Iron Ore Swaps:
Cleared Volume
Takes Off
By Rachel Koning Beals
T
he iron ore swaps market is young but
growing fast. The number of swaps
cleared this year is already more than
double last year’s total, and the structural
trends driving the upward trend are still in
their infancy.
“Iron ore swaps are arguably the most
successful commodity market launch of
the past decade,” said Phillip Killicoat, a
London-based vice president with Credit
Suisse’s commodities group. “The financial
iron ore market has grown from zero in
2008 to a nearly 400 million tons per annum market today.”
Credit Suisse estimates that total swaps
trading is on track to match physical iron
ore volumes of more than 1 billion tons a
year by as early as 2015. The main reason
for this new market is a structural shift in
iron ore pricing. Long-term fixed contracts
have given way to short-term contracts
based on spot market prices. At the same
time, fluctuations in demand for iron ore
have increased the volatility of pricing, creating greater need for hedging.
These market shifts have proven to be
an opportunity for clearinghouses and Singapore Exchange in particular. SGX began
clearing iron ore swaps through its AsiaClear
service in 2009 and currently it clears about
90% of the global iron ore swaps market,
according to SGX officials. Its lead role in
the iron ore swaps market is bolstered by
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Singapore’s position as a regional trading
hub positioned between China, the world’s
biggest consumer of iron ore, and major
iron ore suppliers in Australia such as BHP
Billiton and Rio Tinto.
“Clearing has made trading iron ore
swaps more secure and transparent while
keeping the anonymity coveted by many
market participants,” said George Dranganoudis, Singapore-based managing director at ICAP Energy Asia Pacific. “As a
result, an increasing number of Chinese
participants in particular are now turning
to iron ore swaps as a way to manage balance sheet risk.”
Market Participants
Participants in the Iron Ore Swaps Market
Miners
30%
Merchants
30%
Standardized Contract
The swap that SGX clears is based on a
standardized amount of iron ore (500 metric tons) and settles against an index compiled by The Steel Index, a subsidiary of
Platts. TSI’s iron ore reference price is based
on actual physical spot transactions in specified grades of iron ore delivered to two Chinese ports. The transaction data come from
550 companies in the industry, including
global miners, steel mills, manufacturing
companies and fabricators.
During 2012, SGX cleared 108.9 million tons of iron ore swaps. For the first half
of this year, SGX cleared 109.4 million metric tons of swaps and another 13.5 million
metric tons in iron ore options. SGX esti-
Mills
5%
Steel
Consumers
10%
Source: Credit Suisse
Investors
or Financial
Participants
25%
mates that its combined swap and options
volume is equivalent to 31% of the underlying physical market.
Building on its success with iron ore
swaps, SGX began offering clearing for iron
ore options in September 2012. Volume
was quite low initially but began to take off
this year, and as of June 27,000 contracts
had been cleared.
A large proportion of options open interest belongs to relatively sophisticated
international traders, but a growing number of Chinese participants are trading iron
ore options as an insurance policy against
price volatility, according to ICAP’s Dranganoudis.
SGX also has introduced a futures version of the iron ore swap contract in April
2013, largely in response to global financial
reforms. These contracts so far have been
lightly traded relative to the cleared swaps
and options even though they can be traded
over the counter and are fully risk-fungible
with their equivalent swaps, with identical
settlement prices and margins.
“Clients desire a clearing model which
can adapt to regulatory shifts, and therefore
ing training programs with the China Iron
and Steel Association.
In addition, Hong Kong Exchanges
and Clearing and its subsidiary the London Metal Exchange signed an agreement
in June with the China Beijing International Mining Exchange to cooperate and
exchange information, including information related to trading and clearing
iron ore derivatives.
SGX AsiaClear’s acceptance of clearing for
multiple transaction modes allows the service to bridge different regulatory requirements and regimes as these evolve,” said
Michael Syn, head of derivatives at SGX.
Other clearinghouses also offer clearing for iron ore derivatives, notably CME
Group, ICE Clear Europe, Indian Commodity Exchange, LCH.Clearnet and NOS
Clearing, but none are anywhere near SGX
in terms of market share. A different sort of
competitor is on the horizon, however.
China’s Dalian Commodity Exchange
announced in July plans to launch iron
ore futures contracts by year-end. DCE is
primarily an agricultural futures exchange,
but it is developing several steel-related
contracts. In 2011 it began trading futures
on coke, one of the primary ingredients
along with iron ore in the production of
steel, and in March it began trading futures on coking coal, the raw material for
making coke. To help build an iron ore futures market, DCE is working with China
Beijing International Mining Exchange,
a quasi-public entity that operates a spot
market for iron ore, and has been conduct-
Structural Shift
Until a few years ago, prices for iron
ore were set through annual negotiations
among the world’s biggest miners and producers. That system came under pressure after 2003, when China took over from Japan
as the world’s largest importer of iron ore.
As China’s iron ore requirements outpaced
supply, a nascent spot market grew to supply marginal tonnage to the country’s steel
mills, providing visibility on short-term
prices for the first time.
By 2008 large gaps had emerged between
spot market prices and the annual contracts,
and some steel producers in China defaulted
on their contracts. In response, several large
Cleared Iron Ore Swaps and Options at SGX
Volume measured in number of contracts
60,000
Swaps Volume
Options Volume
Open Interest
50,000
40,000
30,000
20,000
y-1
3
Ma
r-1
3
Ma
-13
Jan
12
-12
No
v-
2
-12
Sep
Jul
y-1
-12
11
r-1
2
Ma
Ma
Jan
No
v-
-11
Sep
-11
Jul
y-1
1
Ma
-11
10
r-1
1
Ma
Jan
No
v-
-10
Sep
t-1
0
Jul
y-1
Ma
r-1
0
Ma
Jan
-10
0
0
10,000
Source: SGX
Futures Industry | September 2013 45
mining companies switched to shorter pricing cycles starting in 2010. Initially the
miners attempted to set prices based on the
average price in the preceding quarter, but
this soon broke down, and pricing is now
based on spot market reference prices. (See
“Steel Futures Forge Ahead” in the January
2011 issue of Futures Industry.)
“The conflict between spot and longterm contract prices spelled doom for the
annual system, which in 2010 was replaced
by contracts based on spot price indices
published by independent pricing agencies,” said Oscar Tarneberg, senior iron ore
analyst at TSI. “The shift toward indexlinked pricing, coupled with rising spot
market volatility, supported the development of the iron ore swaps market which
arose to deal with the increase in price risk.”
The field of participants in the iron ore
swaps market ranges from producers to
miners to consumers and financial institutions. According to Credit Suisse and SGX,
miners account for 30% of volumes in iron
ore swaps, merchants another 30%, mills as
much as 5%, steel consumers 10%, and investors or financial participants about 25%
(see Market Participants chart.)
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According to several industry experts,
market share among banks and other financial institutions is on the rise. Banks and trade
houses enter into iron ore swaps to manage
their exposure to customers that hold physical iron ore positions. “Their involvement in
the market will continue to grow as the market matures and physical trade participants
become better informed about risk management and hedging,” said SGX’s Syn.
Speculative traders such as hedge funds
use iron ore swaps to arbitrage across related
commodity markets such as freight or to
take a position on construction trends in
China, a key indicator for steel consumption. “Many macro funds trade the iron ore
swaps market as a means of expressing views
on China’s gross domestic product, housing, and the health of the Asian commodity
markets,” said ICAP’s Dranganoudis.
Additionally, speculators within the
Chinese domestic market tend to follow
the price spread between steel rebar futures
traded on the Shanghai Futures Exchange
and SGX iron ore as a directional market
indicator and arbitrage opportunity.
More importantly, there are signs that
commercial hedgers are entering the mar-
ket. “The share of steel consumers and steel
mills is growing,” said Credit Suisse’s Killicoat. “Eighteen months ago, steel consumers [such as construction firms] weren’t participating in the financial iron ore market at
all. Now, they make up about 10%. Downstream steel consuming segments are becoming more active as they tend to be more
sophisticated users of other commodities
derivatives to hedge their input price risk.”
ICAP’s Dranganoudis sees potential for
the iron ore swaps market on the scale of
what has already taken hold in the coal market. There are some 800 metric tonnes of
seaborne physical coal traded globally that
generates a derivatives market of around
2.5 to 3 billion metric tonnes annually. If
the ratio is extrapolated to iron ore, today’s
1.2 billion metric tonnes physical market
would equate to a 3 billion metric tonnes
liquid swaps market—a multiple of 20 to
30 times today’s trading volume.
“We are only at the tip of the iceberg in
terms of the potential of this fast developing
market,” he said.
..............
Rachel Koning Beals is a Chicago-based
writer and editor.