Ahead of the S&P Global Platts Global Metals Awards in London, on May 16, The Barrel presents a special series of articles looking at the global metals trade. Here, Joseph Tong and Petter Kolderup investigate the growth of iron ore derivatives trading, and rising competition between two leading bourses, Singapore's SGX and Dalian's DCE.
In order to become the second-largest economy in the world, China has built up its infrastructure in a systemic, large-scale fashion since opening up in the 1970s. This process has also seen China increase steel output to become the world leader, accounting for half of global production.
Consequently, China is also the largest importer of iron ore – the key feedstock in steelmaking, importing 1.064 billion metric tons in 2018. This is not a small number, and iron ore, now the second-biggest commodity market in the world after oil, deserves substantial attention.
The fast growth in iron ore imports, along with increased steel production, led to the breakdown of the traditional annual benchmark supply contracts between miners and steel producers. As China moved rapidly towards a more spot-based market, a need emerged for derivatives to manage price risk.
As exchanges play an important role in price formation and risk management, their development over the years has consequences for the market, especially for those companies exposed to the underlying physical trade.
Increased liquidity will drive down trading costs and improve price transparency. And given China’s influence on the global economy, and the key position of iron ore as an essential commodity, what happens on the exchanges matters to markets and consumers far beyond Singapore and Dalian.
Singapore and Dalian
From 2009 a range of exchanges started listing iron ore futures. Over time two stood out. The Singapore Exchange (SGX) listed iron ore swaps in 2009, and the Dalian Commodity Exchange (DCE) listed iron ore futures later in 2013. The two venues have become central in iron ore derivatives trading, with monthly volumes peaking in March 2016 – at 7.6 billion mt traded on DCE and 231 million mt on SGX.
There are structural differences between the two exchanges, and their strategic approaches also diverge. DCE, as the long-standing onshore commodities exchange, offers members direct access to its digital trading platform. Yuan-denominated iron ore contracts are listed, which have been available for mainland traders as well as approved international entities since May 2018.
Since listing the iron ore contract, DCE has attracted a big retail investor base in China. According to DCE, corporate clients represented only 2.4% of the investor population, accounting for 23.9% of the volume in 2018. The rest were retail traders transacting via the many securities brokers in China. In contrast, SGX trades cash-settled, US dollar denominated contracts, and the trader composition on SGX was 95% corporate clients and 5% others. Of the corporate clients, banks account for the biggest part, at 35%. Chinese traders with sufficient dollar reserves may also trade iron ore contracts on SGX with central clearing.
The volumes on both exchanges peaked in March 2016, coinciding with a sharp turnaround in iron ore prices, which broke a five-year negative price trend. Platts’ IODEX dropped from $193 per dry metric ton in February 2011 to reach a low of at $38.60/dmt in December 2015, and rising to $51.05/dmt entering March 2016. As the price bottomed out, the volumes slowly declined on DCE and SGX – more so on DCE. In 2015 the volume on DCE was 32.65 times higher than on SGX, in 2016 and 2017, 25.15 times higher.
By 2018, the volume on DCE was 23 times higher. In an attempt to regain momentum in volume growth, and to keep at bay other competing exchanges – such as the Chicago Mercantile Exchange (CME), Hong Kong Exchange (HKEX) and Intercontinental Exchange (ICE) – the two dominant exchanges have been introducing many new initiatives to attract more investors in iron ore. For instance, DCE embarked on an internationalization effort to draw in foreign investors from May 2018, trying to enhance trading volume through the onshore market. With internationalization, approved foreign entities can also dabble in this Yuan-denominated contract.
In the meantime, SGX has introduced a whole suite of derivatives contracts just for iron ore, with 62% Fe, 58% Fe, 65% Fe, lump premium swaps and iron ore options. This suite of risk management tools was designed to appeal to a wider range of iron ore traders. Since the beginning of 2019, SGX options have seen a good upswing in volumes and open interest. Open interest in March was 80.5 million mt versus an average of 65.8 million mt in 2018. Open interest in SGX futures continue to be stable and 53.2 mt traded in March.
Volume trends diverge
SGX and DCE have had differing degrees of success. The volume on SGX has increased over the past year, with open interest holding steady in the 62% Fe futures contract. The iron ore lump contract also had good growth in volumes, supporting the overall iron ore volumes. For DCE, despite the internationalization effort, the volume has continued to drop with dwindling open interest. For instance, over the 5-month period after DCE launched the internationalization campaign, open interest dropped by 68%.
Several factors contributed to the gap in performance between the two trading venues:
1. Trader composition and drop in volatility
The two exchanges have attracted two very different clienteles. The considerably larger proportion of retail traders on DCE implies a prevalence of speculative trade, through Yuan-denominated accounts set up by Chinese securities companies. These retail investors tend to trade more frequently and can easily shift to another asset if iron ore does not provide adequate returns over a short period of time.
Conversely, a much bigger percentage of SGX participants are institutional traders with physical exposure. Mostly hedgers, the traders on SGX are more likely to have consistent physical cargoes to hedge independent of volatility, implying a steady volume. Furthermore, there are many financial institutions trading on SGX and they are thought to be more sophisticated in terms of portfolio and risk management.
Iron ore monthly volatility reached 34% in April 2018, but fell off gradually to 18% in second half of 2018. This huge drop in volatility reduces the appeal of iron ore in investment allocation. Therefore, on DCE, many traders potentially shifted their holdings out of iron ore and into more conventional assets like stocks
2. Political risk in China
Increased political risk in China during 2018 made it more difficult for speculators to read future supply and demand dynamics. This particularly affected iron ore futures volume on DCE. The China-US trade war reached full force with the implementation of steel tariffs in the beginning of June. This new political risk brought about an increased need to hedge, but also turned trading into gambling for speculators. As a result, increased trading volume was seen on the offshore SGX where dollar-denominated contracts are traded, and less interest was shown by both domestic and international traders on DCE. The heightened risk drove away retail investors, while institutional traders in the international market were still carrying out hedging activities as required by physical deals.
3. Investor suitability policy on DCE
In March 2018, DCE implemented an investor suitability policy for iron ore futures trading that applies to both domestic and international new investors. Certain requirements have to be met before being able to trade. For example, a participant’s balance of funds must not fall lower than Yuan 100,000 on five consecutive trading days. The new regulations made it more costly and difficult to access the DCE market-place. In contrast, SGX has maintained a consistent framework for trading and account opening. In addition, participants on SGX tend to be more established and less vulnerable to changes in exchange rules.
4. Reduced risk appetite of retail investors
The Chinese stock market fell sharply in 2018, illustrated by the drop in the Shanghai Composite from 3392 points to 2494 points – a 26.5% fall. This meant many retail investors who speculated on Chinese stocks made huge losses on investment. With this, retail investors trading on the DCE also seemed to develop a reduced risk appetite for commodities, including iron ore, and trading volume and open interest fell as a consequence. The makeup of the trading community is the most important factor behind the fall in open interest and trading volume on DCE. With retail investors representing the majority on DCE, volumes and open interest are likely to reduce during a period of low volatility, as retail investors focus on short term and are more flexible with changing investment holdings.
Also, the lack of exposure in physical trading implies they are merely speculators on the market, rather than traders with consistent hedging needs, even in periods of range-bound trading. On SGX, where there is sizable representation of institutional traders dealing physical cargoes, participants’ hedging activities are more consistent and less influenced by low volatility. With such a distinction in trader types, it was no surprise that the period of low volatility saw open interest and trading volume dwindle on DCE. It is also important to remember that most of the sizable international institutional investors already had access to DCE before the internationalization.
As the iron ore market develops, derivatives instruments serve a bigger-than-ever purpose for trading and risk management. Both traders and speculators need to use futures or swaps for managing price risk or achieving maximum return on investment. The exchanges, including DCE and SGX, are committed to continually introducing and maintaining a greater variety of instruments, spanning options and contracts for different grades of iron ore that are used by steel producers.
For instance, DCE is planning to list iron ore options for the onshore market, so that volatility traders can have the instrument to invest in. In terms of competition, DCE has recouped some lost ground, with both open interest and volume rising since the beginning of 2019. Specifically, open interest has rebounded from the low, and almost doubled since December 2018. Trading volume has increased significantly as well.
Other exchanges like HKEX and CME are also vying to be the go-to place for iron ore trading. CME representatives told Platts they have noticed a growing interest in their ferrous derivatives products. For example, iron ore monthly volumes have more than doubled in 2019, compared to 2018. A lot of the trades are done in the US time zone.
Mark Levin, a managing director at Seaport Global Securities, a US-based investment bank, said the company is monitoring the developments in iron ore derivatives. As China is slowing down, India could be a new growth factor in steel, while in the US, aging infrastructure will need to be replaced at some point it. These are factors that could stoke American investors’ appetite for ferrous derivatives. Technology will play an additional role.
DCE is already screen based, but off-shore exchanges rely in large part on broker-facilitated trades. Both the exchanges and the brokers are competing in developing a fairer, faster and more user-friendly screen for iron ore derivatives trading.
In early April 2019, DCE announced a series of changes governing trading on the exchange. Specifically for iron ore, DCE said that in the event of social unrest, war and natural disasters that affect iron ore production or import, the exchange reserves the right to enter into a special situations phase where the exchange manager can intervene and adjust market’s opening and closing hours, as well as pausing or suspending trading, for example. The aim is to prevent excess volatility and speculation on the exchange.
The policy change was introduced just before the iron ore price reached 5-year high in mid-April, on supply tightness coupled with firm demand. Volatility has returned to the market, and open interest and trading volume are on the rise again. As the trading volume of iron ore reached highest level after a major trend reversal in March 2016, it is worth remembering that prices have now been in a three year positive trend, and a future reversal could push volumes and open interest even higher.