Introduction
Each day, billions of dollars worth of energy products, precious metals,and other commodities are bought and sold on the trading floor of the commodity exchanges. And, shortly after the trading floor closes, electronic trading starts and continues throughout the night. That's because night and day, minute by minute, the value of these strategic commodities are changing, and those changes can have an effect on everything from the price people pay for gasoline to the cost of gold ingots in the Gold Souk.
The prices quoted for transactions on commodity exchanges are the reference for prices that people throughout the world pay for products like crude oil, heating oil, gasoline, natural gas, gold, silver, platinum, and aluminum
Yet the buying and selling on an exchange sometimes occurs far away from oil wells or copper mines. In fact, many participants never see a gallon of heating oil or a bar of silver. If you visit some exchanges, you won't find samples of metal or barrels of oil scattered about, but you will see a lot of people standing in circles yelling at each other.
How can that be? How do these exchanges work? What's all that shouting about?
History of Modern Commodity Exchanges
Starting around the middle of the 19th century in the United States, businessmen began organizing market forums to make the buying and selling of commodities easier. These central marketplaces provided a place for buyers and sellers - such as farmers and grain dealers - to meet, set quality and quantity standards, and establish rules of business. Agricultural commodities were the most commonly traded, but a market will develop for almost any commodity as long as there is an active pool of buyers and sellers.
Years ago, exchange trading resembled a souk. Merchants offering their commodities for sale brought samples to the exchange. Buyers would come to the exchange to examine the quality of the offered merchandise and bid on supplies. Businessmen vied with other buyers or sellers, each trying to obtain the best price for their products or to buy at the most competitive price.
As communications and transportation became more efficient in the early 20th century, centralized warehouses were built in principal market centers such as New York and Chicago. The exchanges in the smaller cities began to disappear.
Today, physical supplies of the traded commodities are nowhere to be found in exchanges. Instead the traders buy and sell on the Exchange through instruments called futures contracts.
A futures contract is a legally binding obligation for the holder of the contract to buy or sell a particular commodity at a specific price and location at a specific date in the future.
The contracts are standardized to make sure that the prices mean the same thing to everyone in the market; everyone trades contracts with the same specifications for quality, quantity, and delivery terms.
That way, if the price of oil is quoted on the exchange at 50 dollars a gallon, everyone knows that is the price for a specific grade and quality of oil in a specified location. No one can say later that they thought it was the price for something else.
Futures contracts are most widely used for hedging. Hedging allows someone to offset the risk of changing prices when he buys or sells physical supplies of a commodity. For example, a copper mining company might sell a futures contract to lock in its sales price and protect its revenue should the market value of copper fall. If copper prices rise instead, then the increased value of the physical metal offsets its loss on the futures contract. At the same time, a pipe manufacturer who buys copper to use as a raw material in the production of pipe might buy a copper futures contract to lock in his raw materials cost. If the price of copper falls, the cost advantage gained by buying the actual copper at a lower price offsets his loss in the futures market. In both cases, the exchange serves to reduce risk
This is a very important point to remember: hedgers don't try to speculate in the market. They use futures to help stabilize their revenues or their costs.
Speculators on the other hand try to profit by buying low and selling high (or vice versa), taking a position in the futures market and hoping the market moves in their favor. They play a very important role in the market by adding liquidity. They often take the opposite sides of the bids or offers that are in the market, ensuring that business will be done. A trade will not be completed unless someone is willing to take the other side of a transaction.
Why do Prices rise and fall?
That's easy. If there are more buyers than sellers, demand is greater than supply and prices will tend to rise. If the opposite is true, prices will fall.
For example, suppose you are selling your car. You put an ad in the paper and wait for potential customers to come to your door. If a lot of people are interested in your collection, you'll probably be able to get your price. But if very few show up, or if 2000 other people are selling cars at the same time but only 1000 people are interested in buying, chances are you'll have to cut your price to be competitive with the other sellers and to attract interest from the few buyers. The futures markets work the same way.
While traders can sometimes see who the other traders are, customers remain anonymous. In fact, a customer who is seeking to take or liquidate a large position may act through several brokers so he does not show what he is doing to his competitors. Of course, both the exchange and the exchange regulator are aware of the identity of anyone holding a substantial position.
This public, yet anonymous system provides a readily available, widely accepted reference price for the underlying commodity, a process that is called “price discovery” because you can always discover the price.
More on Hedging
The basic principles of hedging can be used for many commodities for which no futures contract exists, because often they are similar to commodities that are traded. For example, diesel fuel and jet fuel are similar to heating oil, and the three are often priced within a few cents of each other. So, many people who have to buy or sell large quantities of diesel and jet, such as airlines and oil refiners, have found that they can hedge by using the heating oil futures contract, taking into account the differential between their product and heating oil.
Most hedgers, no matter what the commodity, close out their futures positions before the futures contracts expire, and then make or take their physical deliveries through the people with whom they usually buy or sell their actual supplies. Knowing that at any given time, however, someone may actually demand to buy your products, or sell their's to you at that price, helps keep the value true to life.
Who guarantees the trades?
It is the exchange’s job to guarantee each trade, ultimately acting as the seller to every buyer and the buyer to every seller. This is accomplished through a group of about 40 or 50 member firms called “clearing members”, who include some of the largest and most prestigious names in the banking and financial services industries.
It is through the clearing members that all market participants must post deposits called margin. This is necessary because the exchange must know that participants have sufficient funds to handle losses they may experience in the market. As soon as anyone buys or sells a futures contract, they must deposit with their clearing member an amount of money that the exchange determines is sufficient to cover any one-day price move. As long as that person or firm holds on to the contract, the exchange must maintain minimum margin funds for that position, with the contract holder depositing additional funds whenever the market moves against him.
As a further safeguard, the clearing members contribute to a pool of funds called a guaranty fund that can be used in the event a member or customer of the exchange defaults on his obligation after the customers' own clearing member and the Exchange itself have already contributed funds.
As an added precaution an exchange also has an insurance policy that it could call upon in the unlikely event that the guarantee fund is depleted.
The exchange does not take positions in the market, nor does it even advise people on what positions to take. Instead, it has the responsibility to ensure that the market is fair and orderly. It does this by setting and enforcing rules regarding deposits, trading and delivery procedures, membership qualifications, and other aspects of trading. Members who violate the rules can be subject to fines or other sanctions. Looking over the exchange's shoulder is the regulatory agency.
There are a number of commodity exchanges throughout the world, where people participate in a public auction, buying and selling commodities they don't see, with other people whose identities are anonymous.
It might seem hectic and confusing but, in fact, the tried and true method of open outcry has been carefully honed through generations of traders and has supporting it the most sophisticated technology currently available. The individuals in the funny jackets gesturing with their hands are each highly skilled professionals with a great deal of responsibility resting on their shoulders. The commodities must meet strict specifications for quality and quantity, and because the Exchange ultimately guarantees each purchase and sale, the market not only works, but is so effective, that the quotations derived from these transactions are used as pricing standards by companies and individuals around the globe.
The marketplace provided by the Exchange with its price discovery, liquidity, and financial guarantees enables thousands of merchants - from huge oil companies who sell shiploads of crude petroleum to
jewellery retailers - to operate more efficiently, and thus more competitively, something that is of vital importance in today's global economy.
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