On commodity derivatives and the Norwegian initiatives to create a fish derivatives market.(Company overview)

Hedging against future price movements can be important both for those producing goods and for those buying them. Commodity derivatives may be employed as a hedge against price risk, and this is one of the reasons behind several initiatives to establish fish derivatives markets in Norway. This article discusses the general terms for establishing commodity derivatives markets. There is seldom more than one derivatives market for a commodity. The success of a Norwegian fish derivatives market will depend on global competition between such marketplaces, and this competition will determine whether and what type of initiative that will succeed.

Norwegian (and European) legislation for commodity derivatives appears to be adequate. The markets are well organised and Norwegian legislation ensures that transactions involving standardised products are settled in a clearing house and that netting rules apply. This contributes to ensuring financial security in the commodity derivatives markets. The market positions held by financial institutions are otherwise too small to threaten general financial stability.

1. Introduction

During the past decade, power and freight derivatives markets have developed in Norway and efforts are currently underway to establish a salmon derivatives market. All of these markets are based on the participation of buyers and sellers in many countries. Authorities worldwide are increasingly focusing attention on commodity derivatives markets. In the 1997 Tokyo Communique, supervisory bodies from 18 countries recommended standards for the regulation and supervision of commodity derivatives markets. The Markets in Financial Instruments Directive (1) provided the EEA countries with a common standard for regulating these markets (which is in accordance with the Tokyo Communique). In Norway, the Directive was implemented through a new Act on securities trading which came into effect in the latter part of 2007. As a basis for discussing such markets, it may be useful to explain how these markets function.

A derivative is a contract to buy and/or sell an asset at a predetermined date at a price determined at the contract date. The asset to be delivered is called the under(ring asset for the derivative or simply the underlying. Goods and services are the assets underlying commodity derivatives, whereas other financial instruments or foreign currency are the assets underlying financial derivatives. In principle, the derivative's underlying asset should be delivered, but most derivatives markets today only involve a financial settlement. In cases where physical settlement of the underlying asset is required, the market usually provides a delivery facility so that purely financial investors can also participate in the market for the purpose of hedging price risk or speculation.

In derivatives markets, the most common types of forward contracts are futures and forwards. The most important difference between futures and forwards is how the contracts are settled. Both contracts involve a future purchase where the price, quantity and quality of goods and the time and place of delivery are predetermined. The value of a futures contract is set daily at market value and buyers and sellers are credited or debited daily in relation to the changes in value. In a forward contract, the entire settlement takes place when the contract matures.

We also differentiate between derivatives that are traded directly in an organised market (exchange traded) and over-the-counter (OTC) derivatives. When derivatives are traded in organised markets, the product is fully specified. The contracts traded are the same size, the maturity date is the same, and counterparty risk is eliminated since all transactions go through a clearing house which is the central counterparty, etc. This may be compared to the purchase of off-the-shelf items in a supermarket (e.g. 1 kg of sugar). With an OTC transaction, the product can be specially adapted just as the grocer can customise a product to our wishes when we go to the cheese counter and ask for a centre-cut, medium-sized piece of Gouda. The market participants offering OTC contracts are usually brokers, and trading directly in the organised market where they can reduce the risk of their OTC transactions is often an element of their risk management. Therefore, successful marketplaces for commodity derivatives often live in symbiosis with brokers dealing in OTC contracts.