NZX to Milk Dairy Futures with CFTC Approval
Trading on dairy futures in New Zealand will be opened up to US investors if approved by American market regulators, which could substantially increase the market’s volume. The New Zealand Exchange (NZX) has already extended its trading hours on 23 August, opening at 2am local time, to capture overseas traders and is now seeking authorisation from US regulator the Commodity and Futures Trading Commission (CFTC).
“The most imminent thing to affect liquidity on the NZX is that the CFTC is going through the review process with an announcement expected on 1 October 2013 as to whether it will approve NZX products as tradable for US companies,” says Kyle Schrad, risk management consultant at FC Stone, one of the NZX dairy futures broker. “Once that approval is made final we should see some pretty good expansion in terms of liquidity on the NZX.” Trading access to the NZX is offered via the trading platform of CQG, and Leighton Andrews, Head of Sales Asia Pacific & Japan at CQG says that with regulatory approval access could be granted to market participants almost immediately.
“We have relationships with close to 100 global brokers, most are US-based,” he says. “Their clients are already using CQG to trade dairy products on the CME so for them to add NZX as another venue is the flick of a switch.”
Dairy makes up around 25% of New Zealand’s export receipts, which means any volatility in dairy price creates quite a large amount of risk for the country’s economy. In most countries with a dairy business around 5-10% of production is traded on a global basis, and the rest would typically be consumed domestically.
“The US exports 10-11% of total dairy production, for the EU a bit more is exported but for NZ, 99% of our dairy production is exported in the form of dairy commodities so we have quite a large exposure to global volatility,” says Kathryn Jaggard, head of derivatives at NZX.
Up until 6 volatility in dairy commodities – meaning whole milk powder, skimmed milk powder, anhydrous milk fat, butter, cheese and whey powder rather than liquid milk – had been limited, with market data provider Agrifax logging only one NZ$100 short-term price movement between 1991 and 2006.
“Prices were stable and heading steadily upwards at a slow rate,” says Jaggard. ”Then in 2006 there was a significant spike in prices due to weather events and prices spiked to their highest level ever seen in dairy. That particularly impacted processors and sellers who had long term contracts with suppliers and could not benefit from the higher prices.”
Volatility has continued to develop since then because of growing demand for products from emerging economies, such as China. NZ is the biggest exported of whole milk powder to China and that continues to grow. As emerging economies become wealthier and demand greater levels of protein dairy consumption increases; China’s one child policy can lead to four grandparents and two parents all investing in one child.
In 2008 a further development in the dairy industry set the scene for the development of risk management tools: the launch of the internet auction platform, GlobalDairyTrade (GDT). An online platform for selling physical products, GDT started out with dairy firm Fontera acting as the sole seller of products. Since then multiple sellers have joined, such as Arla and Dairy America. GDT became a company independent of Fontera, with the auction being run by Boston-based CRA.
However in 2008 the global financial crisis had left commodity prices flat, amplifying volatility. GDT became established as a pricing benchmark globally for exported dairy products, for Asia Pacific products and also US and European products.
“The emergence of Global Dairy Trade as a pricing benchmark really provided the possibility of creating a futures contract that was cash settled because it produced a reference price that represented actual sales of real products and it was well respected as a pricing benchmark,” says Jaggard.
In 2010 the NZX began to check if there was demand for risk management, to which the answer came back ‘Yes’, with a preference for a futures contract that was cash settled, as physical delivery of dairy creating too many problems (see box “Let’s get physical”).
The exchange spent some time looking at various possible reference prices, including surveys in Oceania, combined with surveys offshore, but they were not deemed robust enough to develop settlement rules for futures contracts.
“In the end we chose to settle our futures contracts trades with Global Dairy Trade,” says Jaggard.
New Zealand may be the most motivated, but it is not the first nation to look looking at how it can best manage volatility. The CME has been listing liquid dairy contracts for 18 years, although its products tend to be US-centric and are tied to US prices. Its biggest contract is Class III Milk Futures which has an open interest of 3-4000 contracts a month to the end of 2013.
In 2010 NZX launched its first dairy product, the whole milk powder futures, which are cash settled to Global Dairy Trade and then in 2011 it launched skimmed milk powder and anhydrous milk fat – a dehydrated butter – contracts. The same year LIFFE launched a skimmed-milk contract, Eurex launched both an international skimmed milk contract and a butter contract and the CME launched an international skimmed-milk contract.
“We suddenly felt rather small,” says Jaggard, “However it certainly reinforced the fact that there was a growing demand for risk management in dairy and we knew we were on the right track. The key difference was the settlement of the contract; we could cash settle through a reference price.”
Not only was the competition complimentary, it could also prove to be a source of liquidity for the exchange notes Andrews.
“A lot of people in the market look at inter-commodity or inter-exchange spreads, so many will be looking at the arbitrage opportunity between CME Globex dairy and NZX dairy products,” he says. “On CQG that is a pretty simple set up to trade. We have CQ Spreader where the spread strategy sits at the exchange level so they can they can spread those product quite easily with very low latency.”
The LIFFE contract is physically delivered but there is some expectation that when there are changes to EU dairy quotas in 2015, that will increase price volatility. At present there are limits on the production of milk in the EU, but when these quotas are dropped in 2015 there will be a lot more milk flowing out of Europe and in all likelihood a rationalisation of the industry with smaller farms consolidated. When Europe becomes more exposed to global dairy prices it will therefore have a greater requirement for risk management which may add to the liquidity on NZX.
“In 2010, having launched in October, we traded about 25 lots and we traded 8000 lots last month,” notes Jaggard. “Open interest at the moment is just over 15,000. One of our challenges to get in with the main financial funds and the extension allows us to cater for the EU and US markets. We are getting quite a lot of volume out of Europe. There are likely to be at least two European dairy contracts because EU prices are generally different to Oceanic prices. As with other contracts that trade a spread, it enhances liquidity in both products so we expect that if Eurex and LIFFE get liquidity in their products, that will only enhance liquidity in ours.”
That is likely to be echoed if the CFTC grant approval adds Schrad: “With US companies being able to trade it you’ll see a lot of interest in spread trading, between the US and international markets which will provide increased liquidity on the marketplace.”
Box out: Let’s get physical
Physical delivery of dairy futures becomes complex for a number of reasons. Firstly a physical product such as whole milk powder can be developed with various specifications, such as vitamin enrichment which can mean there is too much variety of received goods. Launching a specific contract – as the CME did in 2010 with an international kosher skimmed milk futures contract – can be too limited meaning producers don’t participate in the contract.
Buyers may have approved sellers that they source from for particular specifications of products and taking delivery of product should a contract go to expiry may mean they are receiving products that they could not use in the manufacture of their products, creating logistical problems a likely secondary market.
Contamination can also be an issue; if a tag on a container of whole milk powder is broken then it is considered a contaminated batch. Because dairy products have relatively high levels of fat the possibility of bacterial contamination makes quality control and grading very difficult. Even without actual contamination, powdered milk is perishable, with a shelf life of about two years, unlike commodities such as coffee or cocoa.