Trading of Safex silo receipts - the next generation of physical delivery functionality

DR RAPHAEL KARUAIHE, MANAGER: COMMODITY DERIVATIVES, COMMODITY DERIVATIVES DIVISION, JOHANNESBURG STOCK EXCHANGE

The role of any commodity exchange, and in this instance the JSE's Safex Commodity Derivatives Division, is to provide market participants with a price determination mechanism and a price risk management facility through which they can manage their exposure to adverse price movements in the underlying physical market and where performance by both counterparties to the contract is guaranteed.

Since no formal cash market exists for grains in South Africa following the deregulation of the grains market, the development of an efficient physical delivery mechanism ensures that the futures contract closing price reflects the situation in the cash market. Such an efficient mechanism therefore ensures price convergence of both the cash and futures markets at expiration.

All physical deliveries for agricultural commodities on Safex were initially randomly allocated according to a defined methodology. A detailed algorithm currently in use is available on the web page www.jse.co.za/commodities. This facility, though still being used as an option of last resort, allows products to exchange hands between the seller and buyer in completion of a futures contract.

The JSE started to provide for Exchange for Physical's (EFP). This facility allows for both the buyer and seller to notify the exchange prior to allocation that they have reached agreement outside of the exchange and request that the underlying Safex silo receipts be exchanged between the two parties. The EFP is processed at the current Marked-to-Market (M-t-M) value or with the premium included in the JSE's settlement process.

In 2008 the JSE's Commodity Derivatives Division further enhanced its delivery process and to a certain extent allowed for more transparent basis discovery by enabling long positions holders to bid for Safex silo receipts tendered for delivery in completion of a futures contract.

Clients who had a long position for the specific delivery month had an opportunity to bid on preferred locations and in this way provide the market with some indication of the value of grain from one delivery point to the next. The auctioning was largely an enhancement of the current delivery process and was made possible via the new trading software, particularly the delivery mechanism that was significantly automated.

Trading of Safex silo receipts

In recent years there have been a number of attempts at establishing transparent spot market trading environments or platforms with limited success. Since the JSE automated its delivery systems and with the help of Safex silo receipts recognised as a mechanism for delivery, the thought of extending its current platforms to provide a basis trading platform (trading individual delivery points by both buyers and sellers) has been made easier.

The recommendations by the Matthew Roberts Report undertaken on behalf of the National Agricultural Marketing Council (NAMC), also strongly recommended a move by industry participants to look at improving the transparency in the basis markets. With this background, the JSE's Commodity Derivatives Division decided to extend its existing delivery functionality to the market.

Trading of Safex silo receipts is an initiative that will allow market participants to trade grain at a registered delivery point as represented by Safex silo receipts on a cash market basis.

Clients who have a long position for the specific delivery month will have an opportunity to bid on preferred locations. At the same time, clients who have access to physical grain on Safex silo receipts will have an opportunity to offer the stock at a premium. This will provide price discovery in terms of spot basis premiums and transparency for the entire grain market to benefit from.

Clients will no longer be required to have existing futures positions to participate initially. However should orders entered be successful, participants will either be required to open a position during the remainder of the trading session or will be provided with an equal short and long futures position when the physical delivery is processed.

What this facility means to stakeholders

Following are some highlights of potential benefits that this new functionality could bring to the producer or the grain end user.

Those producers who hold Safex silo receipts, have the potential to negotiate a better price. In consultation with their brokers or silo owners, the producer can "offer" his receipts onto the system for a premium over and above the Safex price. The offer therefore will represent the premium per ton price for stock in the specific silo as represented by the Safex silo receipt.

Producer currently receive: Net Price = Safex price – Location differential – Admin fees. Using this facility, potential income to the producer is: Net Price = Safex price – Location differential – Admin fees + Premium. This premium is basis premium.

Buyers on the other hand, i.e. miller and processors, will be able to bid regardless of whether or not there is already stock on offer, at all registered delivery points at a premium per ton basis. This is quite a big improvement on the Safex delivery system since in the past no bids were permissible without available stock on offer. A further plus for the buyer is that he is now in a position to bid for the preferred delivery location from where he can receive his grain should he be successful.

All silo receipt orders will be managed similar to trading orders for futures and options. This means that orders for silo receipts can be suspended, resubmitted or deleted at any time as the market participant finds it necessary to do so.

Market participants will be able to load orders to be valid for a number of days and these will be carried over, if not matched, from one day to the next. They can bid or offer a preferred premium that can be displayed on the screen for several days until it is either matched or withdrawn from the trading platform.

What this trading of silo receipts further means to market participants is that it allows them to trade the basis, as represented by the premium, between Randfontein and the particular delivery location. Trading of silo receipts will reflect the true basis or the willingness to pay by the participants, over and above the ultimate worst case price currently represented via Safex price less the location differential.

Proposed trading hours for the Safex silo receipts will be from 09:00 through until 14:00 each business day. At 14:00 all physical deliveries will be processed and the necessary invoicing generated for the day.

Settlement process

Just like all our listed products, settlement is guaranteed by the JSE and hence there wouldn't be any risk of counterparty default.

A two-day settlement cycle, trade today and be settled tomorrow (or the next business day if tomorrow falls on a weekend), further ensures that the usual delayed payments generally associated with cash markets are eliminated. This is another avoidance of counterparty risk.

While the silo owner continues to guarantee the quality and quantity of the physical stock on the Safex silo receipt, the JSE will guarantee the cash-flow process such that sellers will receive their payment and buyers will receive their physical stock.

Trading of silo receipts will be possible on every day that the JSE is open for business and it will be directly linked to an underlying futures position. Paperwork and all invoicing will be facilitated by the JSE.

Conclusion

The advantages that are made possible by a transparent trading platform for price discovery cannot be over-emphasised. However, like all our instruments, the success of this new product requires that there is enough liquidity in the market; that is, there need to be a good number of buyers and sellers that actively participate in the market.

We sincerely believe this is a great opportunity for the producers to negotiate a better price. Producers will be able to access the system as part of their usual client registration process with their respective JSE Commodity Derivatives Division brokers, and the JSE rules and regulations currently in place ensures that the client is protected.

The JSE is very excited about this new initiative and the opportunities it will bring to the grain market of South Africa. Testing of the system has already begun with all intentions to introduce the additional functionality by the end of September 2012. We look forward to simplifying the physical delivery process for our members that ensures price
convergence and efficient futures markets.

Kindly direct all queries regarding this publication to dr Raphael Karuaihe, manager: JSE Commodity Derivatives Division at (011) 520-7258 or at raphaelk@jse.co.za.