Why Do Commodities Exchanges Exist ?

Modern commodity exchanges are huge financial markets. Their daily transaction volumes run into billions of dollars to say the least.

Many people find it strange that, businesses as rudimentary as mining and agriculture have resulted in the creation of markets which are as massive and as advanced as the commodities exchanges of today! Companies that trade in commodities like corn flour and wheat go to Ivy League universities and hire the top graduates with the highest pay packages!

The average person does not understand what commodity exchanges actually do and how they add value. To explain in simpler terms we will start with the simple exchange of food grains and cash and will slowly build up to the modern day markets.

Model 1: Spot Market

This is the good old traditional way which has been used to trade commodities all over the world. This way entails an exchange of cash for commodities. However, there is a problem. Firstly, commodities are increasingly perishable meaning that the buyers have to be found out in a short span of time.

Secondly there is a problem of price discovery. It becomes difficult for the seller to ascertain whether they are selling at the right price until they are at a market and see that other sellers are also selling at similar rates. This ended up creating the physical commodities market also called as the spot market. It is called the spot market because the transactions are settled on the spot.

Model 2: Futures Market

The spot market helped buyer and sellers locate each other in an inexpensive manner. They also helped the price discovery process. However, there was still a problem. When farmers were farming the produce, they had no idea of the price that it would fetch in the market.

In the event of a bumper produce, the prices would drop and farmers would end up losing money. Buyers were also facing the same uncertainty. In case there was a shortage, they would end up paying more for the same produce.

To avoid this uncertainty farmers started to enter into futures contracts with buyers. Both parties would exchange commodities at a later date. However, the terms would be agreed upon today! Windfall gains and losses will be avoided. However, forward contracts eliminated uncertainty and allowed buyers and sellers to have peace of mind.

Model 3: The Need for a Centralized Counterparty

With the advent of time, futures contracts became the preferred way of dealing. However, other problems started arising. For instance, many times counterparties would go out of business. Therefore the contract entered into would turn worthless. Farmers or buyers would get terms which were worse than what was agreed upon in the contract when they tried to purchase in the spot market.

This created a need for a centralized counterparty, one that would never go out of business. Hence, the idea of an exchange was born. The exchange would be the common counterparty to all businesses. The farmer sells to the exchange and in a separate contract the buyer buys from the exchange. Since the exchange cannot go bust under normal circumstances, the contracts are almost foolproof. This is the reason why markets like Chicago Board of Trade (CBOT) and NYMEX exist.

Model 4: Marking to Market

When markets become centralized counterparties they also started providing leverage to the buyers. They realized that by receiving a small percentage of the contract value from both sides called margin money, they could ensure that both parties complied with the ethics of trading.

Exchanges therefore started marking the trades to the market value. Any differences had to be paid and received in cash. If the parties did not comply with the margin calls made by the exchange, it would sell off the position to another party and the margin money would be forfeited.

Using the techniques of margin money and mark to market modern exchanges ensure that none of the parties can back out on their word leaving the counterparty in a perilous position.

Model 5: Secondary Market

Modern commodities exchanges also provide opportunities for both farmers as well as buyers to exit the contracts when they feel like. Suppose they entered into a contract to sell a certain quantity of corn at a certain price. However, later one of the parties wants to back out. They can do so by selling the contract on the commodities exchange. Since the exchange is the counterparty to everybody, the farmer may not even know that the buyer has been changed! This is called liquidity and proves to be invaluable in case of commodities exchange.

Model 6: The Need for Standardization

Lastly, since exchanges had to sell contracts from one party to another party at a short notice, there was a need that these contracts be standardized. Modern day exchanges provide contracts which are identical in terms of quantity traded, the quality of the commodities and even the expiration dates! This standardization enables buyers and sellers to take each other’s positions effortlessly.

Commodity trading has been enabled by the creation of these exchanges. Till very recently, the standards at different exchanges like Chicago Mercantile Exchange, Chicago Board of Trade and NYMEX were very different from one another. However, they too have merged their standards giving commodity traders across the nation the convenience of trading with interchangeable contracts.