I thought that floor was given its importance in the global metals market that influences almost everything we touch.

Metals producers use futures exchanges like LME to forward sell their anticipated production through short positions, effectively locking in a price they would receive for the metal it plans to produce before the contract’s delivery date. If the price falls, the company can close the trade at a profit. A rising price doesn’t matter to a short producer either, because any price changes on the futures market should offset price changes in the value of the inventories (as long as the traders can meet their margin calls).

Tsingshan wanted to increase production dramatically by manufacturing nickel matte for electric vehicle batteries. The company planned to produce 850,000 tons of nickel in 2022, an increase of 40% in a year. The obvious consequence of this additional nickel hitting the market would be a fall in the price of nickel. However, not everyone shared this pessimism about prices. Hedge funds were buying nickel contracts, betting on the electric vehicle boom. Glencore supposedly also had a position on the LME that would benefit from rising prices. In the beginning of 2022, it had already taken ownership of more than half of the available nickel in LME warehouses.

You probably realized by now that LME did not accept the pig iron nickel Tsingshan produces, or even the matte nickel they’re selling to battery makers. Exchange delivery nickel has to be the refined product and that nearly all comes from one place, Norilsk in Russia.

Norilsk is the world’s northernmost city, built around a series of high-grade nickel sulfide deposits in Siberia whose ore contain concentrations of nickel, copper, cobalt, platinum and palladium. A higher-grade ore, with a nickel content typically above 2 percent, is crushed and smelted to remove any impurities. The smelted material then goes to a refinery where it is processed into pure nickel. The Russian company that operates the mine and smelters, Nornickel, makes and sells briquettes and cathodes of a purity that make them suitable for delivery to LME warehouses to fill open contracts.

The short squeeze

Everything changed when Russia invaded Ukraine. While Russia’s nickel exports haven’t been targeted by sanctions, U.S. and European buyers have nonetheless sought alternatives to Russian sources. Nickel’s price moved sharply higher in the week after Russia’s invasion. This significantly hurt Tsingshan’s short position. Remember, when prices move up, traders like Tsinghshan who have sold futures contracts face margin calls; they must put up more cash to cover potential losses. The short position didn’t raise any eyebrows among traders at first, because it belonged to one of the largest stainless steel manufacturers in the world. Tsingshan could probably get their hands on some refined nickel at delivery time. But the invasion would make that a lot more difficult. If Tsingshan didn’t have the goods, they had to try and casually close the contracts out by buying nickel on LME. All traders know that there’s no reason for the world’s biggest nickel pig iron supplier to be buying nickel on LME, unless they’re short and can’t cover their position.

The moment they realized this, traders started pouncing. It’s free money. On March 7, nickel’s price began its staggering ascent, surging from $30,000 a ton to more than $50,000. LME brokers and their clients were hit with margin call after margin call. Several large brokers got margin calls of close to $1 billion each over the course of the day.

Tsingshan was unable to meet its margin calls due to a lack of available cash and credit. Its banks and brokers, including JPMorgan Chase, BNP Paribas, and Standard Chartered, were also affected as they had taken the other side of Tsingshan’s contracts and offset those by taking short positions on the LME. They now had to pay margin calls without receiving margin from Tsingshan. In response, some of these brokers rushed to buy back nickel contracts, causing the price of nickel to increase further in a short squeeze. This cycle intensified the difficulties for Tsingshan and its brokers.

By now, the entire nickel industry was in crisis. The LME assembled its Special Committee that has the power to issue emergency rules for the market and ultimately suspended trading. The price was frozen, below the record high but still at $80,000 a ton. At that point, Tsingshan wasn’t the only nickel company that was struggling — just the largest. Many producers, traders, and users of nickel with short positions on the LME were facing margin calls many times larger than they were prepared for. At that price of nickel, the brokers themselves wouldn’t be able to pay their margin calls. Four or five of the brokerages that are LME members would have failed, a shock that could have devastated the global metals industry.

LME made an unprecedented decision. It decided to cancel a day worth of trading. Roughly $3.9 billion in value, according to Bloomberg. Exchanges sometimes cancel trades when technology glitches or “fat fingers” cause one-off mistakes, but it’s extremely unusual for an exchange to cancel whole sessions of trading after the fact. The last time LME did this was during the 1985 “Tin Crisis”, when a cartel of producers collapsed. The decision meant traders wouldn’t need to pay margin calls on the basis of the $80,000 nickel price. Effectively, it artificially lowered the market to the moment when prices closed on the 7th of March, at $48,078.

Shortcomings laid bare

To show you how this is also a failure of the traditional derivatives exchange model, I will use a simple example to zoom in on LME’s shortcomings in this debacle.

A trader — let’s call him Tsingshan — has $2b of collateral and puts on a $3b short in a contract trading at $1 (so 3 billion contracts). The markets start to go up in price and eventually they're at $1.33. Now Tsingshan has:

position size: 3b contracts = $4b
collateral: $1b

Tsingshan has a huge position now and is fairly leveraged — $4b notional, 4x leverage. Another 25% move and Tsingshan is underwater; each 25% move beyond that costs about $1b. What exchanges in such a situation do, is reach out to the trader and warn them to top up — sending a maintenance margin call. But Tsingshan has at least 1 business day to top up. If it's a Friday evening, then they have at least 3 days or 72 hours.

Unfortunately, a war is unfolding in Ukraine and commodity prices are going through the roof. By the time the next business day ends, there have been 3 days of unusual high volatility. A 25% move bankrupts Tsingshan. A 50% could cost the exchange or whoever is backstopping $1b, if the customer cannot put up more collateral. This could happen in 3 days! And in fact, it did in March of this year. The price of LME nickel rose a whopping 250% in less than 24hrs!

There are really two problems here. First, the exchange margin calls based on time, not on price. When Tsingshan reaches 6x leverage, it's time to issue a margin call. Because the goal of the margin call is to ensure that before Tsingshan runs out of collateral, the trader either

(a) tops up their collateral
(b) reduces their position

Once the contract reaches a price of $1.66, trader will fully run out of collateral; any move beyond that and trader goes negative account value. The goal is for Tsingshan to deleverage before the contract reaches $1.66. Time is arbitrary here. The contract could move 1% in 3 days, or it could move 150%. What matters is the price. You have to close down before contracts hit $1.66.

Say that closing down Tsingshan’s position — buying back 3b contracts — would have a 10% impact. This means that, if Tsingshan isn't going to top up, you have to start reducing their position before the contract hits around $1.50 — adding 10% impact to that would move markets to around $1.66. So in this hypothetical situation, you have to begin liquidating Tsingshan's position when the contract hits $1.50 completely, independently of when that happens. If a week later the contract is at $1.35, it's fine. But if a minute later it's at $1.50, it's time to start closing down Tsingshan. This is how liquidations should be done. Exchanges should begin deleveraging a position as soon as it's running too low on collateral, independent of time. Sometimes one day is too long.

Which brings me to the second problem. This happened just before the weekend. The exchange wasn't open over the weekend and so the fastest they could margin call was 72 hours. On Monday, 7 March, the market unraveled quickly, with prices rising by a stunning 66% to $48,078. On Tuesday the price went vertical, soaring $30,000 in a matter of minutes and just after 6 a.m. the price of nickel passed $100,000 a ton.

| Bloomberg

Nickel’s 250% price spike in less than 24 hours plunged the industry into chaos, triggering billions of dollars in losses for traders and leading LME to suspend trading for the first time in 3 decades. And worst of all, they canceled trades. As explained above, this could have been prevented if margin calls were made sooner. This was not some black swan event. Margin calls are delayed regularly, because the interests of brokers (FCMs) are not always aligned with the exchange. They could call their customer — who may be the largest nickel producer in the world representing a significant part of income — and ask to top up the margin. Tsingshan could have replied that they’re good for it, but cannot make payment immediately. By not forcing margin payment, this broker is now risking the guarantee fund i.e. other customers' funds. It is all based on trust and individual decisions. Moreover, regulators didn’t realize the size of the over-the-counter positions, having wrongly assumed that looking at the positions on LME was enough — ignoring privately negotiated over-the-counter (otc) derivative and physical commodity trades.

Pioneering new infrastructure

FTX’s proposal to CFTC earlier in the year addressed the first issue and would be groundbreaking for futures markets. They were proposing a direct clearing model built around real-time risk technology, similar to that currently used by spread betting platforms such as IG Index, Robinhood and E*Trade. This was seen as a threat to traditional market infrastructure players such as central counterparty clearing houses (CCPs) and FCMs, as FTX was proposing to risk manage each underlying client directly. Some CCPs are already calculating margin requirements on a near real-time basis. However, they typically only request additional collateral at certain times of the day and often only send these requests to clearing brokers, who may not pass them on to (important) clients.

In the proposed model the relationship is directly with the clients, meaning that the clearing house would be responsible for ensuring that they have sufficient collateral on a real-time basis and cannot rely on brokers to provide credit i.e. asking margin upfront, instead of extending credit. The new model would ensure that positions are closed out if collateral held is insufficient, instead of simply requesting additional collateral if the risk increases beyond a certain threshold. This real-time margining prevents investors from accruing greater and greater losses. In the case where there is a large liquidation and markets are moving down too quickly to successfully close the position before bankruptcy, a backstop liquidity provider system would step in. Liquidity providers who have opted in to the system will internalize the position, taking over the whole obligation and collateral. They would do this before the account actually goes bankrupt, so they have a chance to successfully manage the position. Interestingly, this could introduce competition for future exchanges — something even FTX’s critics admitted would be a positive development.

This new clearing model thus fosters competition, democratizes derivative trading and protects smaller investors from accumulating debts they cannot afford. CME, despite its strong criticism to FTX’s proposal, unscrupulously followed suit later by applying to CFTC for an FCM license themselves — likely inspired by rising interest rates and the lost revenue from brokers collecting margins. Meanwhile, FTX perversely became the victim of the risk that they correctly identified to CFTC, by not swiftly deleveraging a losing position of a key customer—they allowed their sister company, hedge fund Alameda Research, to trade entirely outside their own liquidation rules.

The other issue laid bare by the LME nickel squeeze — otc trade in physical commodities and their derivatives — can be addressed in several ways. Some argue for regulation, in the same way that Enron was addressed by Sarbanes-Oxley and after the 2008 financial crisis we saw Dodd-Frank and Basel III. Javier Blas pointed out that G7 countries could for example set up a register of international oil transactions, as they agreed to do in 1979. This was never implemented because oil traders were vehemently against it. Wider regulation is probably not the answer, as commodity trade is global and would require a multilateral approach — unilateral government interference is what usually leads to windfall opportunities for traders.

The only way I believe you can improve this is by creating a digital exchange with an otc environment (dark pool) — enabling traders to move volumes around the globe openly or privately, while aggregating all pricing & volume information for the sake of risk management. This approach would ensure self-regulation and make commodity trade more efficient in the process. Moreover, it would address the fact that otc markets often fail to demonstrate resilience to market disturbances and become illiquid and dysfunctional at critical times. In periods of high volatility with a lot of noise, price discovery breaks down and traders exit the market — leading to severe supply chain disruptions.

Vital role of commodity traders

The proper functioning of commodity markets is of critical importance to mankind. Most countries, including the Netherlands and the majority of other OECD countries for example, are not self-sufficient. They depend on breadbaskets for food — countries like the US, Brazil or Ukraine — that produce more crops than they consume domestically. They depend on mining powerhouses, like Australia, Chile and Russia, for metals like nickel, cobalt and copper that are crucial for EVs and the clean energy transition (IEA estimates that the market for such metals could increase 30-fold by 2040). As a result, any supply volatilities — climate change, war — can have a dramatic impact on pricing and the global economy. It is vital that commodities move efficiently from places where there is surplus to where there is deficit. This is what traders do best, but offline physical markets do not create the systemic resilience we need. Plus, digital derivative markets could use an update as well, as LME has shown us. In fact, digitalising physical trade and real-time margining goes hand in hand — without real-time benchmarks from the physical commodity markets, it will be hard to price derivatives in this new clearing model.

At Vosbor, we have developed an exchange for the global trade in agricultural commodities. We have launched in beta with the leading groups in the industry, determined to facilitate the transition of international commodity trade to a digital environment that benefits all participants in the supply chain. We are not out to disrupt anyone — in fact, we want to add more traders and liquidity. Nor do we intend to change the relationship-based business, but rather help everyone capture more value. Soon, we will offer commodity derivatives and will increase liquidity with financial investors. We plan to expand into other markets like metals, as trade in bulk commodities is very similar across the board (why our beta users Cargill and Glencore are successful in both agriculture and metals). We are lowering the cost and risk of trading. Together we are going to make commodity markets more efficient, robust and accessible to all.

Perpetual swaps for farmers

Mon, 19 Sep 2022 00:00:00 GMT

This post will explain the option to effectively hedge the price risk using perpetual swaps, or perpetuals, and compare this to the alternative hedging instruments such as futures contracts.

Imagine a crop farmer who is exposed to a number of risks that may affect the returns on the farming operation. Not only is he exposed to production risks like adverse weather, pests and diseases, but also has to worry about price and demand for his crop at time of harvest. These factors may negatively affect the balance sheet, which in turn affects his ability to grow crops in the next season and in extreme cases result in his bankruptcy. Whilst a farmer can lock in on a future price by means of a forward contract with a trader or consumer at a minimum price (marketing contract), this would not always optimize the returns. Also storing the commodities for sale in better times may be costly and affects quality over time. And what if other farmers do the same? An alternative is to buy crop revenue and/or yield insurance.

Today few farmers are hedging their risks themselves using existing futures contracts for a number of reasons:

Existing futures contracts do not correlate well with conditions on the ground, which produce ineffective hedges for the risks associated with the local environment (eg. weather). For example, farmers operating in Australia who hedge their price risks with futures based on the US market and fundamentals have a very high basis risk (the difference between the futures price and the spot price).
Futures exchanges require high initial margins of around 8-10% meaning the position is leveraged up to 10x. Considering high position values, this results in very high entry costs for a farmer who needs to deposit this amount up front.
Opening and managing a position on a futures exchange comes with additional brokerage, exchange and clearing costs. To trade on the exchange you need to go through a complex- and involving onboarding process.
Futures contracts typically come in 50-150 metric ton lots, which does not allow people to precisely hedge the exact amount exposed to a risk (eg. yield expected by the farmer).

Farmers need a stable income to fund their operations, pay for their inputs (seeds, fertilizer, herbicide, pesticide, machinery, fuel, labor) and for their land. A good price for the crops harvested or financial compensation when this price is insufficient, will contribute to an economically viable operation. This post will explain the option to effectively hedge the price risk using perpetual contracts and compare this to the alternative hedging instruments such as futures contracts.

The financial environment of a farmer

For the scenarios presented here we will assume a context where a farmer is growing 800 hectares of wheat in Australia and exporting through the port of Adelaide. On average over the past 10 years the farm has been producing 2-2.5 tonnes per hectare and the rough estimated average price observed in the past 10 years is approximately USD 6.5 per Bushel. The farmer has defined a conservative target for this year, with a break-even price of USD 6.0 per Bushel and an estimated yield of 80% of 2.25 tonnes per hectare. With 1 bushel representing 0.0272 metric tonnes, we find that the required yield for the farmer this year needs to represent the following value;

800 * (0.8 * 2.25) ÷ 0.0272 * 6.0 ≈ USD 317,647

Note: normally we should also reserve the costs for the logistics to transport the grain to the port. This is all assumed to be discounted in the price and therefore financed by the buyer.

What follows are two scenarios that the farmer could face. Scenarios that affect the yield (harvested crops) or price, and therefore impact the potential income of the farmer. For each of these scenarios we demonstrate how the farmer could employ Vosbor perpetual contracts to hedge their price risk and retain a stable, good enough, income.

Scenario 1 “Good year for Australian Wheat”

In comparison to the other Wheat producers in the World, Australia is preparing for a great year, where prices are well above the global market prices offered. At the time of planning the farmer observes a spot price for the wheat index on Vosbor of USD 6.2 per Bushel, which is identical to the future price quoted in the May contract for wheat. The farmer decides to open a USD 320,000 Vobor perpetual short position at a price of USD 6.2 per Bushel (51,613 contracts) with an investment of USD 32,000. Thus the farmer invests with a leverage of 10x.

In the example Vosbor uses a 3% maintenance margin requirement for this perpetual contract. This 3% maintenance margin requirement means that the farmer will be automatically liquidated only when his investment reaches a leverage of 33x as a result of a price hike of the index. So the Farmer needs to keep his margin account above USD 9,600, which would be the balance when the index price increases with more than 7%, this to avoid an auto-liquidation trigger. If the price is approaching USD 6.63 (close to +7%) per Bushel, the Farmer should add funds to not lose his position.

Fortunately the price first decreases to USD 6.0 per bushel and then after spiking to 6.45 in June settles at 6.3 in September at the time of harvest. Since the Vosbor Index is representative for the region of the farmer, the base is small at harvest. The farmer now sells the harvested wheat at USD 6.3 per bushel. And closes the perpetual short position with a loss at USD 6.3 per bushel.

The effect of these transactions are:

Sale:

800 * (1.0 * 2.25) ÷ 0.0272 * 6.3 ≈ USD 416,912

Note: 1.0 represents 100% harvested crops in our scenario

Performance hedge:

51,613 * (6.2 - 6.3) ≈ USD -5,161.3

The position has been open for 150 days (early May - end of September), and in this time the perpetual has been higher than the Index (wheat price traded on the platform) for 100 days.

Funding premium received:

Every 8 hours a funding fee to be paid or received by the farmer is calculated. The funding fee depends on the current funding rate, position size and current price of the asset:

Funding Fee = Position Size * Mark Price * Funding Rate

Example below presents the formula used to calculate the funding fee at a time, when for the last 8 hours perpetual contract was on average trading at a higher price than the index (in this case farmer who has a short position open receives funding):

51'613 * $6.20 * 0.0005% ≈ $1.60

As funding fee is paid or received every 8 hours, the total funding paid or received by the farmer is a sum of all fundings settled during 150 day when the farmer had the position open. Assuming an average funding rate of 0.0005% / 8hrs (0.0015% / day) we expect to receive the following roughly estimated funding premium:

51,613 * 6.2 * ((100 * 0.000015) - (50 * 0.000015)) ≈ USD 240

Note: from the 150 days that you had an open short position 100 days the perpetual was trading at a higher price than the index.

So, the total performance of the sale including the hedge is:

USD 416,912 - 5,161.3 + 240 ≈ USD 411,991

Alternatively the Farmer could have decided to hedge the price risk using futures contracts. For this the farmer is using the most liquid futures that are available on Chicago Mercantile Exchange (CME). The farmer decided to sell futures in May at a price of USD 6.2 per Bushel, and then to buy these contracts in September just before the contract was supposed to be delivered.

Note that it is more likely to find a CME future price that does not reflect the fundamentals for an Australian farmer. We would expect to find a base difference, but for the simplicity of our calculation example we reflected this to be the same as the Vosbor wheat index price that represents the price for the Australian farmer.

The contract at CME is priced 620 U.S. cents per Bushel, with a minimum contract size of 5000 Bushels. We need to sell contracts that matches:

800 * (0.8 * 2.25) ÷ 0.0272 ≈ 52,941.18 Bushels

Note: Which considering the contract size, comes down to 11 contracts.

The margin requirement (initial margin) is 10% of a 5,000 Bushel wheat contract. To sell 11 contracts, the farmer needs to fund and maintain the following margin level:

10% * 11 * 5,000 * 6.2 = USD 34,100

With a maintenance margin set to 9.1%. Which means that whenever the future price falls below 9.1%, you receive a margin call and need to add funds to move your margin balance to at least USD 34’100 (the initial margin level). In September the farmer buy’s 11 contracts for USD 6.3 per Bushel. And sells his harvest for USD 6.3 per Bushel. These transactions result in the following proceeds:

Sale:

800 * (1.0 * 2.25) ÷ 0.0272 * 6.3 ≈ USD 416,912

Note: 1.0 represents 100% harvested crops in our scenario

Performance hedge:

11 * 5,000 * (6.2 - 6.3) ≈ USD -5,500

There are further costs associated with the futures option. You also need to pay brokerage fees. But ignoring that for now, the overall result is:

Overall result:

USD 416,912 - 5,500 ≈ 411,412

Scenario 2 “Long, warm and dry summer”

This year the summer has been a long dry one. There was not enough water to irrigate and grasshoppers were destroying the crops. Historically these situations have resulted in 20% crop loss despite pesticides treatment. You with your current state of crops could expect not more than USD 5.2 per Bushel.

At the time of planning (well before disaster strikes) the farmer observes a spot price for the wheat index on Vosbor of USD 6.2 per Bushel, which is identical to the future price quoted in the May contract for wheat. The farmer decides to open a USD 320,000 Vobor perpetual short position at a price of USD 6.2 per Bushel (51,613 contracts) with an investment of USD 32,000. Thus the farmer invests with a leverage of 10x. Since the Vosbor Index is representative for the regions of the farmer, the base is small at harvest. The farmer now sells the harvested wheat at USD 5.2 per bushel. And closed the perpetual short position with a profit at USD 5.2 per bushel. The effect of these transactions are:

Sale:

800 * (0.8 * 2.25) ÷ 0.0272 * 5.2 ≈ USD 275,294

Note: 0.8 represent a loss of 20% on the harvested crops in our scenario

Performance hedge:

51,613 * (6.2 - 5.2) = USD 51,613

The position has been open for 150 days (early May - end of September), and in this time the perpetual has been lower than the Index (wheat price traded on the platform) for 50 days. Assuming an average funding rate of 0.0005% / 8hrs (0.0015% / day) we also receive the following funding premium:

Funding premium received:

51,613 * 6.2 * ((50 * 0.000015) - (100 * 0.000015)) ≈ USD -240

So the total performance of the sale including the hedge in this example is:

USD 275,294 + 51,613 - 240 ≈ USD 326,667

Would this trader have used futures to hedge its position then we would have found the following.

Sale:

800 * (0.8 * 2.25) ÷ 0.0272 * 5.2 ≈ USD 275,294

Note: 0.8 represent a loss of 20% on the harvested crops in our scenario

Performance hedge:

11 * 5,000 * (6.2 - 6.3) = USD -5,500

Note: since this was a local disaster. Futures at CME traded at 6.3 (not 5.2)

As the markets represented by the futures were not exposed to this scenario like the one that the farmer was facing, the futures hedge ended up introducing a further loss. At harvest it represented USD -5,500 value. Because of the base price difference the farmer could not make the required USD 317,647. He now actually has to incur a total loss of 42,353 + 5,500 = USD 47,853.

Conclusion

Perpetual contracts offer an interesting new way to hedge price risk. Perpetuals can be based on a price index that closely resembles the fundamentals for the farmer, therefore reducing the basis risk. In other words, correlation is significantly improved. Margin requirements are reduced and additional brokerage, exchange and clearing costs can be much lower than in traditional futures market environments. Plus, the onboarding process is more efficient, because of the reduced involvement of third-parties.

The farmer will however need to monitor the perpetual position more actively and there is a risk of auto liquidation, but only at well defined ratios of margin and taking into account the size of the position. No wipe out after a missed margin call however!

The index follows the spot price of the selected index and synchronizes every X hours (funding cycle). All the time that a perpetual moves against the contract (e.g. the perpetual is developing a loss) an additional premium (funding rate) is received, as per funding cycle every X hours. Effectively, ensuring that perpetuals trade much closer to the physical spot index price. This gives farmers the opportunity to sell their crop when they want to sell and food manufacturers the option to buy ingredients when they need them (ultimately exchanging the perpetuals for physical contracts).

One more step in our mission to build the infrastructure for the future of food security!

Vosbor raises $7 million in a round led Lux Capital

Thu, 28 Jul 2022 00:00:00 GMT

Vosbor, the first digital marketplace for global trade in bulk agricultural commodities, today announced a new $7 million Seed round led by Lux Capital with participation from Market One Capital, FJ Labs, 7percent Ventures, Athos Capital and Nucleus Capital. Vosbor also unveiled its flagship trading platform, which connects trading firms and end users across markets in a secure and transparent environment. The platform is currently being piloted by 35 of the leading companies in the agricultural commodity trade. Vosbor also revealed that industry heavyweights Chris Mahoney, former CEO of Glencore Agriculture and Soren Schroder, former CEO of Bunge, are co-investing and have joined the company’s team.

“The agricultural commodity trade — the backbone of our global food supply — still takes place offline, although more than $30 trillion in physical commodities and otc derivatives is transacted every year,” said Maarten Elferink, CEO of Vosbor. “Vosbor brings the agricultural commodity trade online, allowing buyers and sellers to trade more efficiently, simplifying risk management in a world where supply chain risks are mounting, and providing market data unavailable today to enhance decision-making. We make commodity trading cheaper and markets more accessible. In addition, we’re working on new derivatives that will give retail investors a better opportunity to participate in commodity markets, while lowering basis risk for industry participants — farmers, traders, millers, crushers and manufacturers alike. Farmers especially stand to gain, as worldwide there are few who make use of futures to hedge price risk today.”

“By digitizing the agricultural trade, Vosbor is effectively taking the first critical step in alleviating the threats to global food security, as existing offline markets are inadequate to build systemic resilience,” said Peter Hébert, co-founder and managing partner of Lux Capital. “Vosbor’s vision is bold and they're led by an exceptional team capable of transforming vast commodity markets. Lux Capital is honored to be a part of Vosbor’s journey and we are eager to work closely with the team to ensure its long-term success.”

Traders perform a vital role in getting food from surplus to deficit regions

Much of our food — as well as the animal feed and other inputs which become the food we eat — is produced far from where it is consumed. Most countries are not self-sufficient and rely on imports for food, the Netherlands included. They depend on several breadbaskets such as the U.S., Brazil, Russia, and Ukraine that produce more crops than they consume domestically. When exports from these countries are disrupted, the problems quickly cascade, as evidenced by the global food crises of 2008 and 2011, and again today. However, agricultural commodity prices were already at record highs, well before the war in Ukraine severely exacerbated the situation — largely driven by the impact of climate change.

Climate change is affecting agriculture worldwide, as increasing water-scarcity, rising temperatures and extreme weather events have already diminished harvests in numerous countries. The US, Canada and Brazil went through extreme heat and drought last year, pushing up prices for corn, wheat, coffee and peas among other crops. Across the globe, farmers will nevertheless need to grow more, because demand will continue to increase. Our planet will have to feed an additional two billion people by 2050 and another 1.5 billion by the end of the century, the UN forecasts. Average global crop yields are increasing too slowly to meet that demand, while urbanization and underinvestment in agriculture complicate this further. Worse, recent crop modeling by SEI and NASA have shown that the yields of crucial crops are declining, with corn yields — the most widely grown crop in the world, which together with rice and wheat contribute to ~50% of daily human energy requirements — potentially falling by 24.2% to 27.2% by the end of the century as a result of climate change.

“Traders are crucial in absorbing supply and demand imbalances, as they swiftly move commodities around the world from surplus to deficit regions,” said Soren Schroder, former CEO Bunge Ltd. “Not only shipping them around the globe, but also storing, processing (milling for example) and consuming them (in feed production for instance). They bring enormous efficiencies to the market. Without traders, global food security would not exist — especially under market conditions like we have today. However, this doesn’t mean there is no room for improvement. From the coffee you drank this morning, the wheat in your muffin to the palm oil in your toothpaste or the livestock feed needed for your milk — most of it is still traded over the phone, executed by email, made binding with various hard copy contracts and involved many different intermediaries. This results in high operational costs, complex execution and little market data to enhance decision-making.” Vosbor is intent on changing that.

To learn more and book a demo, please visit www.vosbor.com.

About Vosbor

Founded in 2019, Vosbor is the first digital marketplace for global trade in bulk agricultural commodities. The recently launched platform allows buyers and sellers to connect, communicate and trade corn, wheat, soybean, palm oil and 14 other agricultural commodities in a transparent and secure environment. Vosbor is based in Amsterdam with additional offices in Singapore. It is backed by leading VCs including Lux Capital, Market One Capital, FJ Labs, 7percent Ventures, Athos Capital and Nucleus Capital. To learn more, please visit www.vosbor.com.

Building infrastructure for the future of food security

Fri, 15 Jul 2022 00:00:00 GMT

In our globalized world, much of our food — as well as the animal feed and other inputs which become the food we eat — is produced far from where it is consumed. Before arriving on supermarket shelves it is traded on international markets and moves through global supply chains. Most countries aren’t self-sufficient and rely on imports for food. They depend on several breadbaskets — countries like the US, Brazil, Russia or Ukraine — that produce more crops than they consume domestically. When exports from these countries are disrupted, the problems quickly cascade — as evidenced by the global food crises of 2008 and 2011, and again today. However, agricultural commodity prices were already at record highs, well before the war in Ukraine severely exacerbated the situation.

Last year the United States went through the hottest summer ever measured, breaking the record set during the Dust Bowl of 1936. In the northern Great Plains, extreme heat combined with extreme drought brought swarms of grasshoppers, decimating the wheat crop. Wheat prices reached their highest level in years. Corn prices rose 45 percent. Meanwhile, Brazil, the largest exporter of soybean and coffee and second only to the US in corn, suffered its worst drought in 91 years. Then a surprise frost struck Brazil’s coffee belt in July, damaging the drought-stricken arabica trees as the buds that will become next year’s flowers fell off — creating 2 harvests failures in one season. The price of coffee today is double that of 2020. In Canada, the worst drought since 1961 doubled pea prices (alternative-meat has made peas more popular than ever).

Climate change is affecting agriculture worldwide, as increasing water-scarcity, rising temperatures and extreme weather events have diminished harvests in numerous countries. Across the globe, farmers will nevertheless need to grow more, because demand will continue to increase. By 2050 there will most likely be two billion people more on Earth and by the end of the century there will be another 1.5 billion. Average global crop yields — the amount of crops harvested per unit of land cultivated — are increasing too slowly to meet that need, while urbanization and underinvestment in agriculture make this situation worse.

It is important to understand the systemic risk of supply volatilities. China, for example, is by far the largest consumer of wheat in the world and only second to the United States in consumption of corn, yet it is almost self-sufficient in production of these crops. When their domestic reserves dwindle due to climate-induced harvest failures, it may force local buyers to import substantially more grain to meet demand, taking a significant chunk out of global supplies — in turn impacting prices and food security worldwide.

Traders perform a vital role in getting food from surplus to deficit regions

Intermediaries are crucial in absorbing such market volatility, as they swiftly move commodities around the world from surplus to deficit regions. Traders are present throughout the supply chain, not just shipping commodities from A to B, but also storing, processing (milling/crushing) and consuming them (for example in meat production). They bring enormous efficiencies to the market, allowing countries to move away from the ancient practice of hoarding grain. Without traders, global food security simply would not exist — especially under market conditions like we have today.

That doesn’t mean there is no room for improvement. The physical agricultural commodity trade has not fundamentally changed over the last 40 years and relies on processes that are even older. From the coffee you drank this morning, the wheat in your croissant, to the feed for the animals or palm oil (present in half of all packaged products in supermarkets, from pizza and chocolate, to deodorant, shampoo and toothpaste) — all of it is traded over the phone, executed by email, made binding with various hard copy contracts and involving many different intermediaries.

This results in high operational costs, complex execution and a lack of transparency with little market data to enhance decision-making. The UN estimates that more than 275 million emails are exchanged annually to process about 11,000 shipments of grain transported across the oceans. That is 25,000 emails per shipment between all parties involved! The market is entirely offline, although with more than $30 trillion dollars transacted physically and in over-the-counter derivatives, agricultural commodity trade is arguably one of the largest untapped e-commerce opportunities out there.

Most trading companies, however, do not just buy and sell physical commodities, they also leverage their knowledge and insights in the derivatives markets. In fact, proprietary trading is a significant part of revenue for the major trading companies. Usually a multiple of what is physically traded and this is reflected in the derivative markets, where the total volume in soybean futures contracts was around 27x greater than the volume harvested worldwide in 2020 (corn futures 12x larger, wheat 10x larger). The financialization of commodity futures markets plays a part here too, as hedge funds, pension funds and other financial investors also trade futures — although they have no interest in ever taking delivery of bulk corn or soybeans.

Commodity trading is all about fundamentals

The way the physical and derivative markets are connected is what makes agricultural commodity trading unique. In the end, the physical and futures contracts converge in a rational response to supply and demand. They reflect reality. Most other financial markets are not rational at all, with much more noise, non-fundamental volatility, and less convergence. Take equity markets, where celebrities nowadays sell shares in shell companies and social-media mobs can drive prices.

Commodity trading is all about fundamentals or changes to supply and demand (crop, weather, logistics, etc). Research is critical. Long before anyone in Silicon Valley talked about big data, commodity traders were aggregating data from thousands of farmers to get a real-time insight into the state of the markets. As data availability increased, algorithmic and high-frequency trading moved into commodity derivatives markets — especially after open outcry disappeared in the early 2000s. Arguably, algorithms are better equipped to find arbitrages and price agricultural commodity derivatives, due to the rational nature of these markets.

Many commodity trading companies saw this opportunity and investments in quantitative trading have been on the rise. Instead of relying on extensive traditional information networks to gain advantages from proprietary data, traders invest in sophisticated systems and dedicated teams to use predictive analytics to draw valuable proprietary insights from common data sources. They now combine quantitative approaches with strong fundamental research.

Our vision is that these trends will further drive liquidity and competition in the commodity markets — resulting in faster trading and reduced spreads. Hyperliquidity is the ultimate state of commoditization, where markets’ efficiency and transparency reach their highest potential levels. Three main forces push commodity markets towards hyperliquidity: an increasing degree of standardization, greater transparency and the emergence of an advanced digital infrastructure. The most liquid agricultural products (corn, soybeans and palm oil) are already highly standardized and the increasing availability of information has been pushing the industry towards digitalization for some time. The global pandemic has accelerated it. What is missing is the digital infrastructure and with climate risks to global food security mounting, this evolution will be key to building systemic resilience.

Digitizing the physical commodity trade enables a crucial upgrade of derivatives markets

That is why we are determined to bring the physical markets online. We’ve built an exchange environment for the global spot and forward trade in grains and oilseeds, currently in beta with all of the leading global commodity trading firms and key buyers participating. This enables trade by increasing efficiency, market participation and compliance, while reducing cost and errors. Besides the physical commodity market, we also digitize existing (brokered) over-the-counter ‘paper’ forward trade. This trade fills a major gap between the futures and physical markets — the most liquid futures market (Chicago Board of Trade or CBOT) offers mainly derivatives based on US products, which do not correlate with for example Russian wheat or Brazilian soybeans (while products meant to solve this issue, such as Black Sea futures, do not converge well). Unlike regulated exchanges however, we don’t offer central clearing. Thus we do not compete with traditional derivatives markets in terms of counterparty risk. Decentralized futures — or perpetual swaps to be precise — could change that.

In traditional derivatives markets, futures contracts are marked for delivery of the commodity in question. For example, corn should be delivered according to the contract when the futures contract expires. Therefore someone is physically holding the corn, which results in ‘carrying costs’ for the contract. Additionally, the price for corn may differ depending on how far apart the current time and the future settlement time for the contract is — this risk of variation between the price of a deliverable commodity and the price of the futures contract is called basis risk. Moreover, holding on to a futures contract also requires that you periodically roll over the contract into a new contract, before the contract’s expiry — creating more basis risk. As the gap widens, the contract’s carrying costs increase, the potential future price becomes more uncertain, and the potential price gap between the spot and futures markets grows larger. This leads to major issues when using futures to hedge physical commodity positions, which the majority of farmers, traders and end users do. The current dislocation in the Black Sea for example, has rendered the wheat futures markets all but useless for hedging purposes.

In 1992 Yale’s Robert Shiller therefore proposed perpetual swaps, with a method for generating asset-price indices through hedonic regression. Perpetuals are synthetic, which means they do not represent or securitize the underlying asset. Instead, it utilizes a periodic ‘funding’ schedule to tether its price to the spot price of the underlying asset. The perpetual is an attempt to take advantage of a futures contract — specifically, the non-delivery of the actual commodity — while mimicking the behavior of the spot market in order to reduce the price gap between the futures price and the price of the underlying commodity.

Only recently did perpetuals start trading broadly, in cryptocurrency markets ($195b daily vol). In May 2016 BitMEX first offered them and instantly became popular as it permits highly-leveraged trading at different time-horizons, without significant counterparty risk in the absence of regulated intermediaries. Due to its synthetic nature, you can trade much more volume than would be possible by the actual circulating liquidity of the underlying asset. The volume is essentially only limited by open interest.

So how does it work? As described, the instrument is tethered to an asset synthetically. Unlike a future, which is a contract to buy or sell an asset at a particular price in the future, perpetuals simply track the price of the asset using incentives based on price indexes. There is no need to actually fulfill the contract or hold the underlying asset. No need for a central clearing counterparty and algorithms will perform functions in the futures markets now entrusted to brokers, called futures commission merchants in futures markets. Like any futures contract, you can take a long/buy position, or a short/sell position. To price the instrument, the market displays an index from multiple exchanges, which is managed off-chain to prevent delays in updating and slippage (price changes between placing your order and execution). At certain intervals, say every eight hours, the prices of the longs and short are compared to the index price, and those on the right side of the trade pay the counterparty (called funding). This creates a powerful incentive to keep the price of the perpetual in sync with the spot price, as any difference would present an arbitrage opportunity for a trader.

Digitizing the physical agricultural commodity trade creates unique pricing benchmarks backed up by real trades, and presents a foundation for new financial instruments such as perpetuals. These will give retail investors an opportunity to participate in the agricultural commodity markets directly, while enabling institutional investors to take deep positions in specific markets, like short soybean Brazil or long milling wheat Indonesia. Traders will have more ways to capitalize on information advantages and the increase in liquidity would allow all industry participants — farmers, traders, millers, crushers and manufacturers alike — to reduce basis risk. This is exactly what you want when growing demand faces a dwindling supply; volatility can pay off nicely in trading, but it never does for the people that rely on imports for food.

More liquidity results in faster reactions from the market, guaranteeing that price movement happens in anticipation of the actual event, thereby solving the problem before it occurs. Financial investors thus help guarantee food security. 99% of futures are already traded without delivery of the underlying commodities. This liquid market helps farmers decide what to plant, while also offering them the opportunity to sell their crop whenever they want to sell and for the food manufacturers to buy ingredients when they need it (ultimately exchanging the futures for physical contracts). This efficiency allows countries to keep less inventory than they would otherwise have. We need to finetune that system, by creating a liquid digital spot and forward market, to which we can connect a decentralized futures market. Central clearing may become obsolete, but this evolution would be far from disruptive — the world needs more participants in agricultural markets. The higher the liquidity, the better these markets function and the better it is for everyone. We need tools to manage risk and commodity flows in a world where climate risks are ever increasing. We need to build the infrastructure for the future of food security.