• Swap agreements

    The straight meaning of the term 'swap' is to barter or exchange and, this is very much to the point. For example, producers can 'swap' price risk by giving up the benefits from future price rises in exchange for a guaranteed minimum price. Such a swap agreement could even cover more than one crop year, with tonnages and settlement dates set for each quarter. In other words, they are written or tailored to address different, individual requirements.

    In the case of coffee swaps, the price fixing necessary to finalise them would rely on the relevant futures market without actually having to trade futures. This avoids the problems that using futures can cause like having to raise margin calls, particularly when distant positions are to be dealt with. And, futures trading or hedging does not always address individual price insurance requirements.

    Swap agreements are negotiated directly between those wishing to acquire them and solution providers who are prepared to offer or write them. Because such agreements are concluded separately from formal futures trading they are usually known as OTC or 'Over The Counter' products. Swap agreements are extensively used in financial and energy markets but less so in agricultural commodity markets. Yet, demand for them could be on the increase, also because financial institutions are increasingly risk-averse.

    This is pertinent because one difficulty faced by both parties to a swap agreement is performance risk, especially for longer-dated agreements. Different from futures, there is no central clearing mechanism for agricultural swap agreements and, as a result, default is possible. This then limits their attraction as a price insurance vehicle.

    To address this, in February 2009 ICE (Inter Continental Exchange) in New York introduced a clearing facility for agricultural swap agreements - initially for sugar, coffee and cocoa. To quote ICE literature in this respect:

    1. Cleared swaps are over-the-counter (OTC) agreements that are eligible to be cleared by ICE Clear US (the Clearing House), but which are not executed on ICE Futures US (the Exchange), either electronically or on the trading floor. A cleared swap contract is created when the parties to an off-exchange, OTC transaction agree to extinguish their OTC contracts and replace it with a cleared swap contract. This will provide the same efficiencies and benefits that centralized clearing offers traders of contracts listed for trading on the Exchange - including credit risk intermediation and the ability to offset different positions initiated with different counter parties.

    2. This process is accomplished by the submission of each side of an OTC transaction to the Exchange and the acceptance of each side by the Clearing Members of each party to the swap. Cleared swap contracts will offer eligible OTC market participants in these products the ability to clear transactions through ICE Clear US. In addition, Clearing Members will be able to hold the cleared swaps and the margin deposited with respect to them in the same account as they hold position and margin deposited with respect to futures traded on the Exchange.

    In brief therefore, execution of an OTC product that is turned into a 'cleared swap contract' becomes guaranteed by ICE Clear US, just as is the case with Exchange traded futures contracts. It seems logical this should enhance their suitability to be considered as price and credit risk limitation mechanisms. For more on this visit www.theice.com.

    On March 30th 2009 the London NYSE Liffe exchange introduced cash-settled futures and options on its Bclear service for cocoa, robusta coffee and white sugar. Cocoa and white sugar products will expire one month ahead of the expiry of the underlying physical contract and for robusta coffee one month prior to first delivery day. The exchange stated there was a wide range of OTC business taking place on softs and it was of interest to offer clearing services for more of these over the counter trades.

    Updated 03/2009
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