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FFA market on the mend

2009 was a better year than predicted for the FFA sector, says Neville Smith

If the FFA market were to be awarded marks out of 10 for its performance in 2009, it would receive a better grade than was widely predicted at the start of the year. True, volumes in the dominant dry market took a big hit, falling 45% to 1.1 million lots worth around $34.8 billion, but 2009 was far from a disaster.

Rather, the fall was magnified by the exceptional FFA market in 2008. Firm demand from China for bulk commodities buoyed the physical market and supported paper, helping the iron ore swap find its feet as a result. In the tanker market, volumes held up too, though at lower volatility levels, making it a harder year in terms of managing risk versus return.

Last year was also the one where clearing became entrenched, as risk management slid back onto the traders’ agenda. The majority of trades are now cleared. The dry FFA market also found itself scratching a familiar itch, but got little nearer to treating the cause. The announcement by the London Metal Exchange that it sought to launch an exchange-traded FFA market, rekindled the debate that many hoped had gone away – whether the dry market should embrace an electronic, screen-traded future. It was far from dull. And 2010 promises to be just as gripping – perhaps more so – as these trends evolve and the issues raised work themselves through.

Dry FFA market looks up

Dry FFA brokers are united in seeing an encouraging trend to volumes in the last quarter of 2009 and January 2010. This has led SSY and FIS among others to suggest that FFA volumes this year could bounce back to near 2008 levels, perhaps to two million lots or above, albeit at lower values. SSY’s Duncan Dunn says that with smaller lot sizes emerging: “Smaller counterparties can cover their exposure and this is a welcome evolution. At the same time the market has good levels of capacity, with deals being structured out to 2020.”

FIS is similarly bullish, predicting lot levels above two million and a potential market value of $60-$70 billion. The broker has also succeeded in encouraging capesize traders to fix on the C5 and C7 iron ore routes, a potentially huge source of fresh liquidity when teamed with the iron ore swap. “These routes have the potential to be much more heavily traded as principals look to manage the freight exposure within iron ore. The drop-off in liquidity has been a big challenge but a cleared C3-C5 market is a chance to kick-start volumes on routes which represent such a big component of the physical ore price,” says FIS managing director John Banaszkiewicz.

Tanker volatility rises

The positive mood extends to tankers, with GFI-ACM’s Andrew Jamieson noting an increase in volatility in the early part of 2010. The drivers for this, he says, are the fall in the Worldscale flat rate and a physical market, “where brokers know they can negotiate a deal and where deals are moving by several Worldscale points at a time”. Tanker traders work to strict risk management routines and the dry market followed suit last year, fully embracing clearing and paying for the privilege. Clarksons’ Alex Gray notes the cost of trading is a potential stumbling block to increased volumes but says the market is finding solutions. “We are seeing deals where counterparts fix a contract of affreightment and are happy to exchange paper because the physical deal offsets the credit risk. It’s not a solution for the entire market but it’s a workable hybrid for some.”

Looking forward

Whether or how screen trading will find traction in the dry FFA market looks set to be a defining issue this year. Jeremy Penn confirms that attempts to provide a third-party “aggregator” screen by the Baltic proved technically difficult and not much desired by users. The FFA market’s reaction to the LME proposals has been lukewarm at best except among a handful of traders, but there is a feeling that the momentum for change is building again.

“Talking in terms of a solution suggests something is broken and this market is not broken. There are four screens today and probably more will emerge in 2010,” says Alex Gray. “There is a temptation for people to say that brokers don’t want screens, but all the screens out there are broker screens, so it’s not an argument I agree with.” Andrew Jamieson says the dry FFA market could demonstrate maturity by accepting that screens have their place. “It’s a great tool which gives you a firm market, shows transparency and shows you are in the game, even if most of the work goes on behind screen.”

Jeremy Penn says the all-or-nothing argument, that for a screen to be successful it should be dominant, is spurious too. A screen could be successful if it had 30% of the market representing the liquid trades in near dates while the more difficult longer-dated business is done by phone, he suggests. There is perhaps only one dark cloud on the horizon. 2010 is supposed to be a year of regulatory change for the FFA market, with proposals to monitor derivatives trading emerging from the European Commission and the US Commodity Futures Trading Commission.

In outline, the EU at least wants to promote clearing as a means of standardisation and has longer-term plans which discuss “trading venues” for swaps and options. The Baltic is monitoring the Brussels process but says the FFA market has no clear picture yet of what the changes might mean. “What I hope is that regulation doesn’t make it harder for the FFA market to develop,” says Jeremy Penn. “I’m a believer in the evolution of markets and enterprise. Increased transparency is something we should sort out ourselves rather than having someone else tell us how it should work.”

New products have become the watchword of the freight derivatives market, but with dry bulk, tanker and commodity markets maturing there remained one unconquered frontier. Attempts to design a container swap had been going on for years until Clarkson Securities surprised the FFA market with the launch of the Container Freight Swap Agreement (CFSA) in early January. Designed to take advantage of China’s massive container export volumes, the swap mirrors established freight derivatives by offering a dollars per day contract per 20ft equivalent unit on the most liquid routes out of Shanghai.

This is a departure from previous attempts to develop a paper market in boxship charter rates, a deliberate policy, according to Clarksons’ Alex Gray. “Boxship charters are long term and there’s no spot market like in dry or tanker FFAs and even when an index was produced we couldn’t see who it was useful to.”

Instead, the aim of the CFSA is to provide a product that is useful to owners, operators, exporters and importers, as well as to financial institutions keen for an instrument that allows them to trade a highly liquid underlying market. Clarksons believes “the sky is the limit” in terms of potential counterparts.

Clarksons spent two years working with the Shanghai Shipping Exchange on its index methodology. A panel of 15 carriers and 15 service providers has been established to draw up route assessments. The broker is in discussion with clearing houses and hopes to be able to offer the product on a cleared basis from the second quarter of 2010.

This year could see tanker FFAs start to deliver on their long-held promise of a market to rival their bigger dry-bulk sibling. A shot of volatility in the physical FFA market over the turn of the year has given hope that new Time Charter Equivalent (TCE) contracts will be ready to ride a fresh wave of liquidity.

Baltic Exchange chief executive Jeremy Penn says he is optimistic that 2010 is the year that trading in TCEs “really starts to happen”, once the final wrinkles in the methodology are ironed out.

“We have perhaps tended to focus on the difficulties but we are very close to resolving the problems. We’ll go on working through the issues until there are no issues,” he says. GFI-ACM’s Andrew Jamieson, who is chair of the wet FFABA says the work will continue. A meeting in February will attempt to decide whether to continue with TCE development, switch to a dollars-per-tonne alternative or try to develop a happy medium.

“There are few people willing to price the deferred market at present,” he says. “Unless we get the methodology right and get transparency on bunkers, then it’s never going to be liquid because the users are not hedging risk, they are taking on another risk.”

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