One size does not fit all
Can you briefly explain the CME’s existing activities in the derivatives marketplace?
HH: CME Group is an international business, and we are increasing our presence in Europe and Asia. We bring everyone together on one global electronic trading platform, CME Globex, which launched in 1992 and operates virtually around the clock. CME Group is comprised of four futures exchanges: the Chicago Mercantile Exchange; Chicago Board of Trade; the New York Mercantile Exchange; and COMEX. With a history of providing ways to manage risk, we now offer our customers around the world access to some of the leading benchmark products for metals, agriculture, energy, FX, interest rates and equity indices.
Central to everything we do is clearing trades—reducing counterparty risk of default. And since 2002, we have helped companies and banks who might not use futures to centrally clear “over-the-counter” derivatives and reduce counterparty risk through CME ClearPort.
How long has the CME Group been involved in clearing steel products? Explain what is meant by “clearing.”
HH: Everyone knows our COMEX Gold Futures contract, which has been listed on our exchange in New York since 1974. Our steel and iron products are relatively new. We launched our first ferrous contract, the US Midwest Domestic Hot-rolled Coil Steel Index Futures, in 2008. Our iron ore contracts based on Ore 62 percent Fe CFR North China came out last summer and recently we listed the first average price options on these iron ore contracts. So we have been successfully clearing ferrous transactions for a number of years and our research and products teams have extensive experience in this industry.
We recognize the importance of Turkey as a central hub of steel trading. Turkey is the largest importer of ferrous scrap and plays a leading role in determining the international price for this product. It is the pivot point of steel billet trading acting as a conduit for billet exports out of Russia and the Ukraine. We know it is also the world’s largest exporter of rebar, offering much needed liquidity to the Middle East and North Africa. Turkey also provides liquidity to other regions when world supply is tight. We are increasingly looking at this region, as it is our ambition to become the exchange where the world comes to manage steel price risk, just as we are for WTI crude oil, gold etc.
In terms of clearing, I will refer to my own previous experience as a metals trader for a UK merchant bank to explain. I started trading physical metals and hedging over 20 years ago. Each deal was negotiated between two sides and settled by the same two sides. To contain the risk of one side not delivering metal or paying cash, we had to restrict the companies we traded with and limit the number of deals. Still, we could not know whether they were good for the money or metal until the final day.
CME Clearing reduces this risk without changing the underlying deal. Traders can choose to clear their bilateral over-the-counter deals with us, putting us in the middle and facing each counterparty for the trade. For example if a Turkish consumer wants to hedge against the price of HMS I & II 80:20 scrap going up, he can enter into a financial swap with another company or bank. He can reduce his risk of that company failing to pay by using CME as a central clearer for the swap.
To set this up, a company registers online with our CME ClearPort system and once registered, it can add details of the trade. Customers have three options for reporting the trade for clearing through CME ClearPort: Broker Entry; Facilitation Desk or Third-Party Matching. Everyone pays a one-off clearing fee and initial margin, and is notified daily of how much margin is required if the market price moves and everyone is treated the same—same fees, same margin.
A number of other exchanges have followed us and now offer clearing for over-the-counter products. It does matter who you clear with and we are proud of the fact that CME Clearing has a 100-year default-free history.
What do you think about the role of a derivatives market in steel business? Why do you think a derivatives market is necessary for the steel industry?
HH: This market really started to emerge four years ago as the annual contract price setting mechanism started to change. We could see that price volatility was becoming a bigger problem. Also, the industry saw how useful coal and freight derivatives were working and looked for something similar for steel. Derivatives allow price to be managed separately from physical supply. I believe these products can be really useful for businesses who want to reduce a degree of risk in their business and trade in a different way.
The market is looking for new benchmarks for iron and steel prices. The industry can look to the forward curve on our exchange to see settlement prices every day; we put a great deal of work into getting independent marks for this. Many physical traders tell me this is valuable for them, and steel producers also find transparent pricing extremely useful for budgeting and forward planning.
Our team has been engaged with the steel industry for some time, out in Europe, in Asia, in Latin America as well as the US. Our assessment is that the industry requires a suite of products to help it mitigate price risk exposure throughout the supply chain; a single product solution is not right for such a complex and diverse industry. So we are not trying to retrofit steel into the non-ferrous mold. We are providing a range of derivatives so that companies can decide themselves which costs they want to fix and for how long. If companies want to grow their business and customer base, they should find this helps them, as we hear that people are really worried about price uncertainty and credit risk at this time.
The other problem the industry faces is credit risk and the cost of financing. What CME Group is doing is to enable companies to reduce credit risk by clearing derivative deals through us. We did this for the energy sector in 2004 during the Enron crisis and because of our success during that period we have become an industry leader in over-the-counter clearing.
We have heard that the CME Group is planning to expand the clearing service. How are you going to expand in steel?
HH: CME Clearing Europe is our new European Clearing business. As an FSA-approved clearing business, we worked with a number of our Clearing Members to go live in May. Due to the feedback from customers in Europe and Asia, the first products cleared through CME Clearing Europe were energy and we plan to have new metals products listed in the second phase. However, there was no need for European companies to wait for CME Clearing Europe to launch as our CME ClearPort system operates 24 hours and has significant volume from European customers.
How many different contracts would be involved?
HH: CME Group intends to list a range of contracts that better capture the risk factors throughout the supply chain, from raw materials to semi-finished and finished steel products. We will list regional contracts for those products with localized risk factors, and we will also list global contracts for those products that share common risk elements. One thing we have learned over time is that our business is really customer driven. We meet with and listen to the needs of our customers and we are learning more about the needs of the ferrous metals industry. As we grow this business we will communicate with the industry how we are progressing.
How else do you think the CME clearing service would offer a different value to the steel industry?
HH: The iron ore and related ferrous market is the second largest commodity market by volume after crude oil. After extensive consultation with the industry, we have decided that a unique “made for steel” solution is required. The industry can only benefit from using CME ClearPort, with more than 10,000 registered users and proven ability to clear more than 500,000 contracts per day. We have more than 50 clearing firms available for customers to open accounts and a number of them have operations here in Turkey.