Financially Traded Energy Products PDF

2015 Energy Risk Professional
ERP Exam Course Pack
REQUIRED ONLINE READINGS
In addition to the published readings listed, the Financially Traded Energy Products section of the
2015 ERP Study Guide includes several additional readings from online sources that are freely
available on the GARP website. These readings include the following learning objectives that will
be tested on the 2015 ERP Exam:
1. Craig Pirrong, “The Economics of Commodity Trading Firms” (March 2014).

• Identify and describe the functions of commodity trading firms; explain how commodity
trading firms can serve as financial intermediaries.
• Explain how commodity trading firms facilitate transformation of commodities to add
value to producers and consumers.
• Identify the typical risk exposures that threaten the operation of commodity trading firms;
understand how each type of risk arises.
• Understand the processes by commodity trading firms to manage various categories of
risk, including flat price risk, basis risk, credit risk, liquidity risk, freight risk, and other
categories of risks.
• Summarize methods used to measure risk exposure, including the benefits and drawbacks
of VaR, the use of historical and Monte Carlo simulation, and the estimation of extreme
losses.
• Describe trends in asset ownership by commodity trading firms and explain why
commodity trading firms would own midstream, downstream, and upstream assets.
• Assess the potential impact of commodity trading firms on systemic market risk, including
their potential to be a direct source of systemic risk.
© 2015 Global Association of Risk Professionals. All rights reserved.

2. IEA, “The Mechanics of the Derivatives Markets: What They Are and How They Function”
(Special Supplement to the Oil Market Report, April 2011).
• Explain the role of hedgers, speculators, and arbitrageurs in a derivatives market.
• Compare and contrast forward and futures contracts and understand how they are applied.
• Understand the mechanics of a futures position; assess the margin requirements and
profitability of an open futures contract.
• Identify circumstances that would require posting of additional margin (a “margin call”);
quantify the margin requirements for a specified period of time based on incremental MtM
valuations.
• Differentiate and apply market, limit and stop-loss orders.
• Use a long or short futures position to hedge a commodity exposure or an obligation to
buy or sell a commodity.
• Understand how basis risk can arise in a hedging transaction.
• Describe the mechanics of swaps and explain the function of the swap counterparty,
including swap dealers.
• Use forward prices and interest rates to calculate a periodic swap settlement for a multi-
year commodity swap.
• Understand how the market value of a swap changes over time and describe factors that
affect the market value of a swap.
• Demonstrate how a swap represents an implicit lending agreement, use forward
commodity prices and interest rates to derive a fixed swap rate (swap price).
• Compare and contrast American, European and Bermudan options.
• Understand the mechanics and payoff profiles of call and put options; identify when an
option contract is in, at, or out of the money.
3. Gordon Goodman. “Swaps: Dodd-Frank Memories.”

• Understand the financial limits and other obligations that a counterparty must meet to
qualify for the end-user exemption.
• Explain how the use of swap hedges is affected under Dodd-Frank.
• Understand and apply the de minimis threshold and major swap participant (MSP) test as
they apply to counterparty end-user qualification.
• Summarize the reporting process under Dodd-Frank, and identify when a counterparty is
obligated to report a transaction to a swap data repository (SDR).

4. Gordon Goodman. “Dodd-Frank’s Impact on Financial Entities, Financial Activities and

Treasury Affiliates.”
• Understand and interpret the definition of a “financial entity” under the Dodd-Frank Act;
explain how this designation affects mandatory clearing requirements.
• Construct or identify scenarios in which the end-user exemption may be applied to
organizations deemed financial entities.

THE ECONOMICS
OF COMMODITY
TRADING FIRMS
CRAIG PIRRONG
Professor of Finance
Bauer College of Business
University of Houston
ABOUT THE AUTHOR
CRAIG PIRRONG is a professor of finance and the Energy Markets Director for the Global
Energy Management Institute at the Bauer College of Business at the University of Houston.
Pirrong previously was the Watson Family Professor of Commodity and Financial Risk
Management and associate professor of finance at Oklahoma State University. He has also
served on the faculty of the University of Michigan Business School, Graduate School of
Business of the University of Chicago, and Olin School of Business of Washington University
in St. Louis. He holds a Ph.D. in business economics from the University of Chicago.
Pirrong’s research focuses on the economics of commodity markets, the relation between
market fundamentals and commodity price dynamics, and the implications of this relation
for the pricing of commodity derivatives. He has also published substantial research on
the economics, law, and public policy of market manipulation. Pirrong also has written
extensively on the economics of financial exchanges and the organization of financial
markets, and most recently on the economics of central counterparty clearing of derivatives.
He has published over thirty articles in professional publications and is the author of four
books. Pirrong has consulted widely, and his clients have included electric utilities, major
commodity traders, processors, and consumers, and commodity exchanges around the world.
CRAIG PIRRONG
Professor of Finance
Trafigura provided financial support for this research. I also benefited substantially from discussions with
Trafigura management, traders, and staff. All opinions and conclusions expressed are exclusively mine,
and I am responsible for all errors and omissions.
Throughout this document “$” refers to USD.
© Craig Pirrong, March 2014. All rights reserved.
2
TABLE OF CONTENTS
INTRODUCTION 4
I THE BASICS OF COMMODITY TRADING 6

A Commodity Transformations 6
B Value Creation in Commodity Trading 7
C Commodity Trading Firms 9
II THE RISKS OF COMMODITY TRADING 12

A Risk Categories 12
B Risk Management 17
III RISK MANAGEMENT BY COMMODITY TRADING FIRMS 21

A Introduction 21
B The Risk Management Process 22
C Managing Flat Price Risk and Basis Risk 22
D Risk Measurement 24
E Managing Credit Risk 27
F Managing Liquidity Risk 28
G Managing Freight Risk 28
H Managing Other Risks 28
I Paper Trading 29
IV COMMODITY FIRM FINANCING,

CAPITAL STRUCTURE, AND OWNERSHIP 31
A The Financing of Commodity Trading Firms 31
B The Liability Structures of Commodity Trading Firms 33
C The Ownership of Commodity Trading Firms: Public vs. Private 34
D Commodity Trading Firms as Financial Intermediaries 36
V COMMODITY FIRM ASSET OWNERSHIP

AND VERTICAL INTEGRATION 40
A The Physical Asset Intensity of Commodity Trading Firms 40
B Asset Ownership by Commodity Trading Firms 42
VI SYSTEMIC RISK AND COMMODITY TRADING:

ARE COMMODITY TRADING FIRMS TOO BIG TO FAIL? 49
A Introduction 49
B Analysis of the Systemic Risk of Commodity Trading Firms 50
AFTERWORD 58
APPENDIX A 60
Source Data For International Trade Flow in Commodities
APPENDIX B 62
Trading Activity and Physical Asset Ownership for Leading Commodity
Trading Firms
3
INTRODUCTION
The trading of the basic commodities that are transformed into the
foods we eat, the energy that fuels our transportation and heats
and lights our homes, and the metals that are present in the myriad
objects we employ in our daily lives is one of the oldest forms of
economic activity. Yet, even though this activity traces its origins
into prehistory, commodity trading is often widely misunderstood,
and, as a consequence, it is often the subject of controversy. So too
This whitepaper is intended to help demystify the commodity trading

business. It presents a combination of description and analysis:
in it, I describe some salient features of the commodity trading
business and commodity trading firms, and utilize a variety
of economic concepts to analyze and explain them.
SUMMARY CONCLUSIONS
Several fundamental conclusions flow from the analysis:
• Commodity trading firms are all essentially in the business of transforming commodities
in space (logistics), in time (storage), and in form (processing). Their basic function is to
perform physical “arbitrages” which enhance value through these various transformations.
• Although all commodity traders engage in transformation activities, they are tremendously
diverse. They vary in size, the commodities they trade and transform, the types of
transformations they undertake, their financing, and their form of ownership.
• In engaging in these transformation activities, commodity traders face a wide array of risks,
some of which can be managed by hedging, insurance, or diversification, but face others
that must be borne by the firms’ owners.
• Crucially, most commodity trading firms do not speculate on movements in the levels
of commodity prices. Instead, as a rule they hedge these “flat price” risks, and bear risks
related to price differences and spreads—basis risks.
• Risk management is an integral part of the operations of commodity trading firms. Some
major risks are transferred to the financial markets, through hedging in derivatives or the
purchase of insurance. Other risks are mitigated by diversification across commodities
traded, and across the kinds of transformations that firms undertake. Remaining risks are
borne by equity holders, and controlled by policies, procedures, and managerial oversight.
• Commodity trading firms utilize a variety of means to fund their transformation activities.
Different commodity traders use different funding strategies involving different mixes of
types of debt and debt maturities, and these funding strategies are aligned with the types
of transformations firms undertake, and the types of assets they use to undertake them.
Short-term assets like inventories are funded with short-term debt, and long-term assets
are funded with longer-term debt.
• Commodity trading firms provide various forms of financing and risk management services
to their customers. Sometimes commodity marketing, financing, and risk management
services are bundled in structured transactions with commodity trading firms’ customers.
Offering these services to customers exploits trading firms’ expertise in merchandising and
risk management, utilizes the information commodity trading firms have, and provides
better incentives to customers.
• Some commodity trading firms are public companies, whereas some are private.
The private ownership model is well-adapted to traditional, “asset light” transformation
activities, but as economic forces are leading to increasing investments in physical assets
by all types of trading firms, the private ownership model is coming under pressure.
Some major traders have already gone public; others are considering it; and still others are
implementing hybrid strategies that allow them to retain some of the benefits of private
ownership while tapping the public capital markets (sometimes including the equity
markets) to fund some investments.
4
INTRODUCTION
• Commodity trading firms exhibit considerable diversity in their investments in physical

assets, with some firms being relatively asset intensive, and others being very asset light.
These firms also exhibit diverse trends in asset intensity. Within both categories (asset
heavy and asset light), some firms are becoming more asset intensive, and others less
(or remaining relatively constant).
• What economists refer to as “transactions costs economics” provides considerable insight
on what kinds of assets commodity traders own, and why these ownership and investment
patterns have changed over time. Most notably, these transactions costs economics
considerations imply that commodity traders have strong reasons to own “midstream”
assets including storage facilities and terminals. Changes in commodity trading patterns
in the last decade have created needs for increased investments in such midstream assets,
and commodity trading firms have responded by building them.
• Although it has been suggested that commodity trading firms are potential sources of
systemic risk, as are banks, and hence should be regulated in ways similar to banks, they
are in fact unlikely to be a source of systemic risk. That is, commodity trading firms are not
too big to fail. Not only are they substantially smaller than truly systemically risky financial
institutions, they do not engage in the kinds of maturity transformations that make banks
vulnerable to runs; nor are they highly leveraged; nor are they major sources of credit;
and the assets of a firm that experiences financial distress can be transferred to others.
THE REMAINDER OF THIS PAPER IS ORGANIZED AS FOLLOWS:

Section I discusses the basics of commodity trading, focusing on the three major
transformations that commodity traders undertake.
Section II summarizes the various risks that commodity trading firms face.
Section III describes the risk management process at Trafigura.
Section IV examines the financing of commodity trading firms, their ownership structure,
and their provision of funding to their customers.
Section V analyzes asset ownership by commodity firms.
Section VI examines the question of whether commodity trading firms pose systemic risks.
The paper concludes with a brief afterword.
5
I. THE BASICS OF COMMODITY TRADING
SUMMARY
Agricultural, energy and industrial commodities undergo a variety of processes to transform
them into things we can consume. These can be categorized as transformations in space,
time, and form.
Commodity trading firms (CTFs) add value by identifying and optimizing transformations
in commodities that reconcile mismatches between supply and demand:
• in space - using logistics

• in time - through storage
• in form - with processing.
Physical and regulatory bottlenecks may act as constraints on these transformations.
CTFs undertake physical arbitrage activities, which involve the simultaneous purchase
and sale of a commodity in different forms.
CTFs do not speculate on outright commodity price risk, but aim to profit on the differential
between the untransformed and transformed commodity.
CTFs specialize in the production and analysis of information that identifies optimal
transformations. They respond to price signals and invest in physical and human capital
to perform these transformations.
There are many different types of CTF. They vary by size and by product specialization.
Some are independent entities; others are subsidiaries of oil majors or banks. They may
be privately owned or publicly listed.
A. COMMODITY TRANSFORMATIONS
Commodities undergo Virtually all agricultural, energy, and industrial commodities must undergo a variety
transformations... of processes to transform them into things that we can actually consume. These
transformations can be roughly grouped into three categories: transformations in space,
transformations in time, and transformations in form.
in space… Spatial transformations involve the transportation of commodities from regions where
they are produced (supply regions) to the places they are consumed. The resources where
commodities can be efficiently produced, such as fertile land or mineral deposits, are almost
always located away from, and often far away from, the locations where those who desire
through logistics to consume them reside. Transportation—transformation in space—is necessary to bring
and transportation... commodities from where they are produced to where they are consumed.
Just as the locations of commodity production and consumption typically do not align,
the timing of commodity production and consumption is often disjoint as well. This is most
in time... readily seen for agricultural commodities, which are often produced periodically (with a crop
being harvested once a year for some commodities) but which are consumed continuously
throughout the year. But temporal mismatches in production and consumption are not
limited to seasonally produced agricultural products. Many commodities are produced at
a relatively constant rate through time, but are subject to random fluctuations in demand
due to a variety of factors. For instance, wells produce natural gas at a relatively steady rate
over time, but there can be extreme fluctuations in the demand to consume gas due to
random changes in the weather, with demand spiking during cold snaps and falling when
winter weather turns unseasonably warm. Commodity demand can also fluctuate due
to macroeconomic events, such as a financial crisis that causes economic activity to slow.
Supply can also experience random changes, due to, for instance, a strike at a copper mine,
or a hurricane that disrupts oil and gas production in the Gulf of Mexico.
through storage... These mismatches in the timing of production and consumption create a need to engage
in temporal transformations, namely, the storage of commodities. Inventories can be
accumulated when supply is unusually high or demand is unusually low, and can be drawn
down upon when supply is unusually low or demand is unusually high. Storage is a way
6
SECTION I
of smoothing out the effects of these shocks on prices, consumption, and production. in form…
Furthermore, the other transformations (in space and form) require time to complete.
Thus, commodity trading inevitably involves a financing element.
Moreover, commodities often must undergo transformations in form to be suitable for final ...through processing
consumption, or for use as an input in a process further down the value chain. Soybeans
must be crushed to produce oil and meal that can be consumed, or serves as the input for
yet additional transformations, as when the meal is fed to livestock or the oil is used as an
ingredient in a snack. Crude oil must be refined into gasoline, diesel, and other products that can
be used as fuels. Though often overlooked, blending and mixing are important transformations
in form. Consumers of a commodity (e.g., a copper smelter that uses copper concentrates as
an input) frequently desire that it possess a particular combination of characteristics that may
require the mixing or blending of different streams or lots of the commodity.
Most commodities undergo multiple transformations of all three types between the farm,
plantation, mine or well, and the final consumer. Commodity trading firms are vital agents
in this transformation process.
B. VALUE CREATION IN COMMODITY TRADING

Commodity trading is, in essence, the process of transforming commodities in space, time,
and form. Firms that engage in commodities trading attempt to identify the most valuable Commodity traders
transformations, undertake the transactions necessary to make these transformations, and aim to optimize
engage in the physical and operational actions necessary to carry them out. The creation
of value in commodities trading involves optimizing these transformations. transformations
This is an inherently dynamic process because the values of the myriad possible transformations
vary over time due to shocks to supply and demand. For instance, a good harvest of
a commodity in one region will typically make it optimal to store additional quantities
of that commodity, and to transport the additional output to consumption locations.
Developments in oil markets in North America illustrate how dynamic transformation

opportunities can be. Prior to the dramatic increases in oil production in places like the
Bakken, the Permian Basin, and the Eagle Ford, the Midcontinent of the United States
was a deficit production region where the marginal barrel was imported to the Gulf
Coast and transported to the Midcontinent via pipeline to supply refineries in the
region. The unprecedented rise in oil output turned this situation on its head. Soon the
Midconcontinent became an area of supply surplus. This necessitated an increase in
storage in the region, and a reversal of transportation patterns. There have also been
knock-on effects, including the virtual elimination of light sweet crude imports into the
United States and the redirection of Nigerian crude (for instance) to other markets. That is,
a supply shock led to a complete change in the optimal pattern of transformation not just
in the US, but around the world.
The process of making transformations is constrained by technology and available

infrastructure. For instance, transportation technology and resources—ocean freight, rail,
barge, truck, pipelines—determine the set of possible spatial transformations. Similarly,
storage capacity determines the feasible intertemporal transformations.
Constraints on transformation possibilities can vary in severity over time. Severe constraints They overcome
represent “bottlenecks”. One important function of commodity traders is to identify these bottlenecks...
bottlenecks, and to find ways to circumvent them. This can be achieved by finding alternative
ways to make the transformation, and/or investing in additional infrastructure that alleviates
the constraints. Developments in the North American oil market also illustrate these
processes. The lack of pipelines capable of transporting oil from the Midcontinent and
other regions in which production had spiked to refineries on the Gulf was a bottleneck that
severely constrained the ability to move oil from where it was abundant to where it was
scarce. In the short run, traders identified and utilized alternative means of transportation,
including truck, barge and rail. Over a slightly longer time frame some existing pipelines were
reversed and new pipelines were built. Within a period of roughly two years, the bottleneck
had largely been eliminated.
Sometimes bottlenecks are not physical, but are instead the consequence of regulatory or
legal restrictions. At present, the primary bottleneck that is impeding the movement of newly
abundant North American crude to markets where it is scarcer is the US law that largely prohibits
the export of crude oil. Even there, traders are finding ways to alleviate the constraint. For
instance, market participants are investing in “splitters” (“mini-refineries”) that transform crude
oil that cannot be exported, into refined products that can be sold abroad.
7
The primary role of commodity trading firms is to identify and optimize those transformations.
and incur An important determinant of the optimization process is the cost of making the transformations.
transportation, These costs include transportation costs (for making spatial transformations), storage costs
(including the cost of financing inventory), and processing/refining costs. These costs depend,
storage, and in part, on constraints/bottlenecks in the transformation processes. All else equal, the tighter
processing costs... the constraints affecting a particular transformation process, the more expensive that
transformation is.
Commodity traders characterize their role as finding and exploiting “arbitrages”. An arbitrage
...to realize is said to exist when the value of a transformation, as indicated by the difference between
physical arbitrage the prices of the transformed and untransformed commodity, exceeds the cost of making the
transformation.1
Consider a spatial transformation in grain. A firm can buy corn in Iowa for $5.00/bushel (bu)
and finds a buyer in Taiwan willing to pay $6.25/bu. Making this transaction requires a trader
to pay for elevations to load the corn on a barge, and from a barge to an oceangoing ship;
to pay barge and ocean freight; to finance the cargo during its time in transit; and to insure
the cargo against loss. The trader determines that these costs total $1.15/bu, leaving a margin
of $0.10/bu. If this is sufficient to compensate for the risks and administrative costs
incidental to the trade, the trader will make it.
This description of a typical commodity trade illustrates that the commodity traders are
primarily concerned with price differentials, rather than the absolute level of commodity
prices. Traders buy and sell physical commodities. The profitability of these activities depends
on the difference between the prices of the transformed and untransformed commodities,
rather than their level. As will be discussed in more detail subsequently, price levels affect the
profitability of commodity trading primarily through their effect on the cost of financing
transactions, and their association with the volume of transactions that are undertaken.
They trade Although commodity trading firms use centralized auction markets (e.g., futures markets)
primarily to manage price risks, their core activities of buying, selling, and transforming
face-to-face with physical commodities takes place in what economists call bilateral “search” markets.
buyers and sellers Commodity trading firms search to identify potential sellers and potential buyers, and
engage in bilateral face-to-face transactions with them.
This reflects the facts that auction trading on central markets is an efficient way to transact
highly standardized instruments in large quantity, but is not well-adapted to trading things
as diverse as physical commodities. Even a particular commodity—say corn, or crude
oil—is extraordinarily diverse, in terms of location (of both producers and consumers) and
physical characteristics. Moreover, consumers and producers often have highly idiosyncratic
preferences. For instance, oil refineries are optimized to process particular types of crude oil,
and different refineries are optimized differently. The trade of diverse physical commodities
requires matching numerous producers and consumers with heterogeneous preferences.
Centralized markets are not suited to this matching process. Instead, since time immemorial,
traders have searched both sides of the market to find sellers and buyers, and matched them
by buying from the former and selling to the latter in bilateral transactions, and added value
by engaging in transformations.
They invest in To operate in these markets, commodity trading firms specialize in (1) the production and
information systems… analysis of information buyers and sellers active in the market, supply and demand patterns,
price structures (over space, time, and form), and transformation technologies, and (2) the
utilization of this information to optimize transformations. In essence, commodity traders are
the visible manifestation of the invisible hand, directing resources to their highest value uses
in response to price signals. Given the complexity of the possible transformations, and the
ever-changing conditions that affect the efficient set of transformations, this is an inherently
dynamic, complex, and highly information-intensive task.
…and in human and Trading firms also invest in the physical and human capital necessary to transform commodities.
physical resources Commodity trading therefore involves the combination of the complementary activities
of information gathering and analysis and the operational capabilities necessary to respond
efficiently to this information by transforming commodities to maximize their value.
1 This use of the term “arbitrage” is contrary to the strict academic usage in finance, i.e., a transaction that earns a
positive profit with positive probability, but entails no risk of loss. Virtually all of the commodity trades referred to
as “arbitrages” involve some risk of loss. The use of the term is therefore aspirational. It indicates that traders are
attempting to identify and implement very low risk trades, and in particular, trades that are not at risk to changes
in the general level of a commodity’s price.
8
SECTION I
Value creation opportunities in commodity trading depend on the economic environment.

Volatile economic conditions increase value creation opportunities. Supply and demand
shocks can cause geographic imbalances that create spatial arbitrage opportunities for
traders. Greater volatility also makes storage more valuable, thereby creating intertemporal
arbitrage opportunities. Greater economic volatility is also associated with greater volatility
in relative prices, and in particular in temporary mispricings that create trading opportunities.
Moreover, major secular economic shifts can create imbalances that drive trade and increase
arbitrage opportunities. The dramatic growth of China in the past 20 years, and particularly
in the last decade, is an example of this.
These factors explain why the profitability of commodity trading has tended to be greatest They are more
during periods of economic volatility, such as the Iranian Revolution, the Gulf War, and the
collapse of the Soviet Union, and during periods of rapid growth concentrated in a particular
country or region. periods of upheaval
In summary, commodity trading firms are in the business of making transformations.
In doing so, they respond to price signals to move commodities to their highest value uses.
This improves the efficiency of resource allocation. Indeed, as Adam Smith noted centuries
ago, making these transformations more efficiently can be a matter of life and death. 2
C. COMMODITY TRADING FIRMS

A large and diverse set of firms engages in commodity trading.3 Indeed, the diversity is so
extensive, and occurs along so many dimensions, that it is difficult to make generalizations.
Some commodity trading firms are stand-alone entities that specialize in that activity.
For instance, well-known trading firms such as Trafigura and Vitol are independent and
engage almost exclusively in commodity transformation activities.
Other commodity traders are subsidiaries or affiliates of other kinds of firms.
For instance, many banks have (or had) commodity trading operations. Prominent examples
include J. Aron (part of Goldman Sachs since 1981), Phibro (once part of Citigroup and before
that Salomon Brothers, though it is now not affiliated with a bank), and the commodity
trading divisions of Morgan Stanley, J. P. Morgan Chase, and Barclays (to name some of the
most prominent).
Other commodity trading entities are affiliated with larger industrial enterprises. Most
notably, many “supermajor” oil companies (such as Shell, BP, and Total) have large energy
trading operations (though some, notably Exxon, do not). Pipeline and storage operators
(“midstream” firms such as Kinder Morgan and ETP in the United States) in energy often
engage in trading as well.
Commodity trading firms also differ by the breadth of the commodities they trade. Some
are relatively specialized, trading one or a few commodities. Others trade a broader set of
commodities but within a particular sector. For instance, the traditional “ABCD” firms-ADM, Commodity trading
Bunge, Cargill, and Louis Dreyfus-concentrate in agricultural commodities, with lesser or no
involvement in the other major commodity segments (although Cargill does have a sizable
energy trading operation). As another example, some of the largest trading firms such as scope and scale...
Vitol, and Mercuria, and the energy trading-affiliates of the oil supermajors, focus on energy
commodities, with smaller or no presence in other commodity segments. One major trading
firm, Glencore, participates in all major commodity segments, but has a stronger presence
in non-ferrous metals, coal, and oil. Another, Trafigura, is a major energy and non-ferrous
metals trader.
Firms with a presence in a particular sector (e.g., agriculture) also vary in the diversity of
commodities they trade. For instance, whereas Olam participates in 18 distinct agricultural
segments, Bunge focuses on two and other major firms are active in between three and
seven different segments.
2 Adam Smith, The Wealth of Nations (1776). In Chapter V of Book IV, titled “Digression Concerning the Corn Trade and
Corn Laws,“ Smith describes how by engaging in transformations in space and transformations in time grain traders
(“corn dealers”) were invaluable in preventing local shortages from causing famines. He further noted that even
though traders perform their most valuable service precisely when supplies are short and prices high, this is also when
they are subject to the heaviest criticism.
3 I will use the term “commodity trading” to mean the process of purchasing, selling, and transforming physical
commodities.
9
Furthermore, firms in a particular segment differ in their involvement along the marketing
they may own assets chain. Some firms participate upstream (e.g., mineral production or land/farm ownership),
upstream, midstream midstream (e.g., transportation and storage), and downstream (e.g., processing into final
products or even retailing). Others concentrate on a subset of links in the marketing chain.
or downstream... (This is discussed in more detail in Section V.)
Commodity trading firms also vary substantially in size. There are large numbers of small
firms that tend to trade a single commodity and have revenues in the millions of dollars.
At the other end of the spectrum, the largest traders participate in many markets and have
revenues well over $100 billion.
...they can be Firms that engage in commodity trading also exhibit diverse organizational forms. Some,
including many of the most prominent (Cargill, Louis Dreyfus, Koch Industries) are privately
privately owned owned. Some of these non-public traders are funded by private equity investors: TrailStone
or publicly listed (Riverstone Holdings) and Freepoint Commodities (Stone Point Capital) are well-known
examples. Others (e.g., ADM and Bunge) are publicly traded corporations. Some are affiliates
or subsidiaries of publicly traded firms. Yet others are organized as master limited
partnerships with interests traded on stock exchanges: Kinder Morgan, ETP, and Plains
All American are examples of this.
10
SECTION I
11
II. THE RISKS OF COMMODITY TRADING
SUMMARY
CTFs face several overlapping categories of risk.
They have little exposure to commodity prices (flat price risk). They normally hedge
physical commodity transactions with derivatives.
Hedging exchanges flat price risk for basis risk. The basis is the differential between
the price of a physical commodity and its hedging instrument. Basis risk is the risk
of a change in this differential.
CTFs accept and manage basis risk in financial markets. They may also take on
spread risk, which arises out of timing mismatches between a commodity and
a hedging instrument.
Margin and volume risk. CTFs have limited exposure to commodity price risk.
Their profit is largely based on volumes traded and the margin between purchase and
sale prices. Margins and volumes are positively correlated.
CTFs have various kinds of liquidity risk:
• Hedging liquidity. CTFs use futures exchanges to hedge commodities. Loss-making

hedges incur costs daily before offsetting profits on physical commodities are realized.
• Market liquidity. In some commodities markets it may be difficult to realize value from
a trading position at short notice.
• Funding liquidity. With high commodity prices, CTFs need substantial capital to trade
effectively.
CTFs are exposed to a wide range of operational risks. They manage these through
a combination of approaches, including insurance, IT, and health and safety audits.
Other risks include political risk, legal/reputational risk, contract performance risk,
and currency risk.
CTFs can reduce risk:
• Through diversification. There is little correlation between basis risks in different

commodity markets. A CTF can reduce its overall exposure by trading in multiple
commodity markets. Most large CTFs are widely diversified and are therefore less
susceptible to market shocks.
• Through integration. Owning assets across the value chain provides opportunities
to self-hedge. When there is a market shock, cushioning effects generally occur
elsewhere along the value chain.
A. RISK CATEGORIES
Commodity trading involves myriad risks. What follows is a relatively high level overview
of these risks. Note that some risks could fall into more than one category. As will be seen,
a crucial function of commodity traders is to manage these risks. This risk management
essentially involves transferring risks that commodity traders do not have a comparative
advantage in bearing to entities that do: this allows them to generate value by concentrating
on their core transformation activities.
Flat price risk. Traditional commodity trading involves little exposure to “flat price” risk.1
physical commodities In the traditional commodity trading model, a firm purchases (or sells) a commodity to be
transformed (e.g., transported or stored), and hedges the resulting commodity position via
with derivatives... a derivatives transaction (e.g., the sale of futures contracts to hedge inventory in transit) until
the physical position is unwound by the sale (or purchase) of the original position. The hedge
1 The “flat price” is the absolute price level of the commodity. For instance, when oil is selling for $100/barrel, $100
is the flat price. Flat price is to be distinguished between various price differences (relative prices), such as a “time
spread” (e.g., the difference between the price of Brent for delivery in July and the price of Brent for delivery the
following December), or a “quality spread” (e.g., the difference between the price of a light and a heavy crude).
12
SECTION II
transforms the exposure to the commodity’s flat price into an exposure to the basis between
the price of the commodity and the price of the hedging instrument. (I discuss basis risk in
more detail below).
Of course, hedging is a discretionary activity, and a firm may choose not to hedge, or hedge …to exchange
incompletely, in order to profit from an anticipated move in the flat price, or because the cost
of hedging is prohibitively high. Moreover, particularly as some commodity firms have moved
upstream into mining, or into commodities with less developed derivatives markets (e.g., iron basis risk
ore or coal), they typically must accept higher exposure to flat price risks.
Commodity prices can be very volatile, and indeed, can be subject to bouts of extreme
volatility. Therefore, firms with flat price exposure can suffer large losses. This does not
mean that flat price exposure is a necessary condition for a firm to suffer large losses: as an
example, trading firm Cook Industries was forced to downsize dramatically as a result of large
losses incurred on soybean calendar spreads in 1977. Indeed, many (and arguably most) of the
instances in which commodity trading firms went into distress were the not the result of flat
price risk exposures, but basis or other spread risks: a spread or basis position that is big
enough relative to a firm’s capital can create a material risk of financial distress.
Basis Risk. Hedging involves the exchange of flat price risk for basis risk, i.e., the risk
of changes in the difference of the price between the commodity being hedged and the
hedging instrument. Such price differences exist because the characteristics of the hedging
instrument are seldom identical to the characteristics of the physical commodity being
hedged. For instance, a firm may hedge a cargo of heavy Middle Eastern crude with a Brent
futures contract. Although the prices of these tend to move broadly together, changes
in the demand for refined products or outages at refineries or changes in tanker rates or
myriad other factors can cause changes in the differential between the two.
Liquidity considerations lead firms to accept basis risk. In theory, it is possible to find
a counterparty who would be willing, at some price, to enter into a contract that more
closely matches the exposure a firm wants to hedge. However, it can be time consuming
and expensive to find such a counterparty: the firm has to accept flat price risk until a
counterparty has been found. Moreover, it can be time consuming and expensive to exit
such a contract once the hedge is no longer needed (as when a firm hedging a cargo
of crude oil finds a buyer for it), in part because the time and expense of finding a new
counterparty gives the original counterparty considerable bargaining power. By trading
in standardized liquid derivatives contracts (e.g., Brent oil futures, CBOT corn futures),
a hedger must accept basis risk (because the standardized contract almost never matches
the characteristics of the exposure being hedged), but can enter and exit a position rapidly
and at low cost because there are many other traders (other hedgers, speculators, market
makers) continuously present in a heavily traded, liquid market. The speed, flexibility, and
liquidity of trading in a market for a heavily traded standardized instrument reduce the
transactions costs and execution risks of hedging, and for most hedgers the savings in
transactions costs and execution risks more than offset the costs associated with basis risk.
Indeed, there is a positive feedback mechanism that creates a virtuous cycle that leads
to the dominance of a small number—often just one—of standardized hedging instruments
for a commodity, and induces market participants to trade these standardized contracts
rather than customized contracts with less basis risk but higher transactions costs. The
more firms that trade a particular standardized contract, the cheaper it is to trade that
contract. Thus, more trading activity in a standardized contract reduces transactions costs,
which attracts more trading activity to that contract. This commonly results in trading
activity “tipping” to one contract (or at most two) for a given commodity. For instance,
there is only one heavily traded corn futures contract. Oil is exceptional in that two liquid
contracts exist side-by-side. Thus, basis risk is ubiquitous because firms prefer to accept
such risk in order to achieve the transactions cost savings of trading in liquid markets for
standardized instruments.
Although the basis tends to be less variable than the flat price (which is why firms hedge The basis is less volatile
in the first place), the basis can be volatile and subject to large movements, thereby
potentially imposing large losses on hedging firms. And as noted above, it is possible to
take a position in the basis (or spreads generally) that is sufficiently risky relative to a firm’s but there is still a risk
capital that an adverse basis (spread) change can threaten the firm with financial distress. of large losses
Basis risks generally arise from changes in the economics of transformation during the life
of a hedge. Changes in transportation, storage, and processing costs affect relative prices
across locations, time, and form. Sometimes these basis changes can be extreme when
13
there are large shocks to the economics of transformation: for example, the explosion
Basis risks arise of a natural gas pipeline that dramatically reduced transportation capacity into California
in late-2000 caused a massive change in the basis between the price of gas at the
when the economics California border and at the Henry Hub in Louisiana (the delivery point for the most
of transformation liquid hedging instrument). As another example, in the past three to four years, the basis
change… between West Texas Intermediate crude oil and internationally traded crude oils has become
larger, and substantially more variable, due to the dramatic increase in US oil production
and to infrastructure constraints.
Basis risk can also vary by commodity. The basis for refined industrial metals tends to be less
volatile than the basis for metal concentrates hedged using futures contracts on refined metals.
Local, idiosyncratic demand and supply shocks are ubiquitous in commodity markets.
A drought in one region, or an unexpected refinery outage, or a strike at a port affect supply
and/or demand, and cause changes in price relationships—changes in the basis—that should
induce changes in transformation patterns; commodity trading firms play an essential role
in identifying and responding to these shocks.
...or when traders Basis risks can also arise from the opportunistic behavior of market participants. In particular,
corner or squeeze the exercise of market power in a derivatives market—a corner or a squeeze—tends to cause
distortions in the basis that can inflict harm on hedgers. 2 For instance, it was reported that
a commodity in Glencore lost approximately $300 million in the cotton market in May-July, 2011 due to
derivatives markets extreme movements in the basis that were likely caused by a corner of the ICE cotton futures
contract. 3 Basis and calendar spread movements are consistent with another squeeze
occurring in cotton in July, 2012. Squeezes and corners have occurred with some regularity
in virtually all commodity markets. In the last three years alone, there have been reports
(credibly supported by the data) of squeezes/corners in cocoa, coffee, copper, and oil.
Spread risk. From time to time commodity trading firms engage in other kinds of “spread”
transactions that expose them to risk of loss. A common trade is a calendar (or time) spread
trade in which the same commodity is bought and sold simultaneously, for different delivery
dates. Many commodity hedges involve a mismatch in timing that gives rise to spread risk.
For instance, a firm may hedge inventory of corn in October using a futures contract that
expires in December.
Calendar spreads are volatile, and move in response to changes in fundamental market
conditions.4 The volatility of spreads also depends on fundamental conditions. For instance,
time spreads tend to be more volatile when inventories are low than when they are high.
Spreads can also change due to manipulative trading of the type that distorts the basis.
Margins and Margin and Volume Risk. The profitability of traditional commodity merchandising depends
volumes tend to rise primarily on margins between purchase and sale prices, and the volume of transactions.
These variables tend to be positively correlated: margins tend to be high when volumes are
and fall together high, because both are increasing in the (derived) demand for the transformation services
that commodity merchants provide.
The demand for merchandising is derived from the demand and supply of the underlying
commodity. For instance, the derived demand for commodity transportation and logistics
services provided by trading firms depends on the demand for the commodity in importing
regions and the supply of the commodity in exporting regions.
This derived demand changes in response to changes in the demand and the supply for the
commodity. A decline in demand for the commodity in the importing region will reduce the
derived demand for logistical services. The magnitude of the derived demand decline depends
on the elasticity of supply in the exporting region. The less elastic the supply, the less the
2 The subject of cornering (a form of manipulative conduct) is obviously hugely sensitive and controversial, but it is has
been a matter of contention since modern commodity trading began in the mid-19th century. Rigorous economic
analysis can be used to distinguish unusual price movements and price relationships resulting from unusual
fundamental conditions, and those caused by the exercise of market power. Craig Pirrong, Detecting Manipulation
in Futures Markets: The Ferruzzi Soybean Episode, 6 American Law and Economics Review (2004) 72. Stephen Craig
Pirrong, Manipulation of the Commodity Futures Market Delivery Process, 66 Journal of Business (1993) 335. Stephen
Craig Pirrong, The Economics, Law, and Public Policy of Market Power Manipulation (1996). Craig Pirrong, Energy
Market Manipulation: Definition, Diagnosis, and Deterrence, 31 Energy Law Journal (2010) 1. Using the rigorous
theoretical and empirical methods set out in these publications it is possible to identify several recent episodes in
which it was extremely highly likely that prices and basis relationships were distorted by the exercise of market power.
It is important to emphasize that these methods can be used-and have been-to reject allegations of manipulation.
3 Jack Farchy, Cotton trading costs Glencore $330m, Financial Times, 7 February, 2012.
4 For instance, an unexpected increase in demand or decrease in supply tends to lead to a rise in prices for delivery near
in the future, relative to the rise in prices for later delivery dates.
14
SECTION II
underlying demand shock reduces the derived demand for logistical services. This occurs because
the bulk of the impact of the demand decline is borne by the price in the exporting region
rather than the quantity traded, leaving the margin between purchase and sales prices and
the quantity of the commodity shipped only slightly affected.
This means that variations in the quantity of commodity shipments, as opposed to variations Commodity trading
in commodity flat prices, are better measures of the riskiness of traditional commodity
merchandising operations. (Similar analyses apply to the effects of supply shocks, or shocks
to different kinds of transformation such as storage or processing.)
volumes not prices
The amount of financial risk incurred by a commodity trading firm due to variations in
margins and volumes depends on the kinds of transformations it undertakes, and the assets
it utilizes in those transformations. Transformations involving large investments in fixed
assets (notably many processing and refining activities) entail high fixed costs and operational
leverage. The financial performance of a firm with higher operational leverage will vary more
due to fluctuations in margins.
It should be noted further that many commodity firms benefit from self-hedges. For instance, Vertically integrated
a decline in the demand for a commodity (e.g., the decline in the demand for oil and copper
during the 2008-2009 financial crisis) reduces the demand for logistical services provided
by commodity trading firms, but simultaneously increases the demand for storage services.
A firm that supplies logistical services and operates storage facilities therefore benefits self-hedges
from an internal hedge between its storage and logistics businesses; the decline in demand
in one is offset by a rise in demand in the other.
These considerations highlight the danger of confusing the riskiness of commodity prices
with the riskiness of commodity trading, i.e., the provision of commodity transformation
services. Although changes to underlying supply and demand for commodities affect
demand for transformation services, the latter tend to be less volatile (especially when
underlying demand and supply are highly inelastic), and because there are frequently
negative correlations (and hence self-hedges) between the demands for different types
of transformations.
Operational Risk. Commodity firms are subject to a variety of risks that are best
characterized as “operational”, in the sense that they result from the failure of some
operational process, rather than from variations in prices or quantities. The list of potential
operational risks is large, but a few examples should suffice to illustrate. A firm that
transports a commodity by sea is at risk to a breakdown of a ship or a storm that delays
completion of a shipment, which often results in financial penalties.
A particularly serious operational risk is rogue trader risk, in which a trader enters into
positions in excess of risk limits, without the knowledge or approval of his firm. The firm can
suffer large losses if prices move against these positions. A rogue trader caused the demise
of one commodity trading company, Andre & Cie. The copper trading operation of Sumitomo
suffered a loss in excess of $2 billion due to rogue trading that lasted nearly a decade.
Contract Performance Risk. A firm that enters into contracts to purchase or sell a
commodity is at risk to the failure of its counterparty to perform. For instance, a firm that
has entered into contracts to buy a commodity from suppliers and contracts to sell the
commodity to consumers can suffer losses when the sellers default. In particular, sellers have
an incentive to default when prices rise subsequent to their contracting for a sales price,
leaving the commodity trading firm to obtain the supplies necessary to meet its contractual
commitments at the now higher price, even though they are obligated to deliver at the
(lower) previously contracted price.
This is a chronic problem in the cotton market, and this problem became particularly acute
beginning in late-2010. Initially, many cotton producers reneged on contracts to sell cotton
when prices rose dramatically. Subsequently, cotton consumers reneged on contracts when
prices fell substantially. As a result, several commodity trading firms suffered large losses in
cotton that had materially adverse effects on their overall financial performance. Contract
performance has also been an issue in sales of iron ore and coal to Chinese and Indian buyers:
this has tended to result in traders dealing with such buyers only on a spot basis.
Market Liquidity Risk. Commodity trading (including specifically hedging) frequently

requires firms to enter and exit positions quickly. Trading risks are lower, to the extent that
it is possible to enter and exit without having a large, adverse impact on prices. That is,
trading is less risky, and cheaper, in liquid markets.
15
Liquidity can vary across commodities; e.g., oil derivative markets are substantially more
liquid than coal or power derivatives markets. Moreover, liquidity can vary randomly—
and substantially—over time. Liquidity can decline precipitously, particularly during stressed
market periods. Since market stresses can also necessitate firms to change positions (e.g.,
to sell off inventory and liquidate the associated hedges), firms can suffer large losses in
attempting to implement these changes when markets are illiquid and hence their purchases
tend to drive prices up and their sales tend to drive prices down.
As frequent traders, commodity trading firms are highly sensitive to variations in market
liquidity. Declines in liquidity are particularly costly to trading firms. Moreover, firms that
engage in dynamic trading strategies (such as strategies to hedge financial or real options
positions) are especially vulnerable to declines in market liquidity. Furthermore, to the
extent that declines in liquidity are associated with (or caused by) market developments
that can threaten commodity traders with financial distress, as can occur during financial
crises, for instance, liquidity is a form of “wrong way” risk: under these conditions, firms may
have to adjust trading positions substantially precisely when the costs of doing so are high.
There are liquidity Funding Liquidity Risk. Traditional commodity merchandising is highly dependent on
risks for funding, access to financing. Many transformations (e.g., shipping a cargo of oil on a very large
cruise carrier are heavily leveraged (often 100%) against the security of the value of the
in markets, commodity. A commodity trading firm deprived of the ability to finance the acquisition
and when hedging of commodities to transport, store, or process cannot continue to operate.
Risk management activities can also require access to funding liquidity. A firm that hedges
a cargo of oil it has purchased by selling oil futures experiences fluctuating needs for
(and availability) of cash due to the margining process in futures. If prices rise, the cargo
rises in value but that additional value is not immediately realized in cash.5 The short
futures position suffers a loss as a result of that price increase, and the firm must
immediately cover that loss of value by making a variation margin payment. Thus, even
if the mark-to-market values of the hedge and the cargo move together in lockstep,
the cash flows on the positions are mismatched. Maintaining the hedge requires the firm
to have access to funding to bridge this gap.
Firms can suffer funding liquidity problems due to idiosyncratic factors or market-wide
developments. As an example of the first, a firm that suffers an adverse shock to its balance
sheet (due to a speculative loss, for instance) may lose access to funding due to fears that it
may be insolvent. As an example of the second, a shock to the balance sheets of traditional
sources of funding (e.g., a financial crisis that impairs the ability of banks to extend credit)
can reduce the financing available to commodity firms.
Funding liquidity is often correlated with market liquidity, and these types of liquidity can
interact. Stressed conditions in financial markets typically result in declines of both market
liquidity and funding liquidity. Relatedly, stresses in funding markets are often associated
with large price movements that lead to greater variation margin payments that increase
financing needs. Moreover, declines in market liquidity make it more costly for firms
to exit positions, leading them to hold positions longer; this increases funding needs,
or requires the termination of other positions (perhaps in more liquid markets) to reduce
funding demands.
Currency Risk. Most commodity trading takes place in US dollars, but traders buy and/or
sell some commodities in local currency. This exposes them to exchange rate fluctuations.
Commodity trading Political Risk. Commodities are produced, and to some degree consumed, in countries with
political and legal systems characterized by a weak rule of law. Commodity trading firms
that operate in these jurisdictions are exposed to various risks not present in OECD
in territories with countries. These include, inter alia, the risk of expropriation of assets; the risk of arbitrary
a weak rule of law changes in contract terms at which the firms have agreed to purchase or sell commodities;
and outright bans on exports.
Such risks exist in OECD economies as well, though to a lesser degree. For instance, OECD
countries sometimes intervene in commodity markets in attempts to influence prices.
Thus, there is a continuum of political risks, and although some countries pose very high
levels of such risk, it is not absent in any jurisdiction.
5 Inventories financed with traditional transactional bank credit are typically marked to market on a weekly basis.
If the price rises over a week, the funding bank increases the amount loaned, whereas if the price falls, the inventory
owner/borrower pays down some of the loan.
16
SECTION II
Legal/Reputational Risk. Various aspects of commodity trading give rise to legal Many commodities
and reputational risks for commodity trading firms. Many commodities are potential
environmental hazards, and firms are subject to legal sanctions (including criminal ones) pose potential
if their mishandling of a commodity leads to environmental damage. These risks can be environmental
very large, particularly in oil transportation. Note the 200 million euro fine imposed on
Total arising from the Erika incident, or Exxon’s massive liability in the Exxon Valdez spill;
hazards
although these are not commodity trading firms, firms that engage in oil transportation
are exposed to such risks. One commodity trading firm, Trafigura, paid a large monetary Legal sanctions and
settlement and suffered substantial reputational damage when “slops” produced when reputational damage
cleaning a tanker that it had chartered, the Probo Koala, were disposed of improperly
by an independent contractor, causing some people exposed to the slops to fall ill. can be substantial
Furthermore, commodity trading firms frequently operate in countries in which corruption
is rife, making the firms vulnerable to running afoul of anti-corruption laws in the United
States, Europe, and elsewhere.6 Moreover, commodities are sometimes the subject of trade
sanctions. Since these sanctions create price disparities of the type that commodity firms
routinely profit from they create an enticement for trading firms to attempt to evade the
sanctions. As a final example, commodity trading firms may have opportunities to exercise
market power in commodity markets; indeed, their expertise regarding the economic
frictions in transformation processes that make such kinds of activities profitable and their
size make them almost uniquely positioned to do so. The exercise of market power in this
way is sometimes referred to as manipulation, or cornering: such actions cause prices to
diverge from their fundamental values and leads to distortions in commodity flows.
There are recent examples in which commodity traders have been accused of each of
the foregoing legal transgressions. This has exposed these firms to legal sanctions and
reputational damage. These risks can be substantial. For instance in late-June, 2012 a
class action was filed in the United States accusing one major commodity merchant, Louis
Dreyfus (and its Allenberg subsidiary), with cornering cotton futures contracts in May and
June 2011.7 Although the accused firm has vigorously denied the allegation, the potential
exposure is large (in the hundreds of million dollars) and is therefore a material risk that
illustrates the potential for contingent liabilities arising from manipulation claims.
Given the current environment in which manipulation generally, and commodity

manipulation specifically, is the subject of considerable political and regulatory attention,
this is a real risk attendant to commodity trading, and likely a growing one. 8 Note
specifically recent allegations of manipulation involving LME metal warehousing
and Brent crude oil. 9 Even though manipulation is difficult to prove in legal proceedings,
allegations are increasingly common, costly for the accused to defend, and can result
in serious reputational damage even if the allegations are not proven in court.
B. RISK MANAGEMENT
Commodity trading firms universally emphasize their expertise in risk management, and
the importance that they place on managing risks (price risks in particular). They utilize
a variety of tools to achieve risk control objectives. Most notable among these are hedging
using derivatives (e.g., selling crude oil futures or a crude oil swap to hedge a cargo of
crude oil) and diversification across commodities and integration of different links in the
value chain.
As noted above, hedging transforms the nature of a firm’s risk exposure from flat price risk
to basis risk. These basis risks can be material, also as noted above.
Diversification across commodities makes firm financial performance less dependent

on idiosyncratic events in any particular commodity. Given the nature of commodities,
particular markets or submarkets are prone to large shocks that can seriously impair the
profitability of operating in those markets. Diversification is a way of reducing the overall
riskiness of a commodity trading firm. This is particularly important for privately-held
firms that have limited ability to pass idiosyncratic risks onto diversified shareholders.
6 For instance, ADM recently agreed to pay a fine of $54 million to settle charges that it bribed Ukrainian government
officials. Gregory Meyer, ADM to pay $54 million to settle bribery charges, Financial Times, 20 December, 2013.
7 In re Term Commodities Cotton Futures Litigation 12-cv-5126 (ALC) (KNF) (SDNY). Term Commodities is a subsidiary
of Louis Dreyfus. Louis Dreyfus BV and Allenberg Cotton (another Louis Dreyfus subsidiary) are also named defendants.
8 There are examples of commodity trading firms paying large sums to settle claims of market manipulation.
These include Ferruzzi (in soybeans) and Sumitomo (in copper).
9 Morgan Stanley, Phibro, Trafigura and Vitol are also defendants in the Brent lawsuit. Kevin McDonnel et al v. Royal
Dutch Shell PLC et al, 1;13-cv-07089-UA (SDNY).
17
Most large trading firms are widely diversified. Many smaller firms are more specialized,
reduce risk by and less diversified. The latter are obviously more vulnerable to adverse developments
in a particular market.
To quantify the potential benefits of diversification, I have evaluated data on world trade
flows by commodity code. Specifically, I have collected data on world imports and exports
of 28 major commodities for the 2001-2011 period from the International Trade Centre
UNCTAD/WTO.10 Using this data, I calculate correlations in annual world imports and exports
across these 28 commodities. I calculate two sets of correlations between percentage
changes in trade flows across commodities. The first set is based on nominal trade flows,
measured in US dollars. The second set is based on deflated trade flows. To calculate
deflated traded flows, I divide the nominal trade flow in a given year by the nominal price
of the commodity in question, scaled so that the 2001 value is 1.00.11 The deflated trade
flow is a measure of the quantity (e.g., barrels of oil or tons of coal) of each commodity
traded in a given year.
Correlations of nominal trade flows across commodities are generally positive. The median
nominal import and export correlation is close to 50%. However, deflated trade flow
percentage changes exhibit much lower correlations. The median correlation for deflated
import percentage changes is .065, and the median correlation for deflated export percentage
changes is .031. Approximately 40% of the correlations based on the deflated flows
are negative.
As noted elsewhere, the derived demand for the services of commodity trading firms,
and their profitability, is dependent on the quantities of commodities traded, rather
than prices. Therefore, the correlations based on deflated data are more relevant for
evaluating the potential benefits to the firms of diversification across commodities.
The lack of correlation generally, and the prevalence of negative correlations indicate
the potential benefits of diversification across commodities in reducing the variability
of trading firm risk.
Diversification can also reduce a trading firm’s exposure to basis risk. Dealing in multiple
commodities diversifies away basis risk to the extent that basis movements exhibit little
correlation across commodities.
Integration in the Integration in the value chain also tends to reduce risk. As noted earlier, there can be
value chain can self-hedges in the value chain, as in the case of storage on the one hand and through-
put-driven segments on the other. Moreover, shocks at one level of the value chain often
reduce overall risk have offsetting effects (or at least, cushioning effects) at others. For instance, a supply
shock upstream that raises prices of raw materials tends to depress processing margins.
Integrating upstream and processing assets can stabilize overall margins, thereby reducing
risk. Again, this is particularly useful for privately held firms that cannot readily pass on
risks through the equity market, or for firms subject to other financing frictions. Moreover,
it is more valuable across segments of the marketing chain where markets are not available
to manage price risk at these stages of the chain, or these markets are relatively illiquid
(e.g., iron ore, alumina and bauxite, or coal).
Diversification and integration are primarily useful in managing risks idiosyncratic to

particular commodities or commodity submarkets, e.g., a drought that affects wheat
production and hence prices. They are less effective at mitigating systematic shocks that
affect all commodity markets, e.g., a global financial crisis, or a decline in Chinese growth
(because China is a major importer of all important commodities).12
Although commodity trading firms emphasize their risk management orientation and
prowess, they have considerable discretion in their ability to manage—and assume—risks.
Risk measurement is a crucial component of risk management. Most commodity trading

firms utilize Value-at-Risk as a risk measurement tool. The limitations of this measure
are well known. In particular, commodity trading firms incur model risk (including risks
10 The commodities included are listed in Appendix A. The data was accessed using the ITC’s Trade Map system.
11 The nominal price for each commodity is based on data provided in the World Bank Commodity Price Data (Pink Sheet)
annual average commodity prices. For commodities (such as oil, coal, or wheat) where there are multiple varieties or
grades reported (e.g., Brent and WTI; Australian, Columbian, and South African coal), I utilize the simple average of
the 2001=1.00 deflators.
12 There are some exceptions. As noted previously, some commodity trading activities like storage are profitable when
commodity demand is low even though such demand shocks tend to reduce the profitability of other trading company
operations.
18
SECTION II
associated with the estimation of parameter inputs). Such model risks have been
implicated in large losses in virtually every market and type of trading firm (e.g., banks,
hedge funds), and they must be considered a serious concern for trading firms as well,
especially given the fact that these firms have extensive involvement in commodities and
markets for which pricing, volatility, and correlation information is particularly scarce
(especially in comparison to financial markets).
Given the importance of the subject, I now turn from this more general discussion of risk
management to a more detailed analysis that focuses on risk management at Trafigura.
19
20
SECTION III
III. RISK MANAGEMENT BY COMMODITY

TRADING FIRMS
SUMMARY
This section examines risk management systems and processes in one company to develop
a more granular picture.
Risk management at Trafigura is highly centralized. A Chief Risk Officer has overall
responsibility. A Risk Committee and a Derivatives Trading Committee assess risk
concentrations and set limits.
Trading desks operate within centrally determined parameters. Outright market price
risks are almost always hedged via futures or swaps. Basis risks are managed in financial
markets. Hedges are executed through an internal broker and overall risk is consolidated are usually less
at Group level.
highly leveraged
Trafigura has invested $550 million over the last three years in risk management and
measurement systems.
• The company’s Value-at-Risk (VaR) model combines 5,000 risk factors to assess net
exposure. It uses Monte-Carlo simulations to predict P&L outcomes in multiple
scenarios. Its VaR target is 95% confidence that its maximum one-day loss is less
than 1% of Group equity.
• Trafigura augments its VaR data with stress tests and analysis that estimate P&L
outcomes in extreme scenarios.
• Trafigura’s enhanced VaR analysis addresses many, but not all, of VaR’s deficiencies.
The company therefore supplements this analysis with qualitative assessment.
Trafigura has experienced a low rate of credit losses in its history. A formal process
assigns a credit limit for each counterparty. It typically bears less than 20% of trading
counterparty credit risk and transfers the remainder to financial institutions.
The company manages liquidity risk by diversifying types of funding and providers of funding.
Trafigura manages freight risk using Forward Freight Agreements and fuel swaps.
It manages operational risks through a combination of liability insurance, best practice

procedures, and Group-wide quality controls. It has a comprehensive framework for health,
safety, environmental, and community (HSEC) performance.
The company and its subsidiary Galena Asset Management also engage in speculative
paper trading. This takes advantage of Trafigura’s industry knowledge. Traders deal
in calendar and intra-market spreads; they have very little exposure to flat price risk.
A. INTRODUCTION
Trading firms have always been at the forefront of the management of commodity price risk.
This fact was recognized by one of the first great scholars of futures markets, Holbrook
Working. Working noted that open interest in futures markets (the number of outstanding
contracts) varied with the amount of a crop that was in the hands of merchandisers. Open
interest was bigger for commodities like wheat that was largely marketed, rather than held
by farmers to feed livestock, than it was for corn, which was held by farmers as a feed grain
in far larger proportion. Similarly, Working noted that the seasonal patterns in open interest
matched crop marketing patterns, with open interest reaching its maximum some time after
the harvest, and hence after farmers had sold the crop to merchandisers. From these facts,
Working concluded that commodity merchants who transformed wheat, corn, and cotton
in space and time were the primary users of futures contracts, and that they used these
contracts to hedge their risk.
Commodity trading firms remain major users of futures contracts, and other derivatives
contracts, as a centerpiece of their risk management programs. Viewing logistics, storage,
and other transformations as their core businesses, they do not have a comparative
advantage in bearing flat price risks. As a result, they hedge most price risks using exchange
traded (“listed”) or over-the-counter derivatives.
21
Although as a general rule commodity trading firms are hedgers, firms have different risk
management is management policies, pursue different risk management strategies, and have different
risk management procedures in place. Moreover, although commodity price risk is arguably
representative the largest risk for most trading firms, other risks, notably credit and operational risks,
of the industry are also material and involve their own company-specific policies, procedures, and strategies.
Therefore, it is impractical to characterize in detail risk management by commodity traders
generally, and I focus on Trafigura as a representative example of how commodity traders
manage risk. A review of the disclosures of some publicly traded commodity trading firms
suggests that Trafigura’s approach to risk management is broadly representative of major
commodity firms generally.
B. THE RISK MANAGEMENT PROCESS

Risk management Risk management in Trafigura is highly centralized. The company has a Chief Risk Officer
is highly centralized (“CRO”) who reports directly to the Chief Operating Officer (“COO”) and the Management
Board. The CRO is a member of the Risk Committee, which also includes company directors
and senior traders. The Committee meets regularly to assess and manage risk exposures,
and to adjust strategies in light of prevailing market conditions. The CRO performs functions
such as overseeing the refinement of risk models, the review and testing of model performance,
and reviewing exposures across businesses. The CRO is independent of the “front office”
revenue generating operations of the company.
Trafigura also has a Derivatives Trading Committee that is responsible for implementing the
company’s risk management policies. It evaluates risk limits and concentrations, and monitors
markets to identify emerging risks and opportunities.
Quantitative data This process is highly dependent on the collection, analysis, and distribution of information
is critical regarding risks. Some of this information is “hard” data on positions in both physical
commodities and derivatives contracts. Other “hard” information includes data on current
and historical prices of the commodities that Trafigura trades, and models to analyze this
data: I discuss risk measurement and risk modeling in more detail below. Using these data and
analytics, the firm produces quantitative measures of overall risk exposure, and the risks of
individual trading books. The company establishes limits on these quantitative risk measures,
both on a firm-wide basis and for each individual trading team. A team is notified when its
measured risk approaches its assigned limit.
Given the number of commodities that Trafigura trades, and the large number of prices
(e.g., spot prices of various varieties of oil at various locations, futures prices for different
maturities) collecting, storing, distributing, and analyzing this hard information is an
extremely computationally and information technology intensive process. Largely as a result
of the computational demands of the risk management process, Trafigura has spent $550
million on information technology hardware and software in the past three years. This is
an overhead expense, and from the perspective of the industry overall, expenditures on risk
management information technology creates a scale and scope economy that tends to favor
consolidation of the industry into a smaller group of large firms, and which makes it more
difficult for smaller and more specialized firms to compete. The increasing data and analytical
intensity of trading and risk measurement modeling is tending to increase the degree of these
scale and scope economies.
Qualitative Other information is “softer”, more qualitative information about market conditions and market
information is dynamics. Trading desks constantly active in the market obtain this information, and provide it
to the CRO, the Risk Committee and the Derivatives Trading Committee. The CRO, the Risk
also important Committee, the Derivatives Trading Committee and the Trading Desks collaborate to integrate,
interpret, and analyze this information. They then utilize this analysis to assess and manage risks.
C. MANAGING FLAT PRICE RISK AND BASIS RISK

It is standard practice at Trafigura to hedge market price risks where possible. Indeed, hedging
Market price risks is required under the terms of some transactional financing arrangements. In the past
are always hedged (prior to 2007) the bank providing funding for a transaction controlled the hedge through
a tripartite agreement (TPA) between it, the brokerage firm, and the client; this arrangement
where possible is still utilized for smaller and medium sized-traders. In this arrangement the bank has a
security interest in the portfolio of derivatives and the product being hedged (e.g., a cargo
of crude oil), and finances the margin calls on the futures.
At present, however, Trafigura (and other larger traders) do not utilize this TPA mechanism,
as it is operationally and administratively cumbersome. Instead, although the bank lending
against a physical position has a security interest against that inventory, and adjusts the
22
SECTION III
financing on a weekly basis (or perhaps more frequently under volatile conditions), it has
no interest in, or even view of, the futures or swap position used to hedge. Instead, Trafigura
and other traders operating in this way endeavor to hedge all the risk via futures or swaps,
self-finance the initial margins (mainly out of corporate lines), and also finance any
mismatches in variation margin payments: mismatches arise because futures (and some
swaps) are marked to market daily, which results in daily variation margin payments, but
as just noted normally the bank lending against inventory only marks its value to market
on a weekly basis.
In addition to hedging inventories, Trafigura also routinely hedges future physical Future physical
transactions. For instance, it may enter into an agreement to purchase crude from West transactions are
Africa for delivery in two months at the Brent price plus/minus a differential, and enter into
another contract to sell that cargo to a US refiner at the West Texas Intermediate price plus/ routinely hedged
minus a differential. This set of transactions exposes the company to fluctuations in the
Brent-WTI differential, which it can, and routinely does, hedge by buying Brent futures and
selling WTI futures.
This type of transaction receives different accounting treatment than a hedge of a physical
inventory. Whereas the derivatives position associated with the physical inventory
is accounted for as a hedge, the derivatives used to hedge the forward floating price
transactions are put in the trading book. These positions can represent a substantial fraction Hedges are executed
of Trafigura’s total net notional derivatives positions. For instance, as of September 30, 2011, centrally through an
the notional value of derivatives held for trading purposes represented approximately 45%
of the total notional amount of Trafigura’s derivatives.1 Although as discussed later some internal broker
of the derivatives held for trading purposes are fairly characterized as speculative (though
mainly involving speculation on price differentials rather than flat prices), most are entered
for the purpose of managing price risks.
The hedging process is rather mechanical and centralized. When the price on a physical trade
(e.g., the purchase of a physical oil cargo) is fixed, the Deals Desk initiates a hedge. The hedge
is executed through a broker by the central execution desk of Trafigura Derivatives Limited (TDL):
all hedges are also centrally booked through TDL, which acts as an internal broker for the group.
There is thus a separation of the execution of physical trades from the management of the
market price risk associated with those trades, and the risk management function is centralized.
Trafigura primarily utilizes futures and swaps to manage its risks. For instance, it typically hedges
the purchase of a cargo of crude oil by selling oil futures or an oil swap. Options can be used to futures and swaps to
manage risk as well, but Trafigura does not use them extensively in its hedging program.2
manage risk
Due to differences between the characteristics of the commodity being hedged, and the
hedging instruments, no hedge is perfect, and Trafigura bears some residual risk. For instance,
hedging a cargo of Nigerian crude with Brent crude futures or WTI crude futures involves
a mismatch in quality, location, and timing. Since these factors influence price, mismatches
cause the prices of the hedge instrument and the commodity being hedged not to move
in lockstep. Trafigura is at risk to changes in the difference between the price of the hedged
commodity and the hedge instrument. This difference—the basis—is variable, due to this
differential movement in prices arising from the mismatches. Thus, a hedger like Trafigura
is exposed to basis risk, and hedging involves the substitution of basis risk for flat price risk.
Since the prices of hedging instruments and the commodities hedged are correlated, however,
basis risk is typically substantially less than flat price risk.
The amount of basis risk differs by commodity. For instance, whereas copper cathodes stored
in an LME warehouse can be hedged quite effectively using LME copper futures, copper
concentrates can be hedged less effectively. The copper content in the concentrate can be
hedged, because many contracts for the sale of concentrates specify that one component
of the price will be based on copper content and the LME price: the LME price risk can be
hedged. But the other components of the price, notably treatment and refining charges,
cannot be hedged, and are a source of basis risk.
Basis risk can also vary over time. For instance, the basis tends to be more volatile when
inventories are low. Changes in the severity of constraints can also affect the variability
1 Base Prospectus, Trafigura Funding S.A. (14 November, 2013) F-31-F-33.

2 This illustrates that the firm aims to eliminate flat price exposure, because an option hedge leaves a (one-sided)
exposure. For instance, a firm can hedge a cargo of crude against price declines by buying an oil put. This protects the
firm against price declines, but allows it to profit from price increases. Thus, an option hedge retains a price exposure,
and due to its one-sided nature this hedge is costly: the firm must pay a premium to purchase the put. If the firm’s
objective is to eliminate price exposure, it can avoid this cost by merely selling futures as a hedge.
23
of the basis. For instance, the basis tends to be more variable when transportation capacity
is tightly constrained than when it is not. As an extreme example, the basis between WTI
at Cushing, Oklahoma and the prices of crude oil at the Gulf of Mexico exhibited relatively
little variability when the main flow of oil was from the Gulf to the Midcontinent and there
was abundant pipeline transport capacity. When oil went into surplus at Cushing, and there
was no pipeline capacity to ship it to the Gulf, the basis became more variable.
It uses its market Trafigura manages basis risk using its knowledge of the relationships between prices of related
knowledge but different commodities. Moreover, just as Holbrook Working described in his writing on
hedging by commodity traders in the 1950s, the traders use their marketplace knowledge
to manage basis to try to predict future basis movements, and place their hedges to earn a profit from a
relationships favorable movements in the basis. Thus, to the extent that Trafigura speculates, most of its
speculation is on basis relationships.
The underlying physical transactions and the hedges associated therewith are included in the
company’s centralized risk measurement system (described below). The basis risk on a trading
book’s position contributes to the overall risk of the firm. Moreover, the risk measurement
system calculates the risk associated with a trading desk’s positions, and the trading desk is
subject to risk limits: its measured risk cannot exceed the assigned limit. Furthermore, trades
are marked to market on a daily basis based on proprietary forward curves produced by the
Risk Control Group, and exception reports are generated when a position incurs a change in value
in excess of $50,000. Traders have to explain the reason for the exception to senior management.
Although traders attempt to manage basis risk through judicious design of hedges, this risk
overall risk is cannot be eliminated. However, to the extent that basis movements are uncorrelated across
different transactions, this risk can be reduced through diversification. In particular, given
reduced through that basis movements in different commodities (e.g., oil and copper) are driven by different
fundamentals, they are likely to exhibit little correlation, and hence a firm that trades a
diversified portfolio of commodities can reduce risk exposure. This provides an advantage
to larger firms that participate in a variety of different commodities, engage in a variety
of transformations, and trade in many geographic markets.
D. RISK MEASUREMENT
With respect to market price risks, a trading company such as Trafigura can be viewed as a
It monitors portfolio of positions in a myriad of physical commodities and financial derivatives contracts
Value-at-Risk (including futures contracts and swaps). Given information about the variability of the prices
associated with individual positions, and the covariation between these prices, it is possible
to compute various measures of the risk of the overall portfolio.
Consistent with standard industry practice for trading generally (not just commodity trading),
Trafigura employs Value-at-Risk (“VaR”) as its measure of the overall price risk of its portfolio
of physical and derivatives trading positions. Value-at-Risk is defined as the amount of money,
or more, that can be lost over a given time horizon with a given probability.
Implementation of VaR requires the user to choose a probability level, and a time horizon.
Consistent with standard industry practice, Trafigura uses a one-day time horizon, and a 95%
probability (“confidence”) level. As of 30 September, 2013, Trafigura reported its VaR as $11.3
million. This means that on 95% of trading days, the company would be expected to suffer
losses of less than $11.3 million. Put differently, on 5% of trading days, the firm could expect
to lose more than $11.3 million.
As noted above, the company has established a VaR target. Specifically, the firm attempts
to maintain VaR at less than 1% of group equity. Using equity to set the target reflects the
fact that capital represents loss bearing capacity. Thus, the company compares the risk of
loss, as measured by VaR, to its risk bearing capacity.
Its risk analysis Again consistent with standard industry practice, Trafigura uses a simulation (“Monte Carlo”)
method to calculate VaR. In particular, it uses a variant on the industry standard historical
examines extreme simulation VaR method. That is, it randomly draws changes in the prices of instruments in
scenarios its portfolio from historical data. The company’s VaR system currently takes into account
over 5,000 risk factors. These include the forward prices for the commodities the firm trades,
interest rates, foreign exchange rates, and equity prices. Based on these simulated price
movements, the profits/losses on each position in the portfolio are calculated and then added
to determine the simulated profit/loss on the entire portfolio. It makes many such random
draws: there is one portfolio profit per simulation.
24
SECTION III
The standard approach in the industry is to rank the many simulated profit/loss outcomes,
and to set and the 5% VaR equal to the level of loss such that 95% of the simulations have
a smaller loss (bigger profit), and 5% of the simulations have a bigger loss: the approach can
be applied to other confidence levels.
This is acceptable for calculating VaR, but as will be discussed in more detail below, it is
important for trading companies to understand the likelihood of outcomes that are more
extreme than the VaR. That is, it is important to understand what happens in the left tail
of the probability distribution of possible outcomes. Due to the relative rarity of such extreme
outcomes, historical simulations will produce few observations, making it difficult to achieve
such an understanding based on historical simulation alone.
Therefore, Trafigura adds another step. It uses the simulated profit-and-loss outcomes
to fit “heavy-tailed” probability distributions for portfolio P&L. Heavy-tailed distributions
(such as Generalized Hyperbolic Distributions) take into account that extreme outcomes—
which are of central importance to determining the risk of a trading operation—occur more
frequently than under the Gaussian (Normal) distribution (the standard bell-curve widely
used in statistics, and which is the basis of standard derivatives pricing models such as the
Black-Scholes equation). Trafigura uses the heavy-tailed distribution fitted to the portfolio
profit and loss simulation outcomes to calculate VaR, and to calculate other measures of risk
that focus on extreme losses (i.e., losses in excess of VaR): these measures are discussed below.
This historical methodology has decided advantages over alternative methods, most notably Historical simulation
“parametric” methods that require the choice of particular probability distributions (like the has advantages over
normal distribution) that may fail to capture salient features of price behavior. If large price
moves are more common in the data than the standard probability distributions would imply, theoretical models…
the historical method will capture that behavior, especially if the method is augmented by
using the simulated outcomes to fit heavy-tailed probability distributions. Moreover, the
historical simulation captures dependencies between the changes in different prices (of which
there are many: recall that Trafigura’s VaR is based on 5,000 different risk factors) that are
not well-characterized by standard probability distributions, and which would be daunting
to estimate parametrically in any event.3
The company regularly re-calibrates and back-tests its VaR model. Risks that perform poorly
in back-tests are subjected to thorough review involving extensive discussions with traders
operating that market.
The most problematic feature of historical VaR simulations is that the user is a prisoner …but the future
of the historical data: current conditions may not be well characterized by past conditions. may be different
Moreover, since conditions change over time, not all historical data is equally informative
about current risk conditions, and it is a non-trivial problem to determine which data is most from the past
representative of current circumstances. This is particularly true inasmuch as Trafigura trades
so many markets, and it is likely that current conditions in market A may match time period
X well, but conditions in market B may match another period Y better. Trafigura has devoted
considerable resources to developing analytic techniques to choose the historical data that is
most representative of current conditions, but even the best techniques are imperfect, and
what’s more, major economic shocks can render current circumstances completely different
than anything in the historical record. For example, price movements during the 2007-2008
Financial Crisis were far outside anything experienced in the historical data used by firms to
calculate VaR at that time.
In part for this reason, VaR is increasingly being augmented by stress tests that estimate
possible losses under extreme scenarios that may not be present in the historical data. Stress
tests are useful in identifying vulnerabilities, and stress scenarios can be constructed that
match current conditions and current risks. Pursuant to US regulatory requirements, Trafigura
does perform stress tests on the funds of its subsidiary, Galena Asset Management. It does
not perform stress tests on the entire Trafigura portfolio due to its diversity and complexity,
and due to the difficulty of establishing realistic stress scenarios.
Instead, to achieve a better understanding of its downside risk exposure under extreme Conditional
outcomes, Trafigura and many other companies in commodity and financial trading augment Value-at-Risk
VaR with other methods: in particular, methods that quantify how large might be the losses
losses
3 Parametric methods face two difficult problems. The first is the sheer number of correlations that need to be estimated.
For a large portfolio with 5,000 risk factors, it is necessary to estimate almost 12.5 million correlations, or find a way of
reducing the dimensionality of the problem, knowing that any such reduction inherently suppresses information.
The second is estimating these parameters accurately, especially since they can change dramatically over time.
25
a firm could incur, if the loss is bigger than its VaR. An increasingly common measure is
“Conditional VaR” (“CVaR”, also referred to as “excess loss”, “expected shortfall”, and “tail VaR”).
This measure takes the average of losses in excess of VaR. It therefore takes into account all
large losses, and presents a more complete measure of downside risks in a trading book.
Trafigura estimates CVaR using the heavy-tailed probability distributions fitted to the profits
and losses generated by the historical simulations.
Another approach to measuring extreme risks that is employed by Trafigura is Extreme

Value Analysis.4 This permits the company to estimate the probability of more extreme
outcomes with losses substantially greater than VaR.
The cost of Although these methods represent a substantial improvement on VaR, they are still
implementing risk dependent on the historical data used to calculate these additional risk measures.
Risk relates to the future, but every known measure of risk relies on what happened
measurement gives in the past. As a consequence, any and all risk metrics are themselves a source of risk. 5
All of these methods are very computationally and data intensive, especially for a large
economies of scale trading firm such as Trafigura that operates in many markets. The cost of implementing
a state-of-the-art risk measurement system is another source of scale economies that tend
to favor the survival of large firms, and it undermines undermine the economic viability of
small-to-medium sized firms.
VaR is by far the most widely employed measure of market price risk, but years of experience
and research (much undertaken by academics) have identified various deficiencies in VaR
as a risk measure over and above the problem inherent in relying on historical data: some of
these deficiencies also plague other measures such as CVaR.
One problem is that the short-time horizon conventionally employed (e.g., the one-day
horizon that Trafigura and many others utilize) does not permit the estimation of losses over
longer time horizons.
Liquidity risk is This is especially relevant because of another factor not well captured by VaR: the liquidity
of positions in the trading book, where by liquidity I mean the ease and cost of exiting
not well captured positions, with illiquid positions being more costly and time-consuming to offset. The fact
by Value-at-Risk that a firm like Trafigura may hold positions in illiquid instruments that may take some time
to reduce or eliminate means that such longer time periods are relevant in assessing overall
risk, and the adequacy of capital to absorb these risks: simple time scaling rules are typically
subject to considerable inaccuracy.
One other issue relating to the use of VaR deserves comment. Specifically, when many
firms in a sector utilize VaR and weight recent data more heavily, another problem arises:
“Procyclicality.”6 This is best illustrated by an example. If oil prices become more volatile,
firms using VaR to measure risk will calculate that their risk exposures have increased. This
is likely to induce some, and perhaps all, of these firms to try to reduce their risk exposures
use similar models it by offsetting positions. The attempt of a large number of firms to do this simultaneously can
reinforces trends cause prices to move yet more, increasing measured volatility, increasing VaR, causing further
reductions in position, and so on. Such feedback loops can be destabilizing, and are often
observed during periods of market turbulence: working through the VaR channel, turbulence
begets position changes that beget more turbulence.
In sum, Trafigura uses a heavily augmented version of the Value-at-Risk approach that is
the standard way to measure risk in commodity and financial trading. The enhancements
implemented by Trafigura address many of the well-known deficiencies of VaR, but some
deficiencies remain, and there are no readily available remedies for them, despite concerted
Quantitative risk efforts in industry and academia to develop them. It will likely never be possible to quantify
modeling has to be future risk exactly, especially since risk quantification inherently relies on historical data.
Thus, quantitative risk modeling must be supplemented by more qualitative judgments about
supplemented risk, and model risk should be backed by capital just like price or credit risks.
4 See, for instance, Rolf-Dieter Reiss and Michael Thomas, Statistical Analysis of Extreme Values (2007).
5 Risk measurement is also substantially more complicated for portfolios that include a large number of non-linear
exposures, such as those that arise from options. Non-linear exposures are more difficult and computationally
expensive to value accurately. Moreover, non-linear exposures depend on risk factors such as volatilities, so the
number of risk factors in portfolios with options is substantially greater than is the case with portfolios that do not
have options. Since Trafigura trades relatively few options, this is not a major consideration for the firm.
6 Tobias Adrian and Hyun Song Shin, Procyclical Leverage and Value-at-Risk, 27 Review of Financial Studies (2014) 373.
Jon Danielsson and Hyun Song Shin, Endogenous Risk, Working Paper (2002).
26
SECTION III
E. MANAGING CREDIT RISK

Trafigura is at risk of loss resulting from the failure of a trading counterparty (either in a
physical trade or a trade in a financial contract) to perform on its contract with the firm.
Counterparties include those to whom Trafigura sells physical commodities, and firms from
which it buys them. Counterparties also include hedge counterparties, which are typically
prime financial institutions or large physical participants (e.g., a multinational oil company).
Finally, counterparties include those providing payment guarantees or other credit risk
mitigants that are used to manage counterparty risks.
Trafigura uses a variety of methods to manage the credit risk that arises from transacting
with these diverse counterparties.
Specifically, it implements a formal credit process. Based on financial information, it establishes

credit limits for each counterparty. This information includes historic payment performance formal credit process
information and creditor financial statements, as well as “soft” information about the creditor’s
business. Tafigura also uses a system (based on the well-known Moody’s KMV methodology)
that creates a credit risk rating for its counterparties. This system takes into account country
and industry factors as well as counterparty-specific financial information.
Credit evaluations are made by teams that specialize based on commodity and geographic
region. The firm has credit officers located in crucial markets throughout the world; these
individuals can utilize local knowledge and contacts to make more accurate evaluations of
counterparty credit risk.
Trafigura historically has experienced a very low rate of credit losses. The firm has suffered
ten final credit losses since its inception in 1993.
If a transaction or transactions with a counterparty would result in a credit exposure to

that counterparty in excess of the credit limit assigned to it, Trafigura purchases payment
guarantees or insurance from prime financial institutions (or declines to make the trade).
The purchase of a guarantee transfers the credit risk associated with the counterparty It insures itself
to the financial institution that provides the guarantee. Trafigura typically bears between by buying payment
10 and 20% of the credit risk associated with its trade counterparties, and transfers the
remainder to financial institutions. Moreover, the company purchases political risk cover for guarantees
any transaction in a country with a Dunn & Bradstreet rating below DB3d, and purchases
such cover on a discretionary basis for exposures in countries rated between DB3a and DB3d.
This transfer creates another counterparty risk: the risk that the provider of the guarantee will
not perform. Trafigura manages this risk exposure through a credit review process employing
a variety of types of information about the guarantee counterparties, and the establishment
of exposure limits with them based on this review process.
Trafigura is also concerned about credit risk concentration by individual counterparty, It monitors credit
industry, and geographic region. It monitors these concentrations on a continuous basis.
risk concentrations
With respect to derivatives counterparties, approximately 70% of the company’s trading centrally
is in “listed” exchange-traded products that are centrally cleared. Another 15% are centrally
cleared over-the-counter transactions: these deals are cleared through the CME Group’s
Clearport system.
Central clearing dramatically reduces counterparty credit risk. Therefore, hedge counterparty
credit risk primarily arises from the 15% of its transactions that are uncleared OTC trades.
These trades are executed with a large number of counterparties, consisting primarily of
prime financial institutions and large physical market participants. Based on a credit review
process, Trafigura assigns credit limits to each counterparty, and requires the counterparty
to post collateral when the limit is exceeded. Credit limits and collateral control credit
exposure to an individual counterparty, and by trading with a large number of counterparties
Trafigura can obtain the hedge transactions it needs without taking on a large exposure to
any counterparty, or counterparties from any region. The use of standardized contracts (ISDA
Master Agreements or long-form Confirmation Agreements) with derivatives counterparties
also facilitates the management of credit risk, most importantly by establishing procedures
to address a credit event (such as a default or downgrade) suffered by a counterparty.
Commodity
The use of cleared instruments requires Trafigura to post initial margins: margins (a form
of collateral) mitigate credit risk, and just as the use of cleared transactions reduces the
credit risk faces from derivatives counterparties, clearing also reduces the losses that its
counterparties would suffer in the event of a Trafigura default. The use of margins—which requirements
27
must be posted in cash or liquid securities—to control credit risk means that achieving this
objective creates demands on the liquidity of the company, and creates liquidity risk. In an
important sense, margining substitutes liquidity risk for credit risk.
The company’s initial margins routinely total in the $700 million-$1 billion range. Trafigura
funds these out of its corporate lines. Moreover, cleared derivatives positions (and some
uncleared positions) are marked to market regularly (usually on a daily basis), and Trafigura
must make variation margin payments on positions that suffer a mark-to-market loss. These
derivatives trades are often hedges of inventory positions that are also marked to market
under financing arrangements, but on a weekly (rather than daily) frequency. This mismatch
in timing of marks and associated cash flows can create an additional funding need: a hedge
position may suffer a loss that requires an immediate posting of margin, and although the
inventory has likely realized a gain, the firm will not receive the cash payment from the bank
for a period as long as a week. The firm uses its corporate lines to manage these mismatches
in cash flows.
F. MANAGING LIQUIDITY RISK

A trading company like Trafigura is acutely dependent on access to liquidity to fund its
activities. Loss of funding, or even a substantial contraction thereof, would seriously constrain
the ability of the company to implement the arbitrage activities through which it generates
value and earns a profit. The primary means of managing this risk include: (a) a substantial
cash balance, with the cash balance varying directly with market volatility; (b) bilateral credit
lines with a large number of banks to fund commodity purchases, with the volume of lines
comfortably in excess of anticipated needs, to ensure that the company can finance its
trading activities in the event that prices move sharply higher; (c) committed, unsecured
credit lines that can be tapped to meet liquidity needs; (d) a securitization program that
accelerates the receipt of cash upon delivery of commodities to buyers, thereby reducing
reliance on credit lines; and (e) significant retention of earnings and subordination of equity
repurchased from employees. In essence, the company manages liquidity risk by diversifying
the types of funding, and diversifying the providers of each type of funding.
Liquidity risks tend to be positively related to the prices of the commodities that Trafigura
trades. (This is true generally for commodity trading firms.) In low price environments,
funding needs are reduced. Moreover, since commodity prices often drop precipitously during
financial crises (e.g., the Asian Financial Crisis of 1997-1998, or the recent 2008-2009
Financial Crisis), the secured, low-risk, and self-liquidating nature of transactional financing
means that banks are willing to enter into bilateral financing arrangements even when they
are sharply reducing their supply of other forms of credit.
Conversely, in high-price environments, credit lines can be insufficient to fund potentially

profitable trades. This is a reason to maintain credit facilities substantially in excess of current
or anticipated needs.
G. MANAGING FREIGHT RISK

As a major charterer of ships to perform its logistical functions, Trafigura is subject to freight
charter rate risks, and to fuel price risks. Once a ship is chartered and the rate fixed, the firm
sells a Forward Freight Agreement to hedge against declines in charter rates. It also purchases
fuel swaps to manage the risk of fuel price changes.
H. MANAGING OTHER RISKS

As noted earlier in Section II, commodity traders are subject to many other risks other than
price and credit risks. These include operational, logistic, environmental, and volumetric risks.
Operational The financial consequences of some risks can be transferred via insurance. The company
purchases marine cargo open cover, charterers’ legal liability oil, charterers’ legal liability
risks are managed metals, and general liability insurance policies. These policies insure against product liability,
through insurance, bodily injury, and pollution.
best practice, and Other risks cannot be insured. Some of these must be controlled through the establishment
compliance of policies and procedures, training employees in these policies and procedures, and the close
monitoring of compliance with them. Trafigura has such procedures for, inter alia, contracts,
charterparties and clauses, environmental policies and legislation, insurance declarations,
claims, and demurrage handling.
Since environmental risks associated with transportation and storage are a particularly acute
concern (due to the potentially large liability costs that a spill or other accident can cause)
28
SECTION III
the firm mitigates risks by restricting its chartering of ships, railcars, trucks, and barges based
on the conveyance age and design (e.g., using only double-hull tankers). Similarly, the firm
inspects all storage locations. To control the risk of theft and contamination, the company
routinely inspects the stocks of commodities it holds.
In 2012, the company implemented a Group-wide initiative to manage health, safety, There is a Group-wide
environment, and community (“HSEC”) risks. This creates a set of policies regarding these framework for HSEC
issues. Managers are accountable for implementing these policies, by, inter alia, providing
resources, training employees, and measuring and reporting HSEC performance. Moreover,
even prior to the formal launch of the framework, Trafigura’s Management Board established
an HSEC Steering Group with a mandate to: oversee HSEC compliance; revise the HSEC
policies and principles based on changes in the company’s operations and the market
environment; analyze and measure HSEC performance; develop and oversee reporting
and assurance processes; report to the Management Board on HSEC performance; and
coordinate external reporting of the company’s HSEC performance. The Steering Group
meets bi-monthly.
I. PAPER TRADING
Although Trafigura primarily uses derivatives contracts to hedge the price risks, it also
engages in limited speculative trading using these instruments. For instance, the crude oil
team has 21 traders, four of whom engage in proprietary “paper” trading. This trading is
subject to risk limits established by the Risk Committee.
Moreover, this trading exploits the information advantages that Trafigura has as the result
of its physical trading. That is, rather than taking positions that expose the firm to flat price risk, speculates on
the paper trading focuses on calendar spreads (e.g., buying January Brent crude and selling
March Brent crude) and inter-market spreads (e.g., Brent vs. WTI). Spreads are driven by the intra-market and
economics of transformations that commodity trading firms specialize in understanding and calendar spreads
implementing. Knowledge of the economics of transformation can be employed to trade
spreads profitably.
Trafigura also engages in speculative paper trading through its Galena Asset Management
arm. Galena traders have access to Trafigura’s physical traders, and their information, which
they can use to devise trading strategies. The information flow is one way: information flows
from Trafigura traders to Galena, but Trafigura traders do not obtain information on Galena
trades and positions. Nor do Galena traders know Trafigura trades and positions. Galena uses
this information primarily to trade calendar and inter-market spreads, and for the same
reason that Trafigura’s proprietary traders do: this information is most relevant to the
economics of transformations that drive spreads.
29
30
SECTION IV
IV. COMMODITY FIRM FINANCING,

CAPITAL STRUCTURE, AND OWNERSHIP
SUMMARY
A CTF’s capital structure depends on the scale of its operations and the size of its asset base.
Leverage for the largest, most asset-heavy CTFs is similar to non-financial US corporations.
Other CTFs are more highly leveraged but much less leveraged than banks.
CTFs’ balance sheets are structured differently from banks. In general, short-term assets
are funded with short-term debt and long-term assets with long-term funding.
Historically, banks have been major suppliers of credit to CTFs. Fears that reduced bank
funding would destabilize markets appear unfounded so far. However, bank funding may
be more restricted in future. This may increase concentration in commodity trading,
but the impact on trading volumes will be limited.
Smaller firms are all privately owned. Private ownership aligns incentives between managers
and equity owners.
Some larger, more asset-heavy CTFs are publicly listed. They may require large-scale equity
investments that exceed the capacity of a small group of owner-managers. Public listing
allows firms to transfer risks to diversified investors.
Broader market developments, including the wider availability of information, are causing
some firms to become more asset-intensive. This will put increasing pressure on the private
ownership model.
CTFs also act as financial intermediaries for their customers through complex transactions
that bundle financing, risk management and marketing services. Common structures
include trade credit agreements, prefinancing, commodity prepays and tolling
arrangements. Banks and other financial institutions remain, overwhelmingly,
the ultimate source of credit. CTFs act as conduits between these financial institutions
and their customers.
A. THE FINANCING OF COMMODITY TRADING FIRMS

Like all firms, commodity traders need to finance their operations. Their choices of funding
strategies—their capital structures—influence the efficiency of their operations, and are
crucial determinants of their ability to withstand economic shocks. Moreover, since the
debt and equity issued by commodity trading firms connects them to the broader financial
system, capital structure also determines the vulnerability of trading firms to financial
market conditions—including financial crises—and the influence of commodity trading firms
(and hence commodity market conditions) on the stability of the broader financial markets.
An examination of the available information on the financing of commodity trading firms

indicates that the diversity of commodity trading firm business strategies is mirrored in
the diversity of their financing strategies. Firms differ in their gearing/leverage; the forms
of leverage that they employ; and their ownership of their equity. Moreover, these differences differ from pure
in financing strategies co-vary with the kinds of transformations that firms undertake: firms trading operations
that are more physical asset intensive finance themselves differently than firms that are
engaged in more traditional pure trading activities. Relatedly, as the business strategies
of trading firms are evolving, their financing strategies are evolving as well.
Financial statement information available for some of the largest trading firms illustrates
these points. I start by looking at the leverage of trading firms.
One measure of total leverage is total assets divided by book value of equity. Table 1
presents this measure for 2012 for 18 trading firms for which data are available.
This ratio ranges from 2.38 (ADM) to 111 (E.On Global). The average (which is somewhat
misleading, due to the presence of the outlier E.On) is 18, and the median is 4.
This measure of overall leverage of commodity trading firms is somewhat higher than
non-financial corporations in the United States. As of the end of the third quarter, 2013,
31
the ratio of assets to equity for such corporations was 2.06.1 The more asset-heavy firms
(e.g., Cargill, ADM, Bunge) have leverage ratios that are similar to those for the US
non-financial corporations as a whole: the more asset-light firms are more heavily leveraged.
Moreover, as will be discussed in more detail below, the heavier leverage of the more
traditional trading firms is somewhat misleading. Much of this debt is short-term and
associated with liquid, short-term assets. The net debt of these firms (total debt minus
current assets, which is a better measure of their true leverage) is quite low.
TABLE 1
TOTAL ASSETS/EQUITY (2012)
Arcadia Energy Pte 17.51 Louis Dreyfus B.V. 3.74

Archer Daniels Midland 2.39 Mercuria Energy Trading 5.06
BP International Ltd 5.32 Noble Group 3.80
Bunge Ltd 2.51 Olam 4.02
Cargill 2.37 Shell Trading International 12.09
E.On Global 111.07 Trafigura 7.94
EDF Trading 4.56 Vitol 4.00
Eni Trading & Shipping 35.09 Wilmar 2.76
Glencore 3.08
Data from Bureau van Dijk
Notably, trading firms are much less highly leveraged than banks, to which they are sometimes
compared: some have argued that commodity trading firms should be subject to regulations
similar to banks. Specifically, for US banks that have been designated Systemically Important
Financial Institutions (“SIFIs”), the mean leverage is 10.4 and the median is 10. For European
SIFI banks, the mean is 20.6 and the median is 22.5.
There is a relationship between the leverage of commodity trading firms and characteristics
are usually less of the asset side of their balance sheets. In particular, there is a strong correlation between
the fixed asset intensity of commodity trading firms, and their leverage: more fixed asset
highly leveraged (long term asset) heavy firms tend to be less leveraged. For 2012, the correlation between
the ratio of fixed assets to total assets and the ratio of total assets to book value of equity
(leverage) is -.55. Thus, trading firms that are asset heavy tend to be less heavily leveraged
than those that are asset light. Put differently, pure trading firms that own relatively few fixed
assets tend to be more highly leveraged than firms that also engage in processing or refining
transformations that require investments in fixed assets.
The structure of the liabilities of commodity trading firms is somewhat distinctive, and also
co-varies with the structure of the asset side of their balance sheets. Specifically, short-term
liabilities dominate the balance sheets of trading firms. For the 17 firms in the sample, the
average of the ratio of current liabilities to total liabilities is .75: the median is .70. There is
considerable variation in this ratio across firms: the minimum is .36 and the maximum is 1.00.
Furthermore, there is a strong correlation between this ratio and firms’ fixed asset intensity.
Specifically, the correlation between the ratio of current to total liabilities and the ratio
of fixed (or long term) assets to total assets is -.51. Thus, firms engaged in more fixed asset
intensive transformations (such as processing) have a greater proportion of long-term
liabilities. There is therefore an alignment between the asset and liability structures of
commodity trading firms’ balance sheets.
Available balance sheet information also indicates that commodity trading firms do not
Commodity trading engage in maturity transformation as do banks. Indeed, to the extent that commodity trading
firms engage in maturity transformation, it is the reverse of the borrow short-lend long
transformation that makes bank balance sheets fragile, and which makes banks (and other
liquidity risk than financial intermediaries) subject to runs and rollover risk. Specifically, for all 17 of the
commodity trading firms studied, current assets exceed current liabilities. The median ratio
of current assets to current liabilities is 1.26. Consequently, one measure of net debt (total
intermediaries liabilities minus current assets) is negative for 8 of the 17 firms. Furthermore, the median
1 Board of Governors, Federal Reserve Board, Financial Accounts of the United States, Table B.102. 9 December, 2013.
This calculation is based on historical cost data, which makes it more comparable to the accounting data used to
determine leverage for trading firms. Based on market values/replacement costs of non-financial assets, the ratio is
somewhat smaller: 1.75. Since market values or replacement costs of trading firm assets are not available, I cannot
calculate an analogous figure for them.
32
SECTION IV
ratio of net debt to shareholder equity is very small, taking the value of .014. Since commodity
trading firm current assets (primarily hedged inventories and trade receivables) tend to be
highly liquid and/or of high credit quality (as is documented below) these figures strongly
suggest that as a whole, commodity trading firms run far less liquidity risk than do financial
intermediaries like banks or shadow banks.
In sum, the data show an alignment between the nature of the transformation activities firms
engage in, and their funding strategies. Short-term assets are funded with short-term debt,
and long-term assets are funded with long-term debt. The data also show that commodity
trading firms are not heavily leveraged overall, and that their balance sheets are not fragile
(i.e., subject to liquidity or rollover risk).
B. THE LIABILITY STRUCTURES OF COMMODITY TRADING FIRMS

The foregoing conclusions are reinforced when one evaluates the specifics of commodity
trading firm financing. In particular, there is a close connection between the nature of
transformation activities, and how they are financed.
Consider, for instance, the financing of most short-term arbitrages involving spatial
transformation, storage, and blending. Firms rely extensively on bank borrowings to finance
these transformation activities. In particular, they engage in large amounts of relatively
short-term borrowings, including borrowings through unsecured credit lines arranged with
banks, frequently through syndication arrangements. Moreover, they typically maintain
bilateral credit lines with banks that can be drawn upon to fund the purchase of commodities
and the issuance of credit instruments, such as letters of credit, utilized in the merchandising
of commodities. These are generally used to finance each transaction at 100% of collateral
values, and are marked to market periodically (e.g., weekly, or more often during periods
of large price movements). They are referred to as “self-liquidating” because they are
repaid upon the receipt of payments from the purchasers of the commodity. Given that
these borrowings are secured by commodities that are often saleable in liquid markets,
marked to market, and hedged, and that these exposures have relatively short maturities,
they present less credit risk to the lending banks than unsecured credit, or credit secured
by less liquid collateral.
In the past decade, some commodity trading firms have also arranged non-traditional
short-term financings that could be characterized as “shadow bank” transactions.2
These include the securitization of inventories and receivables, and inventory repurchase
transactions. Borrowings secured by inventories pose limited credit risk to the lender,
especially to the extent that these inventories are in relatively liquid commodities (e.g.,
deliverable aluminum held in an LME warehouse) and are located in jurisdictions where
there is little risk of perfecting legal title; borrowings secured by less liquid commodities,
and in some jurisdictions, pose greater risks. Commodity receivables that back some
securitization structures historically have exhibited very low rates of default, and rates of
default did not rise appreciably even during the 2008-2009 crisis period.3 Moreover, these
structures do not generally exhibit the maturity mismatches that contributed to runs on the
liabilities of some securitization vehicles during the financial crisis. Indeed, in some of these
structures, the liabilities have longer maturities than the underlying assets, meaning that the
challenge they face is replenishing the assets, rather than rolling over the liabilities.
These non-bank financing vehicles may become increasingly important because broader
financial trends may constrain the availability of, and raise the cost of, traditional sources is becoming more
of transactional financing. Historically, banks, and especially French banks, have been major
suppliers of credit to commodity trading firms; five banks, three of them French, are reported important
to provide 75% of the commodity trade finance for Swiss-based trading firms. Deleveraging
post-crisis and dollar funding constraints on European/French banks have led to a reduction
in bank extensions of commodity credit. This has led to increases in funding costs and
reductions in the flexibility of credit arrangements. The impending Basel III rules impose
greater capital charges on commodity lending and trade finance generally, which could
further reduce bank supply of commodity credit.
2 The earliest such transactions that I am aware of is a securitization of base metals inventories undertaken by Glencore
and a securitization of receivables by Vitol in 2003. The term “shadow banking” is used in many different ways. Here
is used to mean financial intermediation through the issuance of debt outside the insured banking system.
3 An International Chamber of Commerce study of data from 2005-2009 found that for trade credit generally (which
includes not just commodity trade finance), default rates averaged .02%, and that the rate of defaults did not rise
appreciably during the period of the crisis. The Offering Circular from a securitization of Trafigura receivables from
2012 reports default rates on the trading firm receivables from November, 2004-February, 2012. Default rates are less
than 0.1%, and delinquency rates never exceed 2.4% and are typically less than 0.1%.
33
Fears of a large reduction in financing available from traditional sources were particularly
acute in early-2012, but have abated somewhat. Moreover, according to statements by
industry participants, the impact has been minimal for larger, more creditworthy trading
firms.4 Nonetheless, the seismic changes in bank regulation, and the potential for further
changes going forward, mean that the traditional commodity trading funding models may
not be sustainable. Thus, it is advisable to consider how commodity firms could replace
reduced transactional bank funding.
A scaling back of lending by traditional suppliers of commodity finance would create

opportunities for new suppliers less severely constrained (e.g., US banks with that can
obtain dollar financing more readily, and non-European regional banks looking to invest
export-driven dollar flows), but given the relationship-specific nature of bank lending these
new suppliers would likely be less efficient than the incumbents. Moreover, global rules like
Basel III will impact banks internationally. The reduction in traditional sources of credit would
also encourage greater reliance on shadow bank-type funding arrangements.
Reductions in Any future reductions in traditional forms and sources of commodity finance would be likely
to have greater impacts on smaller commodity trading firms than on the larger ones. This
traditional sources would tend to increase concentration in commodity trading activities. Moreover, it should
be noted that some of the higher funding costs would be shifted to commodity suppliers
a bigger impact on (in the form of lower prices) and commodity consumers (in the form of higher prices):
that is, higher costs will be associated with higher margins. Given the relative inelasticity
of commodity supply and demand, a large fraction of these higher costs will be shifted via
prices in this fashion, and the impact on commodity trading volumes will be modest.
One area that deserves further study is the possibility that the reduction in traditional
sources of funding for commodity trading could lead to funding squeezes during times
of market stress. Traditional commodity finance has been quite flexible and responsive to
market conditions. Sharp reductions in the supply of commodity financing from traditional
sources would likely result in a decline in the responsiveness of the funding of commodity
trading activities to extraordinary conditions in the commodity or financial markets.
This could lead to funding squeezes during periods of such conditions that could lead to
disruptions in commodity trading; that is, the contraction of traditional sources of
commodity finance will likely increase future funding liquidity risk.
C. THE OWNERSHIP OF COMMODITY TRADING FIRMS: PUBLIC VS. PRIVATE

One important aspect of the capital structure of commodity trading firms is the ownership
of equity. As noted before, some commodity trading firms are listed firms with publicly
traded equity, but others are private firms. Although all small commodity trading firms are
private, the relationship between size and equity ownership is complex. Some very large
commodity trading firms are private, while other firms that are similar in terms of size and
market participation are listed, public firms.
Private ownership The ABCD firms provide an interesting illustration. Although these firms are broadly
aligns incentives comparable in terms of size and breadth and depth of market segment participation, ADM
and Bunge are publicly traded, but Cargill and Louis Dreyfus are private. There is thus
between owners evidently an element of indeterminacy in the choice of public or private ownership.
and managers
This indeterminacy reflects fundamental trade-offs that are particularly challenging for
commodity trading firms. A primary advantage of private ownership is the superior alignment
of incentives between managers and equity owners. Managers who own small (or no) stake
in an enterprise have an incentive to act in ways that benefit themselves, but are harmful to
equity holders. For instance, they may consume excessive perquisites, invest in low-returning
prestige or empire-building projects, or run ill-advised risks: the managers enjoy the benefits
of these activities, but the outside investors bear the costs. In contrast, manager-owners have
lower (and perhaps no) incentive to engage in these wasteful behaviors. Moreover, owner-
managers have a stronger incentive to monitor their peers, and do so more effectively, than
do diffuse outside-equity owners. More generally, since owner-managers more completely
internalize the costs and benefits of their decisions than do the managers of public firms, they have
a stronger incentive to exert effort, control costs, manage risks, and make value-enhancing investments.
4 See, for instance, Mercuria CFO Interview: “We Have Seen a Flight to Quality”, Euromoney, 29 October 2013. Mercuria
CFO Guillaume Vermersch said, “We have seen a flight to quality. Basically, the good and strong tier 1 credits, such
as Mercuria, have had the benefit of additional support and credit lines brought by the same banks that reduced their
balance sheets during the crisis. My only explanation for that is that banks have probably ended tier 2 and 3 credit
relationships to refocus on tier 1 companies like us.” In interviews with me, Trafigura financial executives expressed
similar views.
34
SECTION IV
These benefits do not come for free, however. The main cost of private ownership is inefficient
risk bearing. Whereas shareholders of a listed firm can diversify away the idiosyncratic
(i.e., firm specific) risks of commodity trading, the owner-managers of a private firm hold
a large fraction of their wealth in their enterprise, and hence cannot diversify away these
idiosyncratic risks. Thus, idiosyncratic risks are more costly to bear with private ownership
than public ownership.
The scale and scope of a commodity trading firm’s operations, and the availability of markets
to transfer risk, influence the optimal trade-off between public and private ownership. Private
ownership is more viable for a commodity firm that engages in activities where many of the
risks outside of management control can be transferred to others via financial contracts. ...and makes most
For instance, a firm that engages in activities that primarily involve flat price risks that can sense when risks
be hedged in derivatives markets (e.g., an oil trading firm) or credit risks that can be assumed
by banks or insurers or casualty risks that can be insured can transfer these primary risks can be transferred
through financial contracts, leaving the managers to bear only risks that they can more
readily control (e.g., operational risks that can be mitigated through close management
oversight). Private ownership offers substantial advantages under these circumstances,
because the risk bearing benefits of public equity are modest and the incentive alignment
benefits of private ownership are large.
In contrast, if a firm is engaged in an activity that involves risks that cannot be transferred by
(non-equity) financial contracts, the benefits of public ownership are larger. For instance, the
risks of investing in and operating a large mining or energy production project (e.g., the risks
of increases in labor costs or construction costs, variability in well depletion rates) cannot be
transferred (or are extremely expensive to transfer) using non-equity financial contracts.
Private equity can bear these risks at modest cost if the scale of the activity is sufficiently
small. However, large-scale investments (e.g., in a mine or energy exploration and production)
require equity investments that are beyond the capacity of a small group of managers to
finance. Thus, despite its superior incentive effects, private ownership is incompatible with
the operation of large-scale assets with large exposures to risks that cannot be transferred
to others by non-equity financial contracts.
This suggests that more traditional “asset light” pure trading activities are efficiently
undertaken by private firms, but that more “asset heavy” transformation activities
(e.g., mining, crude oil production, refining and processing) must be financed in large part
with public equity. This is broadly consistent with observed patterns. For instance, most
small, specialized commodity trading firms are privately owned. Even the far larger, but asset
light, trading firms, such as Trafigura and Vitol, are privately owned. This reflects the fact
that many of the largest risks incidental to these businesses can be hedged in derivatives,
credit, or insurance markets. A company that was, in many ways, similar to Trafigura and Public ownership
Vitol, but which integrated into more asset-intensive transformation activities (notably works better for large,
mining)—Glencore—shifted from private to public ownership in parallel with this increasing
asset intensity.
Notable potential exceptions include large, relatively asset-heavy firms such as Cargill and
Louis Dreyfus.5 Their choice to remain private is likely a consequence of path-dependence.
These companies are old (both dating from the mid-19th century), and have accumulated
substantial retained earnings during their long history. This historical success has made
internal equity finance viable: the companies can finance large projects internally, and
diversify risks internally by participating in a wide variety of market segments, thereby
reducing the benefits of selling equity to diversified investors.
The increasing asset intensity of commodity trading firms—a trend discussed in Section V— Increasing asset
is forcing some of them to evaluate their ownership structure. Trafigura is a case in point. intensity may change
It is transitioning from a pure trading model to a more fixed asset intensive model, and this
is forcing it to adjust its financing accordingly. Heretofore it has decided to remain private, ownership structures
and explicitly invokes the incentive benefits of private ownership to explain its choice.
The Trafigura Annual Report states: “We believe [an employee owned private company]
is the best ownership model for our core trading business.” Other firms—most notably
Louis Dreyfus—are actively considering going public.
Creative financing methods (e.g., the issuance of perpetual debt) that offer some of the
advantages of outside equity (e.g., no rollover risk) but which do not require the firm to
go public permit can permit a firm to continue to realize the incentive benefits of private
5 I provide data on the asset-heaviness of some important commodity trading firms in Section V below.
35
ownership: Trafigura and Louis Dreyfus have issued perpetual bonds.6 Moreover, Trafigura
is using hybrid strategies that tap equity financing, but allow it to retain the benefits of
private ownership for its core activities. Specifically, the firm has sold off equity in its Puma
Energy affiliate, and may pursue a similar strategy with its Impala subsidiary in the future.
There are alternatives Private equity stakes sold to outside groups is another way of transferring risks to non-
to public listings managers while maintaining the incentive benefits of private ownership. As noted earlier,
in recent years a variety of private equity firms have invested in commodity trading ventures.
However, these alternative financing methods are inherently limited (because firm debt
capacities are inherently limited due to what economists refer to as “agency problems”).7
Thus, private ownership for companies not blessed with more than a century of good fortune
constrains their future strategic choices. Retention of private ownership necessarily limits the
fixed asset intensity of a firm’s transformation activities, and the types of risks it can run.
This further implies that broader market developments that undermine the viability of the
pure trading model (such as the greater availability of public information about prices)
and that are causing some firms to become more asset intensive will put pressure on the
traditional private ownership model.8 Ownership structure and the nature of firm activities
are complementary, and determined jointly. These things cannot be chosen independently.9
EU-registered private The form of organization (public vs. private ownership) also has implications for public
companies have disclosure, and the amount of information that firms must reveal. In all jurisdictions,
private firms like Cargill, Louis Dreyfus, and Trafigura are obligated to keep accounts and
greater disclosure records, which must be kept according to accepted accounting principles and standards.
requirements Laws regarding what information must be disclosed vary by jurisdiction. In the United
States, private companies are not obligated to disclose publicly accounts or other financial
information. In the European Union, in contrast, every limited liability company (even
private ones) must disclose its balance sheet, income statement, notes to its financial
statements, an annual report, and an auditor’s opinion: this information is available from
the central register of the country where the firm is incorporated.10 Therefore, standard
financial information about companies registered in EU countries (e.g., Louis Dreyfus,
Trafigura) is available, whereas the same is not true for firms incorporated in the US.
Thus, although the ability to limit disclosure of financial information may influence the
choice between private and public ownership in the United States, it is likely a far less
important consideration in Europe.
One final point on disclosure and transparency is warranted. Even privately owned firms
in the United States have to provide financial information to their lenders and derivatives
counterparties, and private firms anywhere can at their discretion distribute their financial
information in ways similar to those used by public companies: Trafigura’s recent publication
of an annual report, available on its website, is an example of this. With respect to disclosures
to government regulators, trading firm positions in listed derivatives are available to
exchange staff and government regulators. Moreover, with new reporting regulations
under Dodd-Frank in the United States and EMIR in Europe, regulators also have, or will have,
access to commodity traders’ positions in OTC derivatives.
D. COMMODITY TRADING FIRMS AS FINANCIAL INTERMEDIARIES

Not only is the funding of commodity firms an important aspect of the trading business:
so is the fact that trading firms also play a role in financing the commodity trade.
Specifically, firms involved in commodity trading often provide various forms of funding
to their customers. Thus, these firms supply financial intermediation services to their
customers. This intermediation takes the forms of traditional trade credit, and more complex
structured transactions that bundle financing, risk management, and marketing services.
Commodity The practice of commodity trading firms extending trade credit to those they sell to is
a venerable one. These receivables (along with inventories) represent the bulk of the current
assets on the balance sheets of trading firms.
trade credit...
An established economics literature provides an explanation for the prevalence of such
6 Javier Blas, Louis Dreyfus taps bond markets for $350m, Financial Times, 6 September, 2012. Javier Blas and Jack
Farchy, Trafigura raises $500m with perpetual bond, Financial Times, 10 April, 2013.
7 Jean Tirole, The Theory of Corporate Finance (2005).
8 Trends in asset intensity, and the reasons for it, are discussed in Section V.
9 Paul Milgrom and John Roberts, Economic Organization and Management (1990).
10 Jones Day, Public Disclosure Requirements for Private Companies: U.S. vs. Europe (2012).
36
SECTION IV
trade financing.11 A firm selling a commodity to a customer frequently has better information
on this buyer than would a bank, due to the trading firm’s intimate knowledge of the buyer’s
operations, how it will employ the commodity, market conditions in the buyer’s region, etc.
This permits the trading firm to evaluate creditworthiness better than the bank, and to monitor
the creditor more effectively than the bank.
Furthermore, trade credit is often less subject to opportunistic behavior by the borrower.
One concern about any credit transaction is that the funds lent are diverted for other
than their intended purpose. Cash is more fungible, and hence more easily diverted, than
a commodity used as an input: converting the input to cash would require the buyer to incur
transactions costs, transportation costs, and other expenses. Moreover, such activity is
subject to risk of detection by the commodity trading firm that sold the input on credit,
due to its information on commodity transactions and movements in the markets it serves.
The lower susceptibility to diversion means that trade credit expands the borrowing capacity
of commodity buyers.12 Commodities are cheaper, and credit to obtain them more abundant,
when commodity trading firms provide trade credit to their customers.
In addition to traditional trade credit, firms involved in commodity trading (including, notably, and provide
some banks that have physical commodity trading operations) increasingly provide structured
financing to their suppliers and their buyers. A common element of these structures is an
off-take agreement, whereby a trading firm agrees to purchase a contractually specified
quantity of a commodity (e.g., copper concentrate or gasoline) from a producer (e.g., a miner
or refiner) usually at a floating price (benchmarked to some market price, plus or minus a
differential). These contracts can vary in duration (e.g., a year, or multiple years) and quantity
(e.g., the fraction of a mine’s output, or its entire production).
One common structure that utilizes an off-take is a prefinancing. Three parties are involved:
a borrower (a producer), a trading company, and a bank. The producer and the trading
company enter into a prepay agreement, and the bank lends money to the producer. Upon
delivery of the commodity from the producer to the trading firm, the trading firm pays (some
or all of) the amounts it owes under the off-take agreement to the bank to repay the loan. ...that bundles
In this arrangement, the bank has no recourse to the trading firm (as long as it performs under
the off-take agreement), and bears all the credit risk associated with the loan to the producer.
and marketing
Another structure is a commodity prepay. There are two major variants of this structure, but activities
under each the trading firm and a commodity seller enter into an off-take agreement, funding
is provided to the producer (the prepayment), and the terms of the off-take arrangement are
set to repay the prepaid amount.
In the first variant, the bank provides limited recourse financing to the trading firm, and the
trader assigns the rights under the off-take agreement to the bank as a security. The trading
firm provides funds to the producer, but the bank absorbs the credit risk on the loan, although
in some instances the trading firm may keep a risk participation (e.g.,10%).
In the second variant, the bank provides full recourse financing to the trading firm, which
makes a loan to the producer. In this variant, the trading firm, rather than the bank, bears the
risk that the producer will not repay the prepaid amount. It is common for the trading firm
to offload all or some of this credit risk by entering into an insurance policy. Depending on the
terms of the financing provided by the bank to the trading firm, the bank may be the loss
payee on this insurance policy.
Another common structure offered by commodity trading firms is a tolling arrangement,

whereby a firm supplies a commodity processor (e.g., an oil refiner) with an input (e.g., oil)
and takes ownership of the processed commodity (e.g., heating oil, jet fuel, and gasoline).
The trading firm pays a fixed fee to the processor, pays the market price to acquire the input,
and receives the market price for the refined products.
These structures bundle together multiple goods and services. For instance, in a simple
off-take agreement, the trading firm provides marketing services and hedging (because
the seller is guaranteed a price, and the commodity firm is at risk to price changes over
the life of the contract). A prepay incorporates these elements and a financing element
as well. The seller receives cash upfront, in exchange for a lower stream of payments in the
future: the discount on the sales price is effectively the interest on the prepay amount.
11 See, for instance, Bruno Biais and Christian Gollier, Trade Credit and Trade Rationing, 10 Review of Financial Studies (1997)
903, and Mitchell Petersen and Raghuram Rajan, Trade Credit: Theory and Evidence, 10 Review of Financial Studies (1997).
12 Mike Burkart and Tore Ellingsen, In Kind Finance: A Theory of Trade Credit, American Economic Review (2004) 569.
37
A tolling agreement bundles input sourcing, output marketing, price risk management, and
working capital financing. The working capital element exists because the commodity trading
firm has to finance the input from the time it is purchased until it can realize revenue from
the sale of the refined good after processing is complete.
The various elements of these bundles could be provided separately. Instead of entering a
tolling arrangement, for instance, a refinery could source its own input and market its own
output, hedge its input purchases and product sales in the futures markets, and finance its
working capital needs by borrowing from a bank. Instead of engaging in a prepay, a miner
could market its own output, hedge its price risk on the derivatives markets, and borrow from
a financial institution or the capital markets.
Bundling services However, there are frequently efficiencies that can be captured by bundling these
transactional elements into a single structure. By exploiting these efficiencies, firms trading
can reduce commodities (which, notably, can include banks as well as non-bank trading firms) reduce
transaction costs… transactions costs and allocate risks more efficiently, thereby benefiting commodity
producers and consumers.
To understand these benefits consider a tolling transaction (which is the structure with the
largest number of elements in the bundle). Refineries, power plants, and the like typically
need to pay for the inputs they process before they receive payment for their outputs.
This creates a need for working capital to finance the timing gap between cash outflows
and inflows.
Providing funding for working capital is clearly a traditional banking activity. One way to
do this is for a lender to provide a loan or credit facility, and leave the refiner or power plant
to acquire inputs and market outputs, and bear and perhaps manage the price and operational
risks associated with those activities.
This exposes the lender of the funds to risk: adverse movements in prices could put the
refiner or generator into financial distress, and perhaps cause a default. The lender could
require the borrower to hedge, but there is a moral hazard: if it does not hedge, or does not
do it effectively, the lender bears risk. This undermines the incentive of the borrower to
hedge, and hedge well. The lender can monitor, but this is costly, and often imperfect.
The moral hazard problem can be eliminated by passing the risk on to the lender. A prepay
agreement or tolling deal does this. These types of deal implicitly provide funding to bridge
the outflow-inflow gap, and pass the price risks back to the lender. The lender can manage
these risks, and the agency cost in this arrangement is lower: because the lender bears the
price risk, there is no moral hazard; it has the incentive to manage the risk; and there is thus
no need to monitor. Therefore, bundling price risk management and funding can reduce the
cost of funding working capital needs. This is presumably more valuable for lower credit
quality refiners and generators.
...and improve There are other potential benefits. The lender may have a comparative advantage in managing
economies of scale risk due to specialization and expertise in this function: commodity trading firms and banks
have a comparative advantage in risk management. Moreover, they may able to be able to
manage risk more cheaply because they run large books: there are economies of scope in risk
management. For instance, a lender doing an off-take deal with a refinery is short crude
and long products, but it might have a long crude position based on a trade it executed with
producer, and might have a short products position as the result of a swap with an airline
or heating oil dealer. These natural hedges reduce the amount of trading necessary to manage
the risks.
Moreover, trading firms specialize in marketing and logistics, and there are scale economies
and scope economies in these activities. It may be cheaper for a big trading firm to provide
marketing and logistical services, thereby eliminating the need for the refiner or the power
plant to pay the overhead associated with such activities. Smaller, or less sophisticated
firms (e.g., a refiner in an emerging market) are likely to benefit most from delegating
marketing, logistics, and risk management services to specialist firms that can exploit scale
and scope economies.
Thus, there are strong complementarities that make it beneficial to bundle financing,
logistical, and marketing activities for some firms that process commodities.
38
SECTION IV
39
V. COMMODITY FIRM ASSET OWNERSHIP
AND VERTICAL INTEGRATION
SUMMARY
Many CTFs are investing more heavily in physical assets as the profitability of pure physical
arbitrage comes under pressure.
The complexity and diversity of CTFs makes it difficult to generalize.
The data suggest that:
• There are two categories of firm: asset-intensive and asset-light.

• There is a trend towards increased vertical integration for some firms, but this is not uniform.
Midstream
All major CTFs own midstream assets such as storage and terminals. There are strong
economic arguments for this. CTFs that control their own storage and processing are not
subject to the risk of a third party creating an artificial bottleneck to extract excess profit.
As arbitrage opportunities become more fleeting there is a greater incentive to integrate.

In oil trading, increased price transparency has restricted arbitrage opportunities and made
access to storage and logistics more valuable.
Recent acquisitions of physical assets by Trafigura highlight the economic factors propelling
midstream investment.
Downstream
Downstream activities are mainly concentrated in emerging markets or developing regions
of advanced economies. These are usually small markets requiring investment. Sometimes
governance is poor. These conditions favor vertical integration. Integrated midstream and
downstream operations are replacing retreating oil majors in emerging markets.
Upstream
Owning production has transactions cost benefits, but these can be achieved in other ways,
for instance with off-take agreements. There are cases of upstream integration in agricultural
products, but the trend is more common in energy and industrial metals.
Vertical Disintegration
Commodity trading firms have also contributed to vertical disintegration by developing
liquid, competitive markets that reduce transactions costs and increase sector efficiencies.
A. THE PHYSICAL ASSET INTENSITY OF COMMODITY TRADING FIRMS

In the past few years, there have been numerous stories and consulting reports claiming
that commodity trading firms are evolving from pure intermediaries that own very few physical
assets, to more vertically integrated firms that invest more heavily in physical assets, in order
to profit from the real optionality inherent in these assets.1 There is a kernel of truth in this
characterization, but reality is more complicated. Many well-known firms commonly identified
as commodity traders (notably the ABCD firms) have always been vertically integrated to some
degree, and have substantial investments in durable physical assets including refining/processing
Patterns of asset plants. Other trading firms are affiliates of asset-heavy firms including most notably vertically
ownership are integrated oil and gas producers. It is the case that some energy and metals trading firms that
historically have been very asset light are becoming more fixed asset intensive through the
very diverse strategically targeted purchase of or investment in physical assets at various stages of the value
chain. But the patterns of asset ownership among commodity traders are extremely diverse,
complex, and dynamic, making generalizations impossible.
Given this complexity and diversity, a detailed analysis of the integration and structure
of commodity trading firms is well outside the scope of this study. I therefore set my sights
on more modest objectives. First, I will present data that quantifies asset intensity and
1 Deloitte, Trading up: A look at some current issues facing energy and commodity traders (2013). Jan Ascher, Paul Laszlo,
Guillaume Quiviger, Commodity trading at a strategic crossroad, McKinsey Working Papers on Risk (2012). Steven
Meersman, Roland Rechtsteiner, Graham Sharp, The Dawn of a New Order in Commodity Trading, Oliver Wyman Risk
Journal (2012).
40
SECTION V
integration by some commodity trading firms. This data shows the diversity of commodity
trading firm integration strategies. This data also illustrates some trends. Second, I will draw
on the economics literature relating to vertical integration and asset ownership to identify
some of the factors that influence the integration of some commodity transformation
activities. Third, I will focus on the evolution of integration patterns among oil and energy
trading firms, focusing on the experience of Trafigura.
The information on individual companies, and integration within particular sectors, is useful
in conveying the diversity of commodity trading firms, and in illustrating the fact that Fixed assets/total
commodity firm presence in multiple stages of the commodity value chain is and has been assets measures
quite common. This information is less useful in illustrating broad patterns. For commodity
trading firms for which financial data is available, however, it is possible to construct measures asset intensity
of asset intensity that proxy for integration along the value chain.
Specifically, the assets held on the balance sheets of traditional pure intermediary trading
firms tend to be predominately current assets, consisting of commodity inventories and
receivables (trade credit granted to customers). A traditional trading firm can operate with
an office, phones and computers, and rent, lease, or charter the physical assets needed to
transform goods in space or time. Thus, current assets tend to represent a large fraction of
the total assets of pure trading firms, and fixed (or long-term) assets tend to represent a small
portion. Conversely, firms engaged in other commodity transformations, notably processing,
invest in and own long-term fixed physical assets, such as refineries. Similarly, firms engaged in
primary commodity production (e.g., mining or oil production) own assets like mines and wells.
I therefore use fixed assets (or long term assets) as a fraction of total assets as a measure
of whether a firm is primarily a pure trader, or is instead more extensively integrated into
asset-intensive transformation activities.2 This data is available for 17 firms for years going back
as far as 2007. Table 2 presents this information in tabular form: Figure 1 presents it graphically.
TABLE 2
FIXED ASSETS DIVIDED BY TOTAL ASSETS AT COMMODITY TRADING FIRMS
2007 2008 2009 2010 2011 2012
Archer Daniels Midland 0.31 0.39 0.42 0.35 0.35 0.34
BP International Ltd 0.20 0.14 0.16 0.29 0.33 0.31
Bunge 0.34 0.35 0.45 0.39 0.44 0.37
Cargill 0.45 0.44 0.43 0.43 0.29 0.35
E.On Global 0.02 0.12 0.06 0.02 0.02 0.02
EDF Trading 0.02 0.02 0.02 0.03 0.02 0.08
Eni Trading & Shipping 0.00 0.01 0.02 0.04 0.06 0.03
Glencore 0.39 0.40 0.42 0.44 0.47 0.49
Louis Dreyfus B.V. 0.18 0.26 0.33 0.29 0.29 0.33
Mercuria Energy Trading 0.00 0.00 0.00 0.03 0.03 0.04
Noble Group 0.19 0.20 0.20 0.29 0.23 0.29
Olam 0.10 0.21 0.27 0.24 0.32 0.36
Shell Trading International 0.00 0.00 0.00 0.06 0.06 0.07
Trafigura 0.06 0.07 0.08 0.08 0.10 0.13
Vitol 0.05 0.05 0.08 0.07 0.08 0.05
Wilmar 0.54 0.54 0.45 0.41 0.40 0.43
Two things stand out. First, firms fall into two basic categories. One set of firms, consisting
of companies including the ABCD firms, is relatively asset intensive. The other set, consisting
primarily of oil traders (and oil and metals traders) are much less asset intensive. The disparities
can be extreme, with some trading firms having virtually no fixed or long-term assets, and
some other firms commonly categorized as traders having nearly 50% long-term physical assets.
Second, there is an upward trend for some firms, but not uniformly across all the firms
in the sample. Among the ABCD firms, ADM and Bunge have exhibited relatively stable ratios,
Cargill’s ratio has actually fallen, but Louis Dreyfus’s has increased. For Asia-based firms,
2 Fixed assets divided by revenues is another measure of asset intensity. Traditional trading firms tend to have large
revenues, because their business consists of continuous buying and selling of commodity inventories, but involves
little investment in fixed assets. The data on this measure exhibit similar patterns to those for fixed assets relative
to total assets, so I do not separately report them.
41
FIGURE 1
FIXED ASSETS DIVIDED BY TOTAL ASSETS AT COMMODITY TRADING FIRMS
0.60
0.50
FIXED ASSETS/TOTAL ASSETS

0.40
0.30
0.20
0.10
0.00
2007 2008 2009 2010 2011 2012
YEAR
ADM BP Bunge Cargill Dreyfus E.On EDF Eni
Glencore Mercuria Noble Olam Shell Trafigura Vitol Wilmar
Wilmar has become less asset-intensive, but Olam and Noble have become more asset-
intensive. Glencore was becoming more asset intensive even before its acquisition of Xstrata.
There is a similar diversity in trends among the traditional traders who are less asset-intensive.
Mercuria has increased its intensity somewhat, though that level remains relatively small, while
Vitol’s intensity increased, then in 2012 decreased back to its 2007 level.3 In contrast, Trafigura’s
asset intensity more than doubled between 2007 and 2012 (and has more than tripled since 2006).
Some (but not all) Thus, it is incorrect to say that commodity trading firms have uniformly become more
asset-intensive. Some have, but some have not. In this, as in so many other things examined
herein, there is considerable diversity among trading firms.
more asset intensive
B. ASSET OWNERSHIP BY COMMODITY TRADING FIRMS
As the data on fixed assets suggests, there is substantial variation in asset ownership across
commodity trading firms. This is further demonstrated by a more detailed examination
of specific trading firms. Some firms own assets at all stages of the value chain—upstream,
midstream, and downstream. Some have investments at all stages for some of the commodities
they trade, but in only one or two of the stages for others.
This finding is documented in graphical form in Appendix B for a selection of major companies.
There is a chart for each company that indicates its activities in 13 major commodities.
Four types of activity are considered: pure trading (with no asset ownership); upstream
(which includes ownership of mines, oil wells, and agricultural land); midstream (which
includes storage and terminals); and downstream (which includes processing and refining).
A solid dark blue box for a particular commodity and activity indicates that the company
owns physical assets for that commodity-activity pair.4
One generalization is that all major commodity trading firms own midstream assets, such
as storage facilities and terminals, although some firms participate in some commodity
markets purely as traders, with no asset ownership. Moreover, some of the increased asset
3 Data on Vitol is available going back to 2003. Its asset intensity decreased by almost 60% (from .11 to 0.5) from 2003
to 2007, before increasing in 2008-2011 and then turning down.
4 I made determinations as to whether a company owned assets in a particular activity-commodity pair based on an
examination of the websites of private companies (e.g., Cargill, Louis Dreyfus, Vitol) and an examination of annual
reports and websites for public companies (e.g., ADM, Glencore).
42
SECTION V
intensity documented above is driven by increasing investments in midstream assets.

As will be discussed in more detail below, there are strong economic reasons for trading
firms to invest in such assets: by doing so, they reduce transactions costs. Moreover, the
increasing availability of information about prices and flows has increased the transaction
midstream assets
cost reduction-related benefits of midstream asset ownership. Generalizations are more
difficult to make about upstream and downstream assets. Hence, the analysis is inherently
more case-by-case. Given the complexity of the markets, I will focus on a few representative
cases to illustrate some of the factors at work.
Another generalization is that trading firm asset ownership cannot be viewed in isolation.
Especially in energy, commodity firms are acquiring assets that other firms are divesting for
strategic reasons. Thus, understanding patterns and trends in commodity trading firms requires
ownership cannot be
an understanding of patterns and trends in other companies, such as large oil companies. seen in isolation
I now consider trading firm investments in midstream, downstream, and upstream assets.
Midstream Investments. Commodity merchandisers have long invested in midstream assets

such as storage facilities and terminals. Historical data and systematic statistics are lacking,
but some documentation dating back to the early-20th century illustrates this point. The
Federal Trade Commission’s (FTC) Report on the Grain Trade analyzed terminal and country
grain marketing around 1920. With some alarm, the FTC documented that merchandisers
tended to control terminal grain elevators, country elevators, and grain export facilities.
It noted that 80% of terminal elevator capacity was owned by “private dealers in grain.”5
Even ostensibly “public” elevators that stored grain for third-parties were largely owned by
grain dealers, and they utilized this capacity in their merchandising activities. With respect
to country elevators and warehouses, the FTC found that 35% were “line elevators” owned
and operated by large grain merchants.6
As noted above, this continues to be the case in the grain and cotton trades today. The major
agricultural trading firms own storage and logistical facilities.
Transactions costs economics sheds considerable light on the need for trading firms to
control storage facilities and terminals. Specifically, the concept of “temporal specificity” to control delivery
is of particular relevance for midstream assets.7 A temporal specificity exists when even
a short delay in obtaining (or selling) a good imposes a large loss on the buyer (or seller). and reduce
Under these circumstances, the seller (or buyer) has considerable bargaining power that he transactions costs
can exploit. Moreover, the wide bargaining range induces wasteful haggling, that sometimes
results in a failure to complete what would have been a mutually beneficial transaction.
This is perhaps best illustrated by a commodity trading example, namely, storage. One of
the main functions of commodity storage is to smooth out supply and demand shocks:
the amount of a commodity in store should go down (or up) when demand is unexpectedly
high (or low), or supply is unexpectedly low (or high).8 These shocks occur continuously, and
particular in volatile market conditions can be large in magnitude. Optimal utilization of
storage capacity requires timely response to these shocks.
Consider a firm that has put a commodity in store in a facility that it does not own, or
control under some contract or lease. There is an increase in demand, making it optimal for
the firm to take the commodity from storage and sell it (or consume it itself). The operator
of the storage facility realizes that the value of the commodity to the customer is maximized
if the customer can access it quickly to respond to the demand shock, and is worth less if
access is delayed. This gives the storage facility operator the ability to extract some of this
value by threatening to delay performance. Although the terms of the storage contract may
attempt to preclude such conduct, contracts are incomplete (i.e., all contingencies cannot
be set out in the contract, leaving room to attempt to evade performance by taking
advantage of one of these contractual gaps), and are costly to enforce (meaning that
the storer might prefer to capitulate to the storage operator’s demand rather than go to
court). Moreover, since timely access to the stored good is essential and getting the contract
5 Federal Trade Commission, Report on the Grain Trade, Volume III: Terminal Grain Marketing (1921) at 7.
6 Federal Trade Commission, Report on the Grain Trade, Volume I: Country Grain Marketing (1921) at 41.
7 For a discussion of temporal specificity, and an application of the concept to the study of a particular market,
see Stephen Craig Pirrong, Contracting Practices in Bulk Shipping Markets: A Transactions Cost Explanation, 36
Journal of Law and Economics (2003) 937.
8 Craig Pirrong, Commodity Price Dynamics: A Structural Approach (2011).
43
enforced is likely to be time consuming, capitulation becomes a more reasonable alternative.9
These problems can be avoided if the firm that stores the commodity controls the storage
facility, either by owning it, or obtaining control via a long-term contract or lease arrangement
that is not subject to opportunistic conduct by the asset owner or user. This logic can explain
the phenomenon noted by the FTC almost a century ago: the decline in “public” warehousing
and merchandiser ownership (or control) of storage facilities. It can also explain the ownership
(or control by lease/contract) of storage facilities across major commodities by trading firms.10
Similar arguments obtain for other fixed logistic assets, such as terminals. Executing an
arbitrage transaction frequently requires unpredictable, rapid and timely access to such
an asset, and this creates a temporal specificity that the asset operator can exploit to extract
a supercompetitive price from the firm attempting to execute the arbitrage. If the firm
executing the arbitrages owns the asset, however, such a “holdup” cannot occur.
It should be noted further that the possibility for such holdups reduces the incentive to seek
out arbitrage opportunities, because the operator of the logistics facility can extract some
of the value that the arbitrageur’s efforts create. If the arbitrageur owns the asset, however,
it can capture fully the value of the arbitrage, and therefore has a stronger incentive to seek
out and exploit such value-enhancing transactions.
Not all logistic assets are equally susceptible to temporal specificity-related holdups. Standardized
bulk ships (or tankers) operating on heavily-trafficked routes are relatively immune, for instance.
If a carrier attempts to hold up a shipper, the shipper can readily find another carrier: competition
sharply mitigates the potential for a holdup.11 However, fixed logistic assets for which there are
few alternatives are more susceptible to this problem. Thus, one expects that commodity traders
need not own standardized bulk carriers or tankers, but have a far stronger incentive to own
terminals or storage facilities. This prediction is largely borne out in practice.
The analysis also has implications for the factors that cause changes in the incentive for
trading firms to integrate into ownership of logistic assets. The more fleeting are arbitrage
opportunities, the more acute are temporal specificities and the greater incentive to integrate.
Recent developments in some commodity markets, notably the oil market, are consistent with
this prediction. Due to information technology, greater ability to monitor the activities of
competing traders (e.g., by tracking vessel movements in real time), and the substantial increase
in price transparency in the energy markets,12 the duration of arbitrage opportunities has
declined substantially. Immediate access to logistic assets and storage facilities is therefore
more valuable for firms that are primarily engaged in executing arbitrages. This helps explain
increased investment of traditional trading houses in midstream logistic assets and storage
facilities, which is a major driver of the increased asset intensity of some of these firms.
There are strong Supply and demand shocks in the commodity markets can increase the demand for
economic reasons midstream infrastructure that is needed to facilitate commodity flows. Moreover, the needed
new infrastructure often exhibits characteristics that makes it economical for those that are
for traders to own going to utilize it, build it and own it, at least for some period. In particular, the infrastructure
midstream often exhibits substantial scale economies at efficient scale, and due to these scale economies
infrastructure assets may be geographically dispersed, with only a small number of facilities
infrastructure serving a particular tributary territory. Moreover, it is often specialized to optimize its
efficiency. Furthermore, it is fixed to a specific location: in the language of transactions cost
economics, it is “site specific.” Finally, some traders control flows of the commodity sufficient
to utilize a large fraction of the asset’s capacity.
All of these factors create the potential for serious opportunism problems if the major users
of the new assets (traders controlling commodity flows) do not own them.13 Specialization
of the asset, site specificity and scale economies that make it efficient for a single piece
of infrastructure to serve a substantial portion of the commodity flows for a large region,
and the fact that large traders control flows of the commodity that can utilize a substantial
fraction of the asset’s capacity mean that bargaining and contracting hazards arise if the
9 The ongoing controversies about long load-out times and alleged opportunistic behavior by industrial metals, coffee,
and cocoa warehouse operators that offer public storage (usually as warehouses regular for delivery under futures
contracts) illustrates the potential for conflicts between those who store commodities in warehouses they do not own
and the owners of these facilities.
10 It also sheds light on current controversies in LME warehousing.
11 My article on contracting practices in bulk shipping markets goes through this argument in detail.
12 Jan Ascher, Paul Laszlo, Guillaume Quiviger, Commodity trading at a strategic crossroad, McKinsey Working Papers on
Risk, No. 39 (2012).
13 For a detailed analysis of these issues, see Oliver Williamson, The Economic Institutions of Capitalism (1985).
44
SECTION V
trader that controls the commodity flows does not control the asset. If the parties attempted
to deal through a long term contract, the asset owner could attempt to evade performance
under the contract to extract a better deal from the trader: the trader may find it better
to agree because alternative ways of moving the commodity are substantially more costly
(because they are out of position relative to the trader’s commodity flows, or not optimized
to meet the trader’s needs). Similarly, the trader could threaten to evade performance by
diverting its flows elsewhere, unless the asset owner makes concessions. If the trader controls
a substantial fraction of the flows that use the asset, if it carries through on the threat the
asset will operate well below capacity, meaning that the asset owner may feel compelled
to make concessions in order to avoid idling the bulk of the facility. Thus, the combination
of traders that control large commodity flows, with assets that are specialized to facilitate
those flows and which must operate at scale, creates the conditions for ongoing and wasteful
disputes between the trader and the asset owner. This problem can be eliminated if the trader
owns the asset.
These considerations are an important driver of the increased asset intensity of some Owning midstream
trading firms that was documented above. Trafigura provides several examples. Consider
the Burnside Terminal on the Mississippi River in Louisiana. The shale gas boom in the
assets creates
United States, and the resulting decline in natural gas prices, has substantially reduced transactions cost
the demand for coal for electricity generation in the United States. This freed substantial
quantities of coal for export, but there is inadequate infrastructure to accommodate an
increase in export flows. Trafigura determined that the Burnside Terminal is ideally placed
to alleviate this bottleneck, but that this required a substantial investment to upgrade the
facility and optimize it for use as a coal (and also alumina and bauxite) terminal. The asset
is specialized, of large scale, site specific, and there are few nearby facilities capable of
handling its volumes. Moreover, Trafigura, as a major trading firm, efficiently markets coal
internationally in sufficient quantity to utilize a substantial fraction of the capacity of the
facility. The transactions cost economics considerations discussed above make it efficient
for Trafigura to own the asset.
Similar considerations pertain in Corpus Christi, where the shale oil boom in Texas created
the need for substantial amounts of new, specialized terminal capacity; in Colombia, where
existing infrastructure is inadequate to handle increased oil and coal output, and the needed
infrastructure exhibits scale economies and is site specific, and where Trafigura controls large
flows of coal and oil; and Peru, where large-scale, specialized storage, blending and terminal
facilities are required to handle large flows of concentrates marketed by Trafigura.
Thus, Trafigura’s increased physical asset intensity is concentrated in logistics assets needed to
handle large volumes of new commodity flows caused by large changes in supply and demand
patterns. Transaction costs considerations make it efficient for the firm, which handles large flows
of the commodities, to own the infrastructure assets scaled and specialized to handle these flows.
Although Trafigura provides an excellent illustration of the economic factors that can drive
increased investment in midstream assets by trading firms, it is by no means the only one.
Another example is Brazil, where existing infrastructure on the Amazon is insufficient to
handle the increased production of soybeans in tributary regions that can be exported to
China. Trading firms, including all of the ABCD firms, are making large investments in handling
and storage facilities on the river, and will own and operate these assets (in some cases in
joint ventures with Brazilian firms).
In sum, commodity trading firms have always owned and operated midstream assets,
like terminals, blending facilities, and storage facilities. The nature of these assets makes
it efficient for firms merchandising large commodity flows to own them: this reduces
transactions costs. Moreover, major changes in supply and demand patterns have led to
the need for new infrastructure, which large commodity trading firms have accommodated
through investment and ownership, thus increasing their fixed asset intensity.
This increased intensity is sometimes explained as the result of commodity trading firms
investing in assets that offer “optionality.” This explanation is incomplete. Optionality
(defined as adjusting the use of the asset in response to unexpected supply and demand
shocks and the associated relative price changes) is a necessary condition for ownership of
an asset, but not a sufficient one. Bulk cargo ships and tankers offer substantial optionality
(in terms of routes and sometimes cargoes), but a trading company does not need to own
a bulk carrier or tanker to exploit that optionality because ships are mobile, and because there
are competitive charter markets with large numbers of buyers and sellers: a trader can exploit
a ship’s flexibility and optionality by chartering it when needed. Many infrastructure assets,
in contrast, are sufficiently unique (in terms of location, configuration, size, etc.) that
45
something analogous to a ship chartering market is not feasible. For these assets, ownership
is necessary to exploit their optionality efficiently.
Downstream Assets. One of the notable developments in energy markets in recent years
is the integration of some large trading firms into the fuel and lubricants retail, distribution,
downstream in and downstream distribution businesses. Puma Energy, originally a wholly-owned subsidiary
of Trafigura, owns and operates fuel storage and marketing businesses (involving distribution,
emerging economies retailing and wholesaling) in 40 countries in Africa, Latin-America, North-East Europe, the
and developing Middle East, Australia, and Asia. As another example, Vitol’s Vivo joint venture (with Helios
markets Investment Partners and Shell) distributes and markets fuel in Africa.
The downstream activities of trading firms are primarily concentrated in emerging markets,
or rapidly developing regions of advanced countries.14 These markets tend to be relatively
small, and have underdeveloped infrastructures and therefore require additional investment.
Moreover, local capital markets are relatively undeveloped. The market sizes are insufficient
to support a large number of efficiently-scaled retailers, wholesalers, and distributors (as is
the case in far larger markets, such as the United States). If these businesses were operated
separately, it is likely that firms at each segment of the marketing chain would have
market power, leading to potential for multiple monopoly markups and the potential for
opportunistic behavior if firms in the different segments attempted to use long term
contracts to mitigate the markup problem. These factors tend to make vertical integration
more efficient than separate ownership of retail, wholesale, and distribution segments.
Further, markets in these countries tend to be highly regulated, and often adopt price
controls. In some, the quality of governance is poor. It is well known that such conditions
tend to favor vertical integration.15
Economic considerations therefore strongly favor the integration of midstream and

downstream functions in fuel markets in emerging economies, and these activities have
historically been integrated in these markets. The previous owners were the oil majors,
and the integration of trading firms into this sector is the flip side of the exit of the majors.
Majors have been becoming less integrated generally because returns in downstream
businesses do not compare favorably with those that can be earned in the very capital-intensive
upstream exploration and production activities. Trading firms that can efficiently supply
inputs into the downstream markets in emerging economies are the natural buyers for
these businesses. So the tale of vertical integration by commodity traders is also very much
a story of disintegration by oil majors.
Recently some traditional trading houses (including Gunvor and Vitol) have acquired oil
refineries. These acquisitions are again to a considerable degree a reflection of developments
in the broader oil industry, in particular the serious erosion in refining economics in Europe.
One major refiner, Petroplus, went bankrupt, and the financial performance of European
refineries generally has led refiners to shed capacity. Some of this capacity has been idled:
from 2006 to 2013, European refining capacity (crude distillation units) declined 7.5%.
Trading firms have found it economical to purchase and operate some of the capacity that
was no longer sufficiently profitable for traditional refiners to retain.
The major agricultural trading firms that merchandise grains and oilseeds also process
these commodities. For instance, Cargill and ADM process wheat, corn, and soybeans.
Bunge processes soybeans.
Processed agricultural products are typically marketed to a large, diverse, and geographically
dispersed group of customers. Efficient performance of this marketing function requires
the same skills and resources required to merchandise unprocessed agricultural products,
including most notably expertise in logistics. Further, expertise in sourcing, storing, and
transporting unprocessed agricultural products can be utilized to acquire efficiently inputs
for processing operations. Thus, there are complementarities between merchandising of
unprocessed and processed agricultural products, providing an incentive for trading firms to
engage in processing. Moreover, there can be benefits of centralizing risk management across
processing and merchandising activities (for both processed and unprocessed products).
This provides an additional reason for firms to engage in both marketing and processing.
Upstream investments. There are some instances of upstream integration in agricultural

products. Olam and Wilmar own palm oil plantations, and Cargill recently announced an
investment in a major Ukrainian agricultural producer, UkrLandFarming. Again, transactions
14 For a detailed analysis of these issues, see Oliver Williamson, The Economic Institutions of Capitalism (1985).
15 George Stigler, The Organization of Industry (1968).
46
SECTION V
costs economics explains how these decisions can increase value. The plantations are large
(due to scale economies), and obviously site-specific, and Olam and Wilmar market large
quantities of oil: ownership avoids the inefficiencies that arise from bilateral monopoly.16
It should also be noted that the companies own and operate processing facilities on the plantations.
Again, this makes sense from a transactions costs economics perspective. Similar considerations
obtain in the case of Cargill and UkrLandFarming. The inefficiencies of having a large buyer and
a large seller dealing at arms length can be mitigated if the buyer has an ownership stake in the
seller (or vice versa).
Integration upstream has been more common in energy and industrial metals. For instance, Energy and metals
Glencore (especially with its merger with Xstrata) has become in effect an integrated mining traders integrate
company. Mercuria has upstream oil and coal assets, and Vitol owns upstream oil assets as well.
Trafigura owns mines in Spain and Peru, and recently sold off another in Peru that it had upstream
owned since 1997.
Transactions costs considerations again explain some of the benefits of integrating processing
and marketing operations. Repeated negotiation of short term agreements between the
operator of a mine, say, and a trading firm that is capable of marketing all (or a large fraction)
of its output is likely to be costly because of the small numbers bargaining problem inherent
in this situation. Integration can avoid that problem.
That said, there are means other than ownership to achieve similar economies. For instance,
a trading firm can enter into a long-term off-take agreement that avoids the costs associated
with repeated negotiations between a mine owner and a trading firm. Although such
long-term contracts are potentially vulnerable to opportunistic behavior by both the producer
and the trading firm/buyer, the ubiquity of these off-take arrangements demonstrates that
these contractual hazards can be surmounted economically. Indeed, off-take agreements are
a more common way than ownership for commodity firms to acquire commodity flows on
a long-term basis from producers.
The case of Trafigura provides some insight into factors that can make ownership of an
upstream asset like a mine efficient. Trafigura has acquired considerable technical expertise
in mining and extraction industries. By purchasing a mine in need of additional investment,
Trafigura can utilize that expertise: the well-known difficulties of selling information or
expertise often make it more efficient for the party with the expertise to make the
investment, rather than provide that information at arms length to a mining company.
Trafigura’s investment in the Aguas Teñidas Mine (MATSA) in southern Spain is an illustration
of this. Further, its purchase of, investment in, and subsequent sale of Compania Minera
Condestable SA in Peru suggests that it is the transfer of expertise, rather than synergies
between operation and marketing that can be decisive in making ownership of an upstream
asset optimal for a trading firm. Trafigura purchased the firm in 1997, and utilized its expertise
to improve its efficiency and extend its life. After 16 years of ownership, the mine had
achieved such a level of efficiency that Trafigura’s expertise was no longer as necessary,
so the company sold its 99% stake to a private mine operator. Importantly, as part of the
sale, Trafigura entered into a life-of-mine off-take agreement for 100% of the mine’s
production. This strongly suggests that the reason for ownership was that this was the
efficient way to transfer technical expertise and management investment in capacity expansion,
and that ownership was not necessary to secure and market the mine’s output efficiently.
Commodity Trading Firms and Vertical Disintegration in Commodity Markets. Commodity trading
Although much public discussion of commodity trading firms focuses on their increasing
integration, it is important to note that commodity trading has also contributed to vertical
generates market
disintegration. As pointed out by Coase long ago, markets and firms are different ways of
carrying out transactions.17 When markets become cheaper to use, some transactions that
used to take place within vertically integrated firms (e.g., the supply of crude oil to a refinery)
can be undertaken in markets instead, and the upstream and downstream parts of the firm
can be separated. By facilitating liquid, competitive markets in crude oil and refined products,
commodity trading firms made it more economical to carry out many transactions that
had taken place within integrated firms on markets instead. The rise of refining independents
and the retreat of oil majors from refining reflects in large part the efficiencies created by
commodity trading firms.
16 Note that upstream integration into agricultural production is most common in crops that are produced at scale on
large plantations (e.g., palm oil), and virtually unknown in crops (e.g., corn) that are grown by large numbers of
relatively small producers.
17 Ronald Coase, The Nature of the Firm, 4 Economica (1937) 386.
47
48
SECTION VI
VI. SYSTEMIC RISK AND COMMODITY

TRADING: ARE COMMODITY TRADING
FIRMS TOO BIG TO FAIL?
SUMMARY
For CTFs to pose a systemic risk three factors must be present:
1. There must be a risk of a large triggering shock.
2. There must be a risk that the shock propagates through the financial system
via contagion or chain reaction.
3. The financial disruption must affect the broader economy.
CTFs are unlikely to be a source of systemic risk for several reasons:
• Even the largest commodity firm is significantly smaller than the major banks.
• Commodity firms’ balance sheets are far more robust.
• Commodity firms are not an important source of credit.
• There is relatively low market concentration among commodity firms.
• The assets used in commodity trading can be redeployed relatively easily.
• The economics of commodity trading help to insulate the industry from the
effects of a large economic downturn.
• Trading firms provide logistical services. Recent history demonstrates that even
large disruptions to logistical networks have limited economic impact.
• There have been numerous recent failures in trading firms, which have had no
impact on the broader financial system.
A. INTRODUCTION
After decades of operating in relative obscurity and out of the glare of publicity, in recent
years commodity trading firms have received much more public scrutiny. Since the Financial
Crisis in particular, some (including some regulators) have questioned whether commodity
trading firms pose risks to the financial system analogous to banks, and hence should be
regulated similarly to banks.1 Most notably, in 2013 the Financial Stability Board (FSB)
requested national and regional regulators to establish whether commodity trading firms
required additional regulation, including initially additional regulatory reporting and
financial disclosures. 2 In 2012, the FSB’s Timothy Lane opined that trading firms might be
systemically important.3 In public discussion, including many articles in the media, the issue
has been framed as “are commodity firms too big to fail?”
An evaluation of this issue first requires a definition of “systemic risk” and an understanding Systemic risks
of what kinds of financial institutions are likely to be systemically important (“systemically
important financial institutions” or “SIFIs”). These terms are widely used, but not always
consistently so. Therefore, it is essential to define the terms. I will use a definition provided system and the
by then Federal Reserve Chairman Ben Bernanke in a letter to Senator Bob Corker in 2009: broader economy
“Systemic risks are developments that threaten the stability of the financial system as
a whole and consequently the broader economy, not just that of one or two institutions.”
Stanford Professor John Taylor advances a three-part test to determine whether systemic
risk exists, and the analysis that follows adheres to this test. Taylor says for a risk to be
systemic, (1) there must be a risk of a large triggering shock (such as a natural disaster or
the failure of a firm or firms,) (2) there must be a risk of the shock propagating through the
financial system via contagion or chain reaction, and (3) the financial disruption must affect
the broader macroeconomy.4
1 Alexander Osipovich, Commodity trading firms face questions over systemic risk, Energy Risk, 20 September 2013,
2 Emma Farge, Commodity traders could face regulation for role as lenders, Reuters 1 May 2013.
3 Timothy Lane, Financing Commodity Markets: Remarks Presented to the CFA Society of Calgary, 25 September, 2012.
4 John B. Taylor, Defining Systemic Risk Operationally, in George Schultz, Kenneth Scott, and John B. Taylor (eds.)
Ending Government Bailouts as We Know Them (2009).
49
The FSB has a similar definition.5 It identifies three crucial criteria for assessing systemic risk:
size, substitutability (i.e., the ability of other firms or entities to provide the services previously
supplied by a failed firm), and interconnectedness.
Commodity trading B. ANALYSIS OF THE SYSTEMIC RISK OF COMMODITY TRADING FIRMS

Given these definitions, and the broader economic literature on systemic risk (especially
of systemic risk the literature that has developed in the aftermath of the recent Crisis), an analysis of
commodity trading firms indicates that they are not a potential source of systemic risk,
and hence do not warrant being regulated in ways similar to SIFIs. Several considerations
support this conclusion.
Commodity firms are not really that big, especially in comparison to major banks.
The assets of Glencore, the largest commodity trading firm, (which has evolved into a very
asset heavy mining firm, more comparable to a Rio Tinto or BHP than a Vitol or Trafigura,
or even an ADM) total slightly more than $100 billion, which ranks it approximately 240th
of world publicly traded corporations in terms of assets. If Cargill, the second largest trading
company in terms of assets, were publicly traded it would rank approximately 450th in terms
of assets. Comparing just to major banks, Glenore’s assets are approximately equal to the 60th
largest bank (by assets) in the world. The banks of similar size include Bank Leumi and Bank
Hapoalim, hardly household names outside their home countries. Cargill is comparable in size
to the 65th largest bank in the world.
Focusing on SIFIs, the median European SIFI bank has assets of $1.3 trillion, and the median
US SIFI bank has assets of $1.18 trillion. Thus, most banks that have been designated as SIFIs
have assets that are an order of magnitude larger than the largest commodity trading firms,
and two orders of magnitude larger than most commodity trading firms. Thus, the financial
distress of even the largest commodity trading firm, or even several of them, would be
unlikely to have the same disruptive impact on the financial system as the collapse of
a middling-size major bank, let alone a behemoth like Deutsche Bank or JP Morgan.6
Their balance sheets The balance sheets of trading firms are not fragile in the same way that banks’ balance
sheets are. The analysis of commodity trading firm financing in Section IV demonstrates
are much more several salient features that bear on the potential systemic risk arising from the financial
robust than banks distress of a trading firm.
First, in comparison to banks in particular, commodity trading firms are not heavily leveraged.
Whereas large bank leverage ratios (measured by book value of assets divided by book value of
equity) range between 9 and 14 for US SIFI banks (with a median of 10), and between 9.6 and
37 for European SIFI banks (with a median of 22), the median leverage for commodity trading
firms I have examined is 4. Moreover, focusing on net debt, many commodity trading firms are
not leveraged at all because current assets exceed total liabilities: since most of these current
assets are highly liquid (e.g., hedged commodity inventories) net debt is better indication of
leverage because commodity firms can sell the current assets to raise cash to pay off liabilities.
Second, the most important factor contributing to financial crises throughout history is the
fact that banks engage in “maturity transformation”, but commodity trading firms do not.
Maturity transformation occurs when banks (or shadow banks) issue short-term liabilities to
fund long-term assets. This requires the banks to rollover debts almost continuously in order
to fund their assets. When lenders suspect that a bank, or the banking system in general is
financially unsound, they may not agree to rollover the bank’s (or banks’) short-term debts
as they come due. This renders the bank (or banks) unable to fund their operations, and they
collapse. Indeed, balance sheet data indicates that major banks do engage in such maturity
transformation.
In stark contrast, as noted in Section IV, commodity trading firms do not engage in maturity
transformation. Indeed, the short-term assets of all commodity trading firms analyzed (which
includes the largest) exceed their short-term liabilities.
Moreover, the character of assets differs substantially between banks and commodity trading
firms. Many bank assets that are funded with short-term liabilities are highly illiquid, meaning
5 Financial Stability Board, Report of G20 Ministers and Governors, Guidance to Assess the Systemic Importance of
Financial Institutions, Markets, and Instruments: Initial Considerations.
6 In January, 2014 the FSB proposed to use an asset value of $100 billion as a threshold to determine whether a
non-bank financial corporation should be designated as a SIFI. Since such corporations typically have far more fragile
capital structures than commodity trading firms, and since most commodity trading firms have assets less than $100
billion, by the FSB criteria even the largest commodity trading firms are not SIFI.
50
SECTION VI
that if banks attempt to dispose of assets to de-lever when they face funding stresses, they
will have to dispose of these assets at fire sale prices. Moreover, since many banks have
similar assets on their balance sheets, fire sales by one bank can reduce the values of similar
assets held by other banks, which can put them under financial strain, leading to further fire
sales. This vicious cycle is characteristic of financial crises.
In contrast, relatively liquid assets (e.g., hedged inventories, trade receivables) predominate
on commodity trading firm balance sheets. As a result, the fire sale problem is mitigated.
Indeed, many of the short-term liabilities of commodity trading firms are secured and
self-liquidating: for instance, a transactional credit issued to purchase an oil cargo is secured
by that cargo, is paid off as soon as the cargo is sold, and is not subject to commodity price
risk because the bank requires the commodity trading firm to hedge.
Even the non-traditional forms of financing employed by some commodity firms, which have
been considered to be a form of “shadow banking” do not have the problematic features of
the liabilities that caused severe systemic problems during the Financial Crisis. The liabilities
that proved toxic during the Crisis (e.g., asset backed commercial paper) were used to
fund long-term illiquid assets. In contrast, facilities like Trafigura’s securitization of trade
receivables issue liabilities with maturities that are typically greater than the maturities
of the securitized assets. Moreover, these assets tend to be of high quality: as discussed
in Section IV, default rates on trade credit tend to be very low.
Commodity trading firms are not even remotely as important as issuers of credit
as banks. One reason that bank failures can be systemically catastrophic is the central credit providers
role of banks in the supply of credit. If banks fail, or become financially distressed in large
numbers, they reduce the amount of credit that they supply, which reduces investment
and consumption (especially of durable goods) in the economy. As noted above, commodity
trading firms do issue credit to commodity consumers and producers (in the form of prepays,
for instance), but ultimately the source of the bulk of this credit is banks. Commodity
trading firms commonly purchase payment guarantees from banks when they extend credit
to customers: in the case of Trafigura, approximately 80% of the credit it extends is backed
by payment guarantees or insurance from banks. Thus, banks bear the bulk of the credit
risk, and hence are ultimately the source of credit; the trading firms are basically conduits
between banks and customers. To the extent that a particular trading firm has a comparative
advantage in serving as a conduit to some customers (because, for instance, its knowledge
of the customers’ business allows it to monitor them more effectively), the firm’s failure
would impair the flow of credit to its customers. But there are alternative ways of providing
this credit (other trading firms can step in the breach, or the customers can borrow directly
from banks), and this mitigates the impact of the failure of the individual firm.
For many commodities, especially the most important ones, there is relatively little They mainly
concentration among commodity trading firms. To illustrate the contrast, in the crude operate in
oil market, two of the largest traders (Vitol and Trafigura) each account for about 6%
of freely traded oil. Glencore accounts for approximately 3%, and Mercuria 3%.7 fragmented markets
Concentrations are somewhat higher in metals Glencore trades about 60% of freely traded
zinc (although the termination of its off-take agreement with Nyrstar under terms imposed
by the European Commission to secure approval of its purchase of Xstrata will reduce this
concentration); 50% of freely traded copper; and 22% of freely traded aluminum. 8
The company also accounts for a large fraction—approximately 28%—of the global thermal
coal trade. Thus, the non-ferrous metals markets are more concentrated and hence more
susceptible to a single trading firm’s distress, than the oil market.
It is important to note that concentration is small in commodities that represent a relatively

large fraction of trade, and that the markets in which concentration is sometimes large
represent very small fractions of trade. For instance, depending on the region, oil represents
between 3 and 10% of imports. This is an appreciable fraction, but concentration in oil trading
is quite low, with the largest firms handling only around 6% of trade.
7 These figures are from reports on these companies’ websites.

8 These figures are derived from Glencore’s IPO Prospectus. Glencore utilizes publicly available data and its own
estimates to determine the “addressable” quantities “that are available to a third party marketer such as Glencore.”
For instance, commodities produced and consumed by a vertically integrated firm are excluded from the calculation.
Domestic Chinese production is also excluded, as are volumes sold directly from a producer to an end-user without
use of an intermediary. As an example, when calculating its share of thermal coal trade, Glencore utilizes seaborne
volume of 692 million MT, out of a total world output of 4,556 m MT. The “addressable” market is typically far smaller
than total global output. Based on total global output, Glencore calculates its market share to be 13% for zinc, 10%
for zinc concentrates, 7% for copper, 4% for copper concentrates, 8% for alumina, 9% for aluminum, and 4% for
thermal coal. Glencore considers the total oil market to be accessible to traders.
51
In contrast, other commodities represent much less than 1% of imports (or exports), meaning
that even if one of the dominant firms in a concentrated market were to disappear, the potential
effect on overall trade and economic activity would be trivial. This conclusion is reinforced
when one examines trade in commodities as a function of GDP: even oil imports are less than
2% of GDP for all regions except Asia, where they are less than 3% of GDP.
This means that the failure of a commodity trading firm is unlikely to disrupt severely the
trade in any major commodity. This conclusion is strengthened by the next fact:
Assets are The assets used in commodity trading are readily redeployable, meaning that the
financial distress of a trading firm has at most a modest impact on the capacity
to trade and transform commodities, and then for only a short interval of time.
Much of the physical and human capital deployed in commodity trading is highly re-deployable.
In the event of distress of a trading firm, its physical assets and employees can move to
other firms. Moreover, insolvency/bankruptcy laws generally facilitate the continued
operation of financially distressed firms, so they can continue to provide transformation
services even while in financial distress (although perhaps less efficiently, due for instance,
to higher costs of funding). These factors limit the duration of the impact of the firm’s
distress. While redeployment is occurring, or if a firm operates less efficiently while in
bankruptcy, customers of the distressed firm will be adversely impacted. This effect will
be most acute if the distressed firm has a large share of for a particular commodity or
geographic region. However, since such conditions are most likely to occur for smaller-
volume commodities and regions (because there is less concentration in the trade of major
commodities in major markets), the broader systemic implications of such disruptions will
be minor.
Commodity trading The economics of commodity markets and commodity trading means that large
economic downturns are unlikely to have a severe impact on the profitability, and
financial condition, of commodity trading firms. If commodity trading firms are robust
to trading volumes to economic downturns, they cannot be a vector of contagion that communicates the effects
not prices of the downturn to its customers and creditors. Economic theory and a variety of data,
demonstrate that commodity trading firms are indeed largely robust.
A large economic downturn does lead to a large decline in the demand for most commodities.
A decline in demand for a commodity leads to a decline in the demand for some transformations,
notably transportation/logistics and processing/refining, but an increase in the demand for
others, notably storage. The declines in derived demand tend to result in declines in both
volumes and margins, thereby reducing the profitability of the firms that engage in the
adversely impacted transformations. To the extent that a commodity trading firm also stores
commodities, it benefits from an internal hedge that offsets the losses from supplying
transformations in space and time.
The magnitudes of these changes in derived demands depend on the magnitude of the
demand shock (and hence the severity of the financial crisis) and the elasticity of supplies
of the underlying commodities. Since many commodities are highly inelastically supplied,
especially in the short run, the effects on margins and volumes, and hence trading firm
profits, can be modest.
Trade data provide some insights onto this source of risk to commodity trading firms.
Figures 2 through 5 depict data relating to world exports by commodity. (Data related to
world imports by commodity behave similarly, so I only present charts on exports.) Figure 2
graphs nominal exports by commodity reported in the ITC data for 2001-2011. These are
indexed to simplify comparative analysis. Note the large downturns in nominal trade
volumes in 2009, reflecting the impact of the financial crisis. Due to the large size of oil and
steel and iron exports compared to those for other commodities, Figure 3 graphs nominal
exports for all commodities except oil and iron and steel. Virtually all commodities exhibit a
noticeable dip in 2009.
As noted above, however, although changes in nominal flows reflect changes in both flat
prices and quantities, quantities are the major determinants of commodity traders’ margins
and profits. Figure 4 depicts annual nominal exports for each commodity deflated by its
average annual price (scaled so that the 2001 average price equals 1.00) and indexed for
comparison purposes. The impact of the 2008-2009 Financial Crisis is much less noticeable
in the deflated exports than the nominal exports. Only iron and steel exhibit a pronounced
dip. Figure 5 presents the deflated exports for all commodities studied excluding oil and iron
and steel. These smaller commodities do not exhibit a pronounced decline in deflated exports
(a proxy for quantity) in 2009.
52
SECTION VI
These charts strongly support the conclusion that a large demand shock primarily affects
commodity prices, and has a much smaller impact on the quantities of commodities traded.
Inasmuch as the profitability of commodity trading firms is primarily driven by quantities
(to the extent that these firms hedge price exposures), the risk that a large demand shock (like
that experienced in 2008-2009) poses to the viability of commodity trading firms is limited.
Demand shocks arising from a macroeconomic shock such as a financial crisis also affect the Macroeconomic
funding needs of commodity trading firms. Crucially, adverse shocks of this nature tend to demand shocks
reduce funding needs and liquidity stresses. Adverse demand shocks reduce prices, thereby
reducing the amount of capital necessary to carry inventories of commodities as they
undergo transformation processes. Moreover, to the extent that commodity trading firms funding needs…
are typically short derivative instruments (which may be marked to market on a daily basis)
as hedges of commodity stocks, price declines generate mark-to-market gains on derivatives
that result in variation margin inflows. This provides a source of funds to repay credit taken
to acquire the inventories. That is, these price declines tend to result in cash inflows prior
to obligations to make cash payments, which further ease funding needs of commodity
trading firms.
Figures 2-5 illustrate this clearly. The nominal value of virtually all commodities traded
declined sharply in 2009, but quantities (as proxied for by deflated exports) did not decline
substantially or uniformly across commodities. This decline in nominal trade reflects the
pronounced price declines that occurred in late-2008 to mid-2009. Moreover, the sharp
decline in the nominal value of a relatively stable quantity of exports means that the
financing needed to carry out such exports declined sharply as well.
FIGURE 2
INDEXED NOMINAL EXPORTS BY COMMODITY
2000
INDEXED $ NOMINAL VALUE (2001 = 100)
1800
1600
1400
1200
1000
800
600
400
200
0
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
YEAR
Aluminum Coal Copper Iron/Steel Iron Ore Oil
The decline in funding needs during periods of sharp demand declines resulting from a shock
arising in the financial system is particularly beneficial, inasmuch as financial shocks constrain
the availability of credit.
The foregoing analysis implies that trading firms should be relatively robust, even to large ...which makes them
shocks emanating from the financial system. This implication is testable, using data from the
2007-2009 financial crisis. I have reviewed data on ADM, Bunge, Cargill, Vitol, Louis Dreyfus,
more resilient
Mercuria Energy Trading, Glencore, Olam, Wilmar, Trafigura, and Noble.
All of these firms remained profitable throughout the 2007-2009 commodity boom-bust
cycle. Between 2007 and 2009 (the nadir of the commodity price cycle), net income changes
ranged between -57% (Bunge) and 224% (Wilmar) with a median of between 44% (Cargill)
and 113% (Noble).
This sample is dominated by firms that are focused on agricultural commodity trading.
Glencore is focused on metals and energy, two notably procyclical commodity sectors:
its profit declined 24% over the cycle. Trafigura is focused on energy and industrial metals:
its earnings rose 85% over the boom-bust cycle. Vitol is another energy-focused trading
53
FIGURE 3
NOMINAL EXPORTS BY COMMODITY EXCLUDING OIL, IRON & STEEL
200,000,000
180,000,000
160,000,000
$ NOMINAL VALUE (000)

140,000,000
120,000,000
100,000,000
80,000,000
60,000,000
40,000,000
20,000,000
0
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
YEAR
Aluminum Coal Copper Iron Ore
FIGURE 4
INDEXED DEFLATED EXPORTS BY COMMODITY
INDEXED $ DEFLATED VALUE (BASE=2001 PRICE)
350
300
250
200
150
100
50
0
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
YEAR
Aluminum Coal Copper Iron/Steel Iron Ore Oil
FIGURE 5
DEFLATED EXPORTS BY COMMODITY EXCLUDING OIL & STEEL
$ (000) DEFLATED NOMINAL VALUE (BASE= 2001 PRICE)
120,000,000
100,000,000
80,000,000
60,000,000
40,000,000
20,000,000
0
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
YEAR
Aluminum Coal Copper Iron Ore
54
SECTION VI
firm, and it experienced a 91% increase in income over the cycle. A third energy-focused
firm, Mercuria Energy Trading, saw its income rise 122%.
These figures are worth noting, given the substantial rise, decline, and subsequent rise in oil
and metals prices over 2007-2009. This performance likely reflects the fact that economic
volatility can create arbitrage opportunities, and serious economic downturns can increase
the demand for some transformation activities, notably storage.
The variability in performance across the firms for which data is available, with some Their performance
companies suffering substantial declines in earnings and other substantial rises over the is relatively
2007-2009 commodity cycle (and Financial Crisis cycle), is inconsistent with the hypothesis
that trading firm financial performance is highly sensitive to global economic conditions. insensitive to global
This is in stark contrast to other SIFIs. Trading firms would be more likely to create systemic economic conditions
risk if, like SIFIs, their earnings were highly correlated over the cycle.
This is true of large banks, whose profits collapsed during the Crisis. Total profits for the 8 US
SIFI banks plunged from $58 billion in 2007 to a loss of $9.8 billion in 2008, and recovered
only to $40 billion the following year. European SIFI banks earned a profit of $114 billion in
2007, but suffered a loss of $16.5 billion in 2008, with profits rebounding to $58 billion in
2009. This performance differs starkly from that of commodity trading firms over this period.
Trading firms provide logistical services, and recent historical experience shows that Disruptions to
even large disruptions of the logistical system have very modest effects on the broader
economy. As noted throughout, one of the primary functions of commodity trading firms
logistics have limited
is to make transformations in space and time—logistical transformations. Even if the economic impact
assets utilized by a distressed trading firm to make these transformations are not
redeployed immediately, the impact on the broader economy will almost certainly be minor.
Recent experience demonstrates that even a major disruption of the logistical system in
a major economic region does not cause an appreciable decline in the world economy.
Specifically, the Japanese earthquake and tsunami in 2011 wreaked massive havoc on the
single most important trading region in the world, but this had only very small effects on
the world economy. These natural disasters seriously disrupted production at numerous
firms that played a central role in global supply chains for high value manufactured output.
A report prepared under the authority of the Directorate General of the Treasury of France
concluded that:
• Japan is a key player in global production chains, particularly in high-technology sectors.

Japanese firms account for over 70% of global production in at least 30 technological
sectors …The triple disaster, which led to a nearly 8% reduction in Japanese products
exports in Q2, also caused disruptions to global supply in some sectors, particularly
in electronics and the automotive industry.
• Japan also plays a key role in Asian trade where production chains are highly integrated.
Schematically, Japan supplies sophisticated intermediate goods to and buys final goods from
its Asian partners including China, the pivot of the new international division of labor, which
performs assembly and transformation of the semi-finished products. Given the network
structure of production processes, a shock affecting an upstream producer can cause
strong fluctuations in the economy as a whole, through cascade effects from one firm
to another.9
Nonetheless, the French Treasury concluded that the effect of the catastrophe on aggregate
output was small, even in Asia. It estimates that the effect was 0.1 point of GDP in China and
0.2 percentage points for other “Asian dragons” in Q2 2011. Furthermore, it concluded that
“the impact is very low” in Europe and the US. Furthermore, it found that “virtually zero”
impact for the full year 2011, because of the “restoration of both Japanese production
capacity and global supply chains.”
The IMF Japan Spillover Report also found that the effects of the earthquake were modest
(outside of the automobile industry) and short lived (even in the auto sector).10
The Japanese natural disaster caused the destruction of production capacity. The affected
capacity was an essential element of a complex supply chain in high value-added industries.
Even so, the spillover effects of this destruction were small and fleeting. This demonstrates
the resilience of economic activity to the disruption of trade.
9 The impact of Japan’s earthquake on the global economy. Tresor-Economics Report No. 100 (2012).
10 International Monetary Fund: Japan Spillover Report for the Article IV Consultation and Selected Issues (2012).
55
The financial distress of a trading firm would not result in the destruction of any productive
assets (although it could impede the efficiency of their use); the assets would be available
to be redeployed, or operated by those who control the distressed firm. No single firm,
or even multiple firms, is as critical in the global supply chain for large, high value added
industries (such as autos and electronics) as the Japanese companies affected by the
earthquake and tsunami. Thus, the effects on the broader economy of the financial distress
of a large commodity trading firm, or even multiple firms, would almost certainly be smaller,
and shorter lived, than the small effects of these natural disasters.
There have been numerous instances in which commodity trading firms have suffered
failed it has not large losses, or actually failed, without causing problems in the broader financial system.
There have been numerous instances in which large commodity trading firms have suffered
caused problems large losses, sometimes resulting in the failure of the firms involved, but where there were
no pronounced disruptions in the commodity markets in which the firm operated, let alone
in the broader economy.
In commodities in particular, large losses at Ferruzzi ($4 billion), Metallgesellschaft (over

$1 billion), Sumitomo ($2 billion), Constellation (a $10 billion loss in market capitalization),
or Amaranth ($6 billion) did not have broader systemic consequences. Enron was the most
important trading intermediary in US natural gas and power markets, and its precipitous
collapse did not disrupt those markets appreciably, let alone the broader economy.
Some months after Enron’s demise, the entire merchant energy sector in the US suffered
catastrophic financial losses. From 25 April, 2002 through the end of May of that year,
the equity values of a portfolio of large energy merchants declined by approximately 91%.
The credit rating of every energy merchant firm was downgraded. Many firms exited the
business, and one prominent firm (Mirant) declared bankruptcy.
Merchant energy firms engaged in the same transformational activities as commodity trading
firms, and also provided risk management and financing for their customers similar to those
provided by commodity trading firms. Despite the acute financial distress of the entire sector,
gas and power continued to flow, houses were heated and lights went on. Moreover, there
was no impact on the broader economy.
Commodity In sum, many commodity trading firms are large, and play a crucial role in facilitating
the flow of vital commodities to their highest value uses, but that does not make
them systemically important in the same way banks and other major financial
a crucial role, institutions are. Commodity trading firms provide very different intermediation services
but they are than banks do. What’s more, they are not central to the provision of credit in the
same way banks are. Furthermore, in comparison to banks, they are not large. They are
not systemically not, therefore, too big to fail, and should not, therefore, be subject to the same kinds
important of regulation as banks.
56
SECTION VI
57
AFTERWORD
Commodity trading firms transform commodities in space, time, and form in order to
enhance their value. Their function is to move commodities from low value uses to high value
ones. In so doing, they enhance the wealth and welfare of both the producers and consumers
of commodities. It may seem paradoxical, but commodity trading raises the prices that
producers receive, and lowers the prices that consumers pay. It is not paradoxical, however,
because commodity traders are both buyers and sellers, and are in the business of earning
a margin between sales and purchase prices: they care little about the level of prices overall.
Competition on margins between traders tends to narrow price differentials and encourages
traders to improve the process of transforming commodities from what producers produce
to what consumers consume.
They do not do this out of altruism. Moreover, their activities are not uniformly beyond
reproach. But the profit motive and intense competition combine to create a powerful
tendency for these firms to create value, of which they take a relatively small portion.
Nonetheless, commodity trading is controversial, especially in times like the present, and the
recent past, in which prices have been high. But this is nothing new. Adam Smith noted the
same phenomenon when writing in 1776 about criticisms of commodity trading dating back
to the 14th century, criticisms eerily similar to those heard today.
Smith had an answer to these criticisms, and his answer remains true today even though
in size, scope, technology, and financing commodity trading today is vastly different than
it was in 1776, let alone the time of Edward VI. Smith understood how the transformation
of commodities by competing firms benefits producers and consumers.
By highlighting the role of transformations, and analyzing them in detail, I have attempted
to provide a conceptual framework for analyzing commodity trading and evaluating the
role of commodity trading firms. Hopefully this will contribute to a more informed public
discussion of commodity trading, and how it can be improved through good policy.
58
AFTERWORD
59
APPENDIX A
TABLE 1
SOURCE DATA FOR INTERNATIONAL TRADE FLOW IN COMMODITIES
COMMODITY UNCTAD/WTO CODE

Animal or Vegetable Fats or Oils* 15
Cane or beet sugar* 1701
Corn* 1005
AGRICULTURAL
Cocoa beans 1801
Coffee* 901
Cotton* 52
Cotton neither carded or combed* 5201
Palm Oil* 1511
Rice* 1006
Soyabeans* 1201
Soyabean oil 1507
Wheat* 1001
ENERGY
Coal* 2701
Petroleum oils (crude)* 2709
Iron and steel* 72

Iron Ore* 2601
Aluminum* 76
Aluminum ores and concentrates 2606
Copper* 74
Copper ores and concentrates* 2603
INDUSTRIAL
Lead 78
Lead ores and concentrates 2607
Nickel* 75
Nickel ores and concentrates 2604
Tin 80
Tin ores and concentrates 2609
Zinc* 79
Zinc ores and concentrates 2608
Annual nominal export volumes for 28 commodities between 2001 and 2011 can be found
on the International Trade Centre’s Trade Map statistical database. These data were used
to calculate correlations between commodities.
A subset of these commodities (asterisked) is represented graphically in Figures 2,3,4 and 5.
60
APPENDIX A
61
r r r r r r
x
we we we we we we
Po Po Po Po Po Po
TRADING ACTIVITY AND PHYSICAL ASSET OWNERSHIP FOR LEADING
s s s s s s
Ga Ga Ga Ga Ga Ga
x
x
al al al al al al
tur tur tur tur tur tur
Na Na Na Na Na Na
al al al al al al
x
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Co Co Co Co Co Co
x
x
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m m m m m m
x
x
x
x
le u le u le u le u le u le u
t ro t ro t ro t ro t ro t ro
Pe Pe Pe Pe Pe Pe
re re re re re re
x
x
nO nO nO nO nO nO
I ro I ro I ro I ro I ro I ro
ls ls ls ls ls ls
x
x
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eta eta eta eta eta eta
lM lM lM lM lM lM
r ia r ia r ia r ia r ia r ia
ust f fe
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Ind Co Ind Co Ind Co Ind Co Ind Co Ind Co
a a a a a a
co co co co co co
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Co Co Co Co Co Co
r r r r r r
ga ga ga ga ga ga
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Su Su Su Su Su Su
n n n n n n
t to t to t to t to t to t to
x
COMMODITY TRADING FIRMS
Co Co Co Co Co Co
s s s s s s
ed ed ed ed ed ed
x
x
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l se l se l se l se l se l se
APPENDIX B
Oi Oi Oi Oi Oi Oi
t t t t t t
ea ea ea ea ea ea
x
x
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Wh Wh Wh Wh Wh Wh
rn rn rn rn rn rn
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Co Co Co Co Co Co
Downstream
Downstream
Downstream
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Downstream
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Midstream
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Midstream
Midstream
Midstream
Upstream
Upstream
Upstream
Upstream
Upstream
Upstream
Trading
Trading
Trading
Trading
Trading
Trading
LOUIS DREYFUS
GLENCORE
GUNVOR
FIGURE 1
FIGURE 2
FIGURE 3
FIGURE 4
FIGURE 5
FIGURE 6
CARGILL
BUNGE
ADM
62
63
APPENDIX B
r r r r r r
x
x
we we we we we we
Po Po Po Po Po Po
s s s s s s
Ga Ga Ga Ga Ga Ga
x
al al al al al al
tur tur tur tur tur tur
Na Na Na Na Na Na
al al al al al al
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Co Co Co Co Co Co
m m m m m m
x
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nO nO nO nO nO nO
I ro I ro I ro I ro I ro I ro
ls ls ls ls ls ls
x
x
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eta eta eta eta eta eta
lM lM lM lM lM lM
r ia r ia r ia r ia r ia r ia
ust f fe
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Ind Co Ind Co Ind Co Ind Co Ind Co Ind Co
a a a a a a
co co co co co co
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ga ga ga ga ga ga
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Su Su Su Su Su Su
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x
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Oi Oi Oi Oi Oi Oi
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Wh Wh Wh Wh Wh Wh
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Trading
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TRAFIGURA
MERCURIA
FIGURE 10
FIGURE 12
FIGURE 11
FIGURE 7
FIGURE 8
FIGURE 9
WILMAR
NOBLE
OLAM
VITOL
Commodity trading is one of the oldest forms
of human activity. It is central to the global economy.
Yet up to now there has been remarkably little
research into this important area.
The Economics of Commodity Trading Firms
through a combination of description and analysis.
Professor Pirrong employs a variety of economic concepts

to investigate the dynamics of the commodity trading business.
His analysis produces valuable insights into the nature
of the business, and the economic role and social relevance
of commodity trading firms.
TD/0062.2e
SPECIAL
SUPPLEMENT
to the April 2011 Oil Market Report
The Mechanics of the

Derivatives Markets
What They Are and How They Function
April 2011

PREFACE

This supplement to the April 2011 OMR is designed as a reference document for member
governments and subscribers. It forms part of an ongoing work programme examining the
mechanics of oil price formation and the interactions between the physical and paper markets.
Further research will be forthcoming in the OMR, the MTOGM and in the form of stand‐alone
papers in months to come. The work programme is being supported by contributions from
member governments, most notably those from Japan and Germany. We are grateful for that
support. Further impetus for this work comes from the joint work programme the IEA is
undertaking alongside the IEF and OPEC secretariats, as requested by IEF, G8 and G20 Ministers.
The work is overseen by David Fyfe, and the supplement’s main author is Bahattin Buyuksahin,
to whom all enquiries should be addressed.

TABLE OF CONTENTS
1. INTRODUCTION TO DERIVATIVES ................................................................................................... 4

1.1 Basics of Derivatives ............................................................................................................................. 5
1.2 Types of Derivatives ............................................................................................................................. 6
1.3 History of Derivatives Markets .......................................................................................................... 6
1.4 The Markets ........................................................................................................................................... 7
1.5 Types of Market Participants in Derivatives Markets ................................................................... 8
1.5.1 Hedgers ............................................................................................................................................ 8
1.5.2 Speculators ...................................................................................................................................... 9
1.5.3 Swap Dealers and Commodity Index Traders ...................................................................... 10
2. FORWARDS AND FUTURES................................................................................................................ 12

2.1 Forward Contracts ............................................................................................................................. 12
2.2 Futures ................................................................................................................................................... 14
2.2.1 Contract Specifications............................................................................................................... 15
Box 1: Grade and Quality Specifications of WTI Contract ........................................................... 16
2.2.2 The Clearinghouse Margins ....................................................................................................... 17
2.2.3 Settlement Price, Volume and Open Interest in Futures Markets ................................... 19
2.2.4 Types of Orders........................................................................................................................... 20
2.3 Hedging Using Futures Contracts ................................................................................................... 20
2.4 Basis Risk ............................................................................................................................................... 22
3. SWAPS ......................................................................................................................................................... 23
3.1 Mechanics of Swaps ............................................................................................................................ 26
4. OPTIONS .................................................................................................................................................... 28
4.1 Call Option ........................................................................................................................................... 29
4.2 Put Option ............................................................................................................................................ 32
4.3 “Moneyness” of Options ................................................................................................................... 33
4.4 Hedging Using Options ...................................................................................................................... 34
5. REFERENCES.............................................................................................................................................. 35
6. GLOSSARY OF THE DERIVATIVES MARKET TERMS....................................................................... 36

1. I NTRODUCTION TO D ERIVATIVES I NTERNATIONAL E NERGY A GENCY ‐ T HE M ECHANICS OF THE D ERIVATIVES M ARKETS
1. INTRODUCTION TO DERIVATIVES

In the last thirty years, the world of finance and capital markets has experienced a quite spectacular
transformation in the derivatives markets. Futures, options and swaps, as well as other structured
financial products, are now actively traded on many exchanges and over‐the‐counter (OTC) markets
throughout the world, not only by professional traders but also by retail investors, whose interest in
these derivatives has increased.

Derivatives are financial instruments whose returns are derived from those of another financial
instrument. As opposed to spot (cash) markets, where the sale is made, the payment is remitted, and the
good or security is delivered immediately or shortly thereafter, derivatives are markets for contractual
instruments whose performance depends on the performance of another instrument, the so‐called
underlying instrument. For example, a crude oil futures is a derivative whose value depends on the price
of crude oil.

Derivatives contracts play a very important role in managing the risk of underlying securities such as
commodities, bonds, equities and equity indices, currencies, interest rates or liability positions.
Commodity derivatives are traded in agricultural products (corn, wheat, soybeans, soybean oil), livestock
(live cattle, pork bellies, lean hogs); precious metals (gold, silver, platinum, palladium); industrial metals
(copper, zinc, aluminum, tin, nickel); soft commodities (cotton, sugar, coffee, cocoa); forest products
(lumber and pulp); and energy products (crude oil, natural gas, gasoline, heating oil, electricity). Financial
derivatives, where in many cases no delivery of the physical security is involved, are traded on stocks and
stock indices (single stocks, S&P 500, Dow Jones Industrials); government bonds (US Treasury bonds,
US Treasury notes); interest rates (EuroDollars) and foreign exchanges (Euro, Japanese Yen,
Canadian Dollar). In recent years, new derivatives instruments have been devised, which are different
from the more traditional instruments, as the underlying asset of these derivatives is no longer
necessarily a liquid, marketable good. For example, derivatives trading has begun on weather and
credit risk.

The derivatives market as a whole, and over‐the‐counter markets in particular, has recently attracted
more attention after the onset of the financial crisis in 2008. In this report, we will look at the main
building blocks of derivatives markets, including forwards, futures, swaps and options markets.

4 A PRIL 2011
I NTERNATIONAL E NERGY A GENCY ‐ T HE M ECHANICS OF THE D ERIVATIVES M ARKETS 1. I NTRODUCTION TO D ERIVATIVES
1.1 Basics of Derivatives

Derivatives contracts get their name from the fact that they are “derived from” some other “underlying”
claim, contract, or asset. For instance, a crude oil forward contract is “derived from” the underlying
physical asset—crude oil. Derivatives are also called “contingent claims.” This term reflects the fact that
their payoff—the cash flow—is contingent upon the price of something else. Going back to the crude oil
forward contract example, the payoff to a crude oil forward contract is contingent upon the price of
crude oil at the expiration of the contract.

Hedgers, speculators and arbitrageurs use derivatives instruments for different purposes. Hedgers use
derivatives to eliminate uncertainty by transferring the risk they face from potential future movement in
prices of the underlying asset. In this regard, derivatives serve as an insurance or risk management tool
against unforeseen price movements. Speculators, on the other hand, use these instruments to make
profits by betting on the future direction of market prices of the underlying asset. Therefore, derivatives
can be used as an alternative to investing directly in the asset without buying and holding the asset itself.
Arbitrageurs use derivatives to take offsetting positions in two or more instruments to lock in a profit.

In addition to risk management, derivatives markets play a very useful economic role in price discovery.
Price discovery is the process of which market participants (buyers and sellers) uncover an asset’s full
information or permanent value, and then disseminate those prices as information throughout the
market and the economy as a whole. Thus, market prices are important not only for those buying and
selling the asset or commodity but also for the rest of the global market’s participants (consumers or
producers) who are affected by the price level.

In summary, two of the most important functions of derivatives markets are the transfer of risk and price
discovery. In a well‐functioning futures market, hedgers, who are trying to reduce their exposure to price
risk, will trade with someone, generally a speculator, who is willing to accept that risk by taking opposing
positions. By taking the opposing positions, these traders facilitate the needs of hedgers to mitigate their
price risk, while also adding to overall trading volume, which contributes to the formation of liquid and
well‐functioning markets.

A PRIL 2011 5
1.2 Types of Derivatives

There are four major types of derivatives instruments. In some respects, these may be regarded as
building blocks and can be categorised as follows:
• Forwards
• Futures
• Swaps
• Options
Each instrument has its own characteristics, which offers advantages in using them, but also brings
disadvantages, which are discussed later in the text.

1.3 History of Derivatives Markets
Although derivatives are frequently considered to be something new and exotic, they have been around
for millennia. There are examples of derivative contracts in Aristotle’s works and the Bible. It is true,
however, that the use of financial derivatives has been growing since 1980s.

The origins of derivatives trading dates back to 2000 B.C. when merchants, in what is now called Bahrain

in the Middle East, made consignment transactions for goods to be sold in India. Derivatives contracts,
dating back to the same era, have also been found written on clay tablets from Mesopotamia, when
farmers borrowed barley from the King’s daughter by promising to return it at harvest time. This trade
can either be considered as a commodity loan or as a short‐selling operation. It is a commodity loan
because farmers borrowed barley in order to use it for planting the crop and they promised to return it
after harvesting. Of course, it is a short‐selling trade since farmers do not have any barley at the time of
contract agreement.1

A more literary reference comes some 2 350 years ago from Aristotle, who discussed a case of
manipulation call option style investment on olive oil presses. In Politics, Aristotle told the story of a
trader, who buys exclusive right to use olive oil presses in the upcoming harvest from the owners of this
equipment. The trader paid some down payment for this right. During the harvesting season, the
demand for olive oil presses rose as predicted by the trader and he sold his right to use this equipment
to other parties. In the meantime, the trader made a profit without actually being in the olive oil
production business. The trader’s trade carried only his down‐payment (option premium) as a risk; on
the other hand, owners of olive oil presses transferred some of the risks associated with the possibility of
a bad crop season to the trader.
1
See Weber (2008) for a detailed excellent review of the history of derivatives markets.

6 A PRIL 2011
Derivatives trading in an exchange environment and with trading rules can be traced back to Venice in

the 12th century. Forward and options contracts were traded on commodities, shipments and securities

in Amsterdam after 1595. The first standardised futures contract can be traced to the Yodoya rice market
in Osoka, Japan around 1700. In the US, forward and futures contracts of agricultural products such as
wheat and corn have been formally traded on the Chicago Board of Trade2 (CBOT) since 1848. The CBOT
initially offered forward contracts on agricultural commodities. In 1865, the first standardised futures
contracts were introduced on the CBOT floor. The Chicago Mercantile Exchange (CME) was established in
1919 to offer futures contracts on livestocks and agricultural products. The CME has increased the
number of contracts listings over time and is now best known worldwide for its financial products,
including its flagship Eurodollar contract.

1.4 The Markets
There are basically two types of markets in which derivatives contracts trade. These are exchange traded
markets and over‐the‐counter (OTC) markets. Regulated exchanges, since their inception in the
mid‐1800s until recently, have been the main venue on which producers and large‐scale consumers of
commodities hedge their risk against fluctuations in market prices, while allowing speculators to make
profits by anticipating these fluctuations. Exchange‐traded derivatives are fully standardised and their
contract terms are designed by derivatives exchanges.

However, due to standardisation and fixed contract specifications in exchange‐traded contracts, financial
institutions began to develop non‐exchange‐traded (or over‐the‐counter, OTC) derivatives contracts.
Instruments in the OTC markets are generally privately negotiated between market makers (or so‐called
swap dealers) and their clients. Unlike exchange traded products, OTC instruments can be customised to
fit clients’ needs. These instruments, like standardised futures contracts, can be used by hedgers to
hedge their exposure to the physical asset itself, or by speculators to make speculative profits if prices of
the underlying asset move in an expected direction.

According to the latest Bank of International Settlements (BIS) survey, the total notional value of all OTC
derivatives reached $583 trillion at end‐June 2010, of which $2.85 trillion (0.5%) was in commodity‐
related derivatives. At their peak in end‐June 2008, the total notional value of commodity‐related
derivatives had reached $13 trillion, or 2% of the total market. The total notional value of all exchange‐
traded derivatives contracts exceeded $90 trillion at that time.

2
CBOT merged with CME in 2007.
A PRIL 2011 7
Figure 1: Size of Over‐the‐Counter and Exchange Traded Derivatives Markets
800
Size of Markets ($ trillion)
700
600
500
400
OTC
300
200 Exchange
100
0

1.5 Types of Market Participants in Derivatives Markets
Trading participants in derivatives markets can be placed into three basic categories as we mentioned
earlier: (1) hedgers (2) speculators and (3) arbitrageurs. In addition to these three broad categories, swap
dealers and commodity index traders are important types of market participants and have been
centre‐stage during the recent debate on financial regulations. We discuss swap dealers and their
business in details in Section 3.

1.5.1 Hedgers
Hedgers use derivatives markets to offset the risk of prices moving unfavourably for their ongoing
business activities. Hedgers, including both producers (oil producers, farmers, refiners, etc) and
consumers (airlines, refiners, etc), hold positions in both the underlying commodity and in the futures (or
options) contracts on that commodity. A long futures hedge is appropriate when you know you will
purchase an asset in the future and want to lock in the price. A short futures hedge is appropriate when
you know you will sell an asset in the future and want to lock in the price. By hedging away risks that you
do not want to take, you can take on more risks that you want to take while maintaining desired/target
aggregate risk levels.

For example, an oil producer can hedge against declines in oil price by selling an oil futures contract (taking
a short position) on the exchange in light of its oil position, which is naturally long, in the physical market. If
the price of oil increases over time, the profits from the actual sale of oil are offset by losses from holding
the futures contract. On the other hand, if prices decline over time, oil producers can offset their losses
from the actual sale of oil from selling their short position in the futures market. Basically, whatever
happens to prices, hedgers are guaranteed to have constant profit.

8 A PRIL 2011
Hedgers, who hold short positions in the physical market, take long positions in the paper market to limit
the risk associated with fluctuations in underlying asset prices. For example, an airline company can
hedge against a rise in oil prices by buying oil futures contracts (taking a long position) on the exchange
for the oil required to operate its business activities (the airline company position is short in the
physical market).

Some hedgers might be both producers and consumers in some related commodities. For example,
refiners use crude oil to produce petroleum products. Crude oil is refined to make petroleum products,
in particular heating oil and gasoline. The split of oil into its different components is frequently achieved
by a process known as “cracking”, hence the difference in price between crude oil and equivalent
amounts of heating oil and gasoline is called a crack spread. Therefore, refiners can take positions in
crack spreads.3

1.5.2 Speculators
Speculators, on the other hand, use derivatives to seek profits by betting on the future direction of
market prices of the underlying asset. Hedge funds, financial institutions, commodity trading advisors,
commodity pool operators, associate brokers, introducing brokers, floor brokers and traders are all
considered to be speculators. In the CFTC’s Commitment of Traders report, hedge funds, commodity
pool operators, commodity trading advisors and associate persons constitute managed money traders.
Speculators use derivatives instruments to make profits by betting on the future direction of market
prices of the underlying asset. Traditional speculators can be differentiated based upon the time
horizons during which they operate. Scalpers, or market makers, operate at the shortest time horizon –
sometimes trading within a single second. These traders typically do not trade with a view as to where
prices are going, but rather ‘make markets’ by standing ready to buy or sell at a moment’s notice. The
goal of a market maker is to buy contracts at a slightly lower price than the current market price and sell
3
The following discussion of crack spread contracts comes from the Energy Information Administration publication Derivatives and Risk
Management in the Petroleum, Natural Gas, and Electricity Industries.
“Refiners’ profits are tied directly to the spread, or difference, between the price of crude oil and the prices of refined products. Because
refiners can reliably predict their costs other than crude oil, the spread is their major uncertainty. One way in which a refiner could ensure a
given spread would be to buy crude oil futures and sell product futures. Another would be to buy crude oil call options and sell product put
options. Both of those strategies are complex, however, and they require the hedger to tie up funds in margin accounts. To ease this burden,
NYMEX in 1994 launched the crack spread contract. NYMEX treats crack spread purchases or sales of multiple futures as a single trade for the
purposes of establishing margin requirements. The crack spread contract helps refiners to lock‐in a crude oil price and heating oil and unleaded
gasoline prices simultaneously in order to establish a fixed refining margin. One type of crack spread contract bundles the purchase of three
crude oil futures (30 000 barrels) with the sale a month later of two unleaded gasoline futures (20 000 barrels) and one heating oil future
(10 000 barrels). The 3‐2‐1 ratio approximates the real‐world ratio of refinery output—2 barrels of unleaded gasoline and 1 barrel of heating oil
from 3 barrels of crude oil. Buyers and sellers concern themselves only with the margin requirements for the crack spread contract. They do not
deal with individual margins for the underlying trades. An average 3‐2‐1 ratio based on sweet crude is not appropriate for all refiners, however,
and the OTC market provides contracts that better reflect the situation of individual refineries. Some refineries specialize in heavy crude oils,
while others specialize in gasoline. One thing OTC traders can attempt is to aggregate individual refineries so that the trader’s portfolio is close
to the exchange ratios. Traders can also devise swaps that are based on the differences between their clients’ situations and the
exchange standards.”
A PRIL 2011 9
them at a slightly higher price, perhaps at only a fraction of a cent profit on each contract. Skilled market
makers can profit by trading hundreds or even thousands of contracts a day. Market makers provide
immediacy to the market. Without a market maker, another market participant would likely have to wait
longer until the arrival of a counterparty with an opposite trading interest.

Other types of speculators take longer‐term positions based on their view of where prices may be
headed. “Day traders” establish positions based on their views of where prices might be moving within
minutes or hours, while “trend followers” take positions based on price expectations over a period of
days, weeks or months. These speculators can also provide liquidity to hedgers in futures markets.
Through their efforts to gather information on underlying commodities, the activity of these traders
serves to bring information to the markets and aid in price discovery.

1.5.3 Swap Dealers and Commodity Index Traders
Instruments in the OTC markets are generally privately negotiated between market makers (or so‐called
swap dealers) and their client. The party offering the swap, or swap dealer, takes on any price risks
associated with the swap and thus must manage the risk of the commodity exposure. The counter‐
parties to swap dealers are generally hedgers, speculators or commodity index traders.

Investor interest in commodities, including oil, has risen quite dramatically over the last decade and
commodities have become a new asset class in institutional investors’ portfolio. Partly, this development
is due to diversification benefits. In addition, the development of new investment vehicles, such as
exchange‐traded funds, has allowed individual investors to get exposure to movements in commodity
prices. Due to the storage and trading costs associated with direct physical investment in commodities,
the main vehicle used by investors to gain exposure to commodities is via commodity indices (baskets of
short‐maturity commodity futures contracts that are periodically rolled as they approach expiry),
exchange‐traded funds or other structured products. These instruments provide generally long‐only
exposure to commodities. The vast majority of commodity index trading by principals is conducted off‐
exchange using swap contracts.

The main goal of commodity index funds is to track the movement of commodity prices. There exist
several major commodity indices as well as sub‐indices. Standard and Poors’ GSCI (formerly the Goldman
Sachs Commodity Index) is the oldest and most widely tracked index in the market. The S&P GCSI, first
10 A PRIL 2011

created in 1991, covers 24 commodities but is heavily tilted toward energy because its weights reflect
world production figures. For example, in 2010, energy markets received almost 72% weight.

Investors are exposed to three sources of returns in total‐return commodity index investments. The first
type is the yield on the underlying commodity futures. The second type is the roll return, which is
generated from the rolling of nearby futures into first deferred contracts. Depending on whether the
forward curve is in contango (when longer‐dated futures prices are higher than nearby contracts) or,
conversely, in backwardation (when nearby prices are higher than longer‐dated futures prices), the roll
yield is either negative (in contango) or positive (in backwardation). The third type is the T‐bill return,
which is the return on collateral. Historically, the roll return has constituted the largest contributor in
total return. However, the roll return component has been negative since 2005 for the S&P GSCI Total
Return Index due to the contango market we observe in crude oil futures markets.

Institutional investors generally gain exposure to commodity prices through their investment in a fund
that tracks a popular commodity index. The fund managers themselves either directly offset their
resulting short positions by going long in futures markets or by entering swap agreements with a swap
dealer. In turn, swap dealers in the OTC market generally go long or short in the futures market to offset
their net long (or short) position. Of course, the client base of swap dealers also includes
traditional hedgers.
A PRIL 2011 11

2. F ORWARDS AND F UTURES I NTERNATIONAL E NERGY A GENCY ‐ T HE M ECHANICS OF THE D ERIVATIVES M ARKETS
2. FORWARDS AND FUTURES

2.1 Forward Contracts
A forward contract is an OTC agreement between two parties to exchange an underlying asset:
• for an agreed upon price (the forward price or the delivery price)
• at a given point in time in the future (the expiry date or maturity date)
Since it is traded between two parties in the over‐the‐counter market, there is a small possibility that
either side can default on the contract. Therefore, forward contracts are mainly between big institutions
or between a financial institution and one of their clients. Forward contracts are most popular in
currency and interest rates markets.

The party that has agreed to buy the underlying asset has a long position. The party that has agreed to
sell the underlying asset has a short position. By signing a forward contract, one can lock in a price
ex ante for buying or selling a security. Ex post, whether one gains or loses from signing the contract
depends on the spot price at expiry. If the price of the underlying asset rises, then the party who has a
long position in the contract gains while the party who has a short position loses.

Example 1: A commodity contract
Trader A agrees to sell to Trader B one million barrels of WTI crude oil at the price of $100/bbl
with delivery in six months. In this forward contract, WTI crude oil is the underlying asset. Trader
A is said to be short the contract, since he must deliver oil in six months. Trader B is said to be
long the contract, since he receives the delivery of oil in six months.

If at the end of six months the price of oil is at $110, then the trader with a long position has a
profit of $10 000 000 and the trader with a short position loses $10 000 000. On the other hand,
if the price of oil is $95 at the end of six months, then the trader with a long position loses
$5 000 000 and the one with a short position has a profit of $5 000 000.

Example 2: A foreign exchange contract
On 18 February 2011, Party A signs a forward contract with Party B to sell one million
British pounds (GBP) at $1.6190 per GBP six months later.
Today (18 February 2011), sign a contract, shake hands. No money changes hands.
Party A entered a short position and Party B entered a long position on GBP.
12 A PRIL 2011

I NTERNATIONAL E NERGY A GENCY ‐ T HE M ECHANICS OF THE D ERIVATIVES M ARKETS 2. F ORWARDS AND F UTURES
But since it is on exchange rates, we can also say: Party A entered a long position
and Party B entered a short position on USD.
18 August 2011 (the expiry date), Party A pays one million GBP to Party B, and
receives 1.6190 million USD from Party B in return.
Currently (18 February, the spot price for the pound (the spot exchange rate) is
1.6234. Six months later (18 August 2011), the exchange rate can be anything
(unknown).
$1.6190 per GBP is the forward price.

The forward price for a contract is the delivery price that would be applicable to the contract if it
were negotiated today. It is the delivery price that would make the contract worth exactly zero.

In the previous example, Party A agrees to sell one million pounds at $1.6190 per GBP at expiry.
If the spot price is $1.61 at expiry, what is the profit and loss (P&L) for party A?
On 18 August 2011, Party A can buy one million GBP from the market at the spot
price of $1.61 and sell it to Party B per forward contract agreement at $1.6190.
The net P&L at expiry is the difference between the strike price (K = 1.6190) and
the spot price (ST = 1.61), multiplied by the notional value (one million). Hence,
the profit is $9 000.

The primary use of a forward contract is to lock in the price at which one buys or sells a
particular good in the future. This implies that the contract can be utilised to manage price risk.
Forward contracts can be used to hedge against unforeseen movement in market prices.
Consider an airline company which is going to buy 100 000 barrels of oil one year from today.
Suppose that forward price for delivery in one year is $100/bbl. Suppose that the yield on a one‐
year and zero‐coupon bond is 5%. The airline company can use a forward contract to guarantee
the cost of buying oil for the next year. The present value of this cost will be 100/1.05=95.24. The
airline company could invest this amount to buy oil in one year or it could pay an oil supplier
$100 at the delivery of the oil. If the spot price at the end of one year is above the agreed
forward price, the airline company gains from this hedging. If the spot price at maturity is below
the forward price, it would lead to the airline company to pay more than the market price of oil.
Regardless of the spot price at the delivery, the airline company protects itself from potential
loss and eliminates uncertainty regarding price movements.

A PRIL 2011 13

2.2 Futures
Like a forward contract, a futures contract is a binding agreement between a seller and a buyer to make
(seller) and to take (buyer) delivery of the underlying commodity (or financial instrument) at a specified
future date with agreed upon payment terms. Unlike forward contracts:
• Futures contracts are standardised and exchange‐traded.
• Default risk is borne by the exchange clearinghouse.
• Traders are allowed to reverse (‘offset’) their positions, so that physical delivery is rare (futures
can be used to trade in the risk, not the commodity). This is true because most hedgers are not
dealing in the commodity deliverable against the futures contract. For instance, an airline
company is not going to use WTI crude oil in Cushing, Oklohama, for its operation, but may use
the WTI futures contract as a hedge. That is, most hedgers are “cross hedgers”. Similarly,
speculators are just betting on price movement, and have no interest in owning the physical oil.
Therefore, most hedgers and speculators reverse their position prior to delivery.
• Value is marked to market daily.
• Different execution details also lead to pricing differences, e.g., effect of marking to market on
interest calculation.

Table 2.1 : Comparison Between Forward and Futures Contracts
FORWARDS FUTURES
Private contracts between two parties Exchange traded
Non‐standard contract Standard contract
Usually one specified delivery date Range of delivery dates
Settled at the end of the contract Settled daily
Delivery or final cash settlement usually occurs Delivery is rare, usually parties offset their
position before maturity
Some credit risk Virtually no credit risk

The fact that futures contracts terms are standardised is important because it enables traders to focus
their attention on one variable, namely price. Standardisation also makes it possible for traders
anywhere in the world to trade in these markets and know exactly what they are trading. This is in sharp
contrast to the cash forward contract market, in which changes in specifications from one contract to
another might cause price changes from one transaction to another.
14 A PRIL 2011

2.2.1 Contract Specifications

One of the main differences between forward contracts and futures contracts is the fact that futures
contracts are standardised. When an exchange introduces a new contract, it has to specify in some detail
the exact nature of the asset, the contract size, delivery point, delivery time, and settlement type
(physical delivery or cash settlement).

The underlying asset in the futures contract can be anything, ranging from commodities to stock indices,
equities, bond, foreign exchange, interest rate, and so on. However, the exchange has to specify the
exact terms in identifying the contract. The financial assets in futures contracts are well defined and
there is no ambiguity. However, in the case of commodities, there may be quite a variation in the quality
of what is available in the marketplace. When the asset is specified, the exchange has to specify in detail
grade or grades of commodity that are acceptable for delivery. For example, the Chicago Mercantile
Exchange (CME) deliverable grade specification of the WTI futures contract is presented in Box 1.

Standardisation of futures contracts also requires the specification of the delivery point and the contract
size (amount of asset that has to be delivered under one contract). For example, under the WTI futures
contracts traded on the CME, delivery can be made F.O.B. at any pipeline or storage facility in Cushing,
Oklahoma with pipeline access to TEPPCO, Cushing storage or Equilon Pipeline Company LLC Cushing
storage. The contract size, on the other hand, is 1 000 US barrels (42 000 US gallons) of WTI crude oil.

Futures contracts are also standardised with respect to the delivery month. The exchange must specify
the precise period during the month when delivery can be made. The exchange also specifies when
trading in a particular month’s contract will begin, the last day on which trading can take place for a
given contract as well as the delivery months. For example, CME WTI crude oil futures are listed nine
years forward using the following listing schedule: consecutive months are listed for the current year and
the next five years; in addition, the June and December contract months are listed beyond the sixth year.
Additional months will be added on an annual basis after the December contract expires, so that an
additional June and December contract would be added nine years forward, and the consecutive months
in the sixth calendar year would be filled in.

Even though physical delivery does not occur on most contracts, delivery is important nonetheless.
Delivery ties the price of the expiring futures to the price of the physical commodity at delivery.
Nonetheless, cash settlement can be considered another way to tie the futures and cash markets
together. In a cash‐settled contract, at expiration the buyer pays the seller the difference between the
fixed price established in the contract and the reference price prevailing on payment.

A PRIL 2011 15


Box 1: Grade and Quality Specifications of WTI Contract (Source CME)
Light sweet crude oil meeting all of the following specifications and designations shall be
deliverable in satisfaction of futures contract delivery obligations under this rule:
(A) Domestic Crudes, (Deliverable at Par)
• Deliverable Crude Streams
West Texas Intermediate
Low Sweet Mix (Scurry Snyder)
New Mexican Sweet
North Texas Sweet
Oklahoma Sweet
South Texas Sweet
Blends of these crude streams are only deliverable if such blends constitute a
pipeline's designated “common stream” shipment which meets the grade and
quality specifications for domestic crude. TEPPCO Crude Pipeline, L.P.'s and
Equilon Pipeline Company LLC's Common Domestic Sweet Streams that meet
quality specifications in Rule 200.12(A)(2‐7) are deliverable as Domestic Crude.
• Sulfur: 0.42% or less by weight as determined by A.S.T.M. Standard D‐4294, or its
latest revision; (3) Gravity: Not less than 37 degrees API, nor more than 42
degrees API as determined by A.S.T.M. Standard D‐287, or its latest revision;
• Viscosity: Maximum 60 Saybolt Universal Seconds at 100 degrees Fahrenheit as
measured by A.S.T.M. Standard D‐445 and as calculated for Saybolt Seconds by
A.S.T.M. Standard D‐2161;
• Reid vapor pressure: Less than 9.5 pounds per square inch at 100 degrees
Fahrenheit, as determined by A.S.T.M. Standard D‐5191‐96, or its latest revision;
• Basic Sediment, water and other impurities: Less than 1% as determined by
A.S.T.M. D‐96‐88 © or D‐4007, or their latest revisions;
• Pour Point: Not to exceed 50 degrees Fahrenheit as determined by A.S.T.M.
Standard D‐97.
(B) Foreign Crudes
• Deliverable Crude Streams
U.K.: Brent Blend (for which seller shall be paid a 30 cent per barrel discount
below the last settlement price)
Nigeria: Bonny Light (for which seller shall be paid a 15 cent per barrel
premium above the last settlement price)
Nigeria: Qua Iboe (for which seller shall be paid a 15 cent per barrel premium
above the last settlement price)
Norway: Oseberg Blend (for which seller shall be paid a 55 cent per barrel
discount below the last settlement price)
Colombia: Cusiana (for which seller shall be paid 15 cent per barrel premium
above the last settlement price)
• Each foreign crude stream must meet the following requirements for gravity and
sulfur, as determined by A.S.T.M. Standards referenced in Rule 200.12(A)(2‐3):
Foreign Crude Stream
Minimum Gravity Maximum Sulfur
Brent Blend 36.4 API 0.46%
Bonny Light 33.8 API 0.30%
Qua Iboe 34.5 API 0.30%
Oseberg Blend 35.4 API 0.30%
Cusiana 34.9 API 0.40%
16 A PRIL 2011

2.2.2 The Clearinghouse Margins

Clearing is the process by which trades in futures and options are processed, guaranteed, and settled by
an entity known as a clearing house. A complete clearing house acts as the central counterparty to and
guarantor of all trades that it has accepted for clearing from its clearing members. The clearing house
“becomes the buyer to every seller and the seller to every buyer” through a process known as
“novation.” The exchange clearing house intermediates all futures transactions. The credit status of the
counterparty becomes irrelevant and contracts become fungible. A transactor needs only to worry about
the credit status of the clearing house.

Clearing houses have a legal relationship only with entities that they have been admitted as clearing
members. That is to say, clearing houses have no legal relationship with the customers of their clearing
members. Clearing members are generally institutions such as futures commission merchants and
broker/dealers that have the financial, risk management, and operational capabilities to function as
clearing members.

Clearing houses perform the following duties:
• Match, guarantee, and settle all trades and register positions resulting from such trades.
• Perform mark‐to‐market calculations of all open positions at least once a day and oversee
the resulting cash flows between clearing member firms.
• Manage the risk exposure that clearing firms present to the clearing house.
• Perform the exercise and assignment of options contracts.
• Facilitate, but not guarantee, the delivery of physical commodities.
• Permit multilateral netting of positions and settlement payments.
• Assuming contracts are fungible (interchangeable), clearing houses offset positions.
• Enable clearing members to substitute the credit and risk exposure of the clearing house for
the credit and risk exposure of each other.
• Maintain a package of financial safeguards that are designed to mitigate losses in the event a
clearing member defaults on its obligations to the clearing house.
• In the event of such a default, meet the obligations of the defaulter by first utilising the
collateral pledged to it by the defaulter.
• If such collateral is insufficient to cover the entire amount of the defaulted amount, then
utilise the components of its financial safeguards package to take care of the remaining
defaulted amount.

A PRIL 2011 17

One of the key safeguards in the risk management systems of futures clearing organisations is the
requirement that market participants post collateral, known as margin, to guarantee their performance
on contract obligations. In contrast to the operation of credit margins in the stock market, a futures
margin is not a partial payment for the position being undertaken. Instead, the futures margin is a
performance bond which serves as collateral or as a “good faith” deposit given by the trader to the
broker. Minimum levels for initial and maintenance margins are set by the exchange. However, futures
commission merchants (FCM) have the right to demand higher margins from their customers.

In a traditional futures market, contracts are margined under a risk‐based margining system, which is
called SPAN. Portfolio margining systems evaluate positions as a group and determine margin
requirements based on the estimates of changes in the value of the portfolio that would occur under
assumed changes in market conditions. Margin requirements are set to cover the largest portfolio loss
generated by a simulation exercise that includes a range of potential market conditions.

Marking to market ensures that futures contracts always have zero value; hence the clearing house does
not face any risk. Marking to market takes place through margin payments. At the inception of the
contract, each party pays an initial margin (typically 10% of the value contracted) to a margin account
held by its broker. Initial margin may be paid in interest‐bearing securities (T‐bills) so there is no interest
cost. If the futures price rises (falls), the longs have made a paper profit (loss) and the shorts a paper loss
(profit). The broker pays losses from and receives any profits into the parties’ margin accounts on the
morning following trading. Loss‐making parties are required to restore their margin accounts to the
required level during the course of the same day by payment of variation margins in cash; margin in
excess of the required level may be withdrawn by profit‐making parties.

For example, the initial margin for one WTI futures contract is $5 000 and the maintenance margin
requirement is $3 750 per contract. Consider the following example. Trader X bought a
10 September 2011 delivery NYMEX crude oil futures contract. Suppose that the current price is $100
(18 February 2011). The broker will require the investor to deposit an initial margin of $50 000 in the
margin account. At the end of each day, the margin account is adjusted to reflect the investor’s gain or
loss. This practice is known as marking to market the account. Whenever the margin account exceeds or
falls below the maintenance margin ($3 750 in our example), then the customer receives a margin call
from its broker (or broker receives a margin call from the exchange). If the margin account exceeds the
maintenance margin, the investor is entitled to withdraw any balance in the margin account in excess of
18 A PRIL 2011

the initial margin and whenever it is below the maintenance level, the customer has to deposit to bring
the margin account to its initial margin level. The extra funds deposited are known as a variation margin.

Basically, if there is a price decline the investor who has a long position has to deposit extra funds, so
called variation margin, to bring the margin account to the initial level. On the other hand, the seller of
the contract account will be credited.

In practice, there is actually a chain of margins. Traders post margins with brokers. Non‐clearing brokers
post margins with clearing brokers. Clearing brokers post margins with the clearinghouses. The margin
posted by clearinghouse members with the clearinghouse is known as a clearing margin. However, in the
case of clearinghouse member, there is an original margin but no maintenance margin.

Table 2.2 : The following table summarises price changes and margin account.
Daily Gain or Cumulative Margin Account
Day Futures Prices of WTI Crude Oil ($/bbl) Margin Call
(loss) Gain (Loss) Balance
18‐Feb 100 50 000

21‐Feb 99.5 ‐5 000 ‐5 000 45 000
22‐Feb 98 ‐15 000 ‐20 000 30 000 20 000
23‐Feb 99 10 000 ‐10 000 60 000
24‐Feb 98.5 ‐5 000 ‐15 000 55 000
25‐Feb 97 ‐15 000 ‐30 000 40 000
28‐Feb 95 ‐20000 ‐50 000 20 000 30 000
01‐Mar 95 0 ‐50 000 50 000
02‐Mar 99 40 000 ‐10 000 90 000
03‐Mar 99 0 ‐10 000 90 000
04‐Mar 100 10 000 0 100 000

2.2.3 Settlement Price, Volume and Open Interest in Futures Markets
The settlement price is the average of the prices at which the contract traded immediately before the
end of trading for the day. The settlement price is very important since it is used to determine margin
requirements and the following day's price limits.

Volume in futures market represents the total amount of trading activity or contracts that have changed
hands in a given commodity market for a single trading day. On the other hand, open interest is the total
A PRIL 2011 19

number of contracts outstanding that are held by market participants at the end of each day. A contract is
created by a seller and buyer of contract, therefore open interest can be calculated as the sum of all the
long positions (or equivalently it is the sum of all the short positions). Open interest will increase by one
contract if both parties to the trade are initiating a new position (one new buyer and one new seller) and
open interest will decrease by one contract if both traders are closing an existing or old position (one old
buyer and one old seller). However, if one old trader is passing off his position to a new trader (one old
buyer sells to one new buyer), open interest will not change.

2.2.4 Types of Orders
The simplest type of order placed with a broker is a market order. A market order is an order to buy or
sell a futures contract at whatever price is obtainable at the time it is entered in the ring, pit, or other
trading platform. However, there are many other types of orders. Most commonly used orders are the
limit order, and the stop order or stop‐loss order.

A limit order is an order in which the customer specifies a minimum sale price or maximum purchase
price, as contrasted with a market order, which implies that the order should be filled as soon as possible
at the market price. Thus, if the limit price is $95/bbl for one April WTI contract for an investor wanting
to sell, the order will be executed only at a price of $95/bbl or more. As opposed to a market order, a
limit order will not be executed unless the price reaches $95/bbl.

A stop order or stop‐loss order is an order that becomes a market order when a particular price level is
reached. A sell stop is placed below the market; a buy stop is placed above the market. The purpose of a
stop order is to close out a position if unfavorable price movements take place.

2.3 Hedging Using Futures Contracts 4

Traditionally, many of the market participants in futures markets were hedgers. Hedgers use futures
markets to reduce particular risks arising from fluctuations in the price of the underlying asset. Of course,
it might not be possible to eliminate the risks completely due to basis risk, which we discuss later in the
text. For the time being, we assume the possibility of a perfect hedge, which completely eliminates the
risk. A hedge might involve taking a long position (long hedge) or a short position (short hedge) in the
futures contract.

4
Futures contracts can be used in similar fashion for speculation purposes as well.
20 A PRIL 2011

A long hedge is appropriate when a company knows it will have to purchase a certain asset in the future
and wants to lock in a price now. For example, an airline company knows that it will require
100 000 barrel of crude oil on 1 July 2011 for its flight operations. The spot price of oil is $95/bbl, and the
future price for July delivery (July is the delivery month for June contract) is $99/bbl. In order to avoid
any risk associated with price change between now and July, the airline company can buy crude oil now
at $95/bbl and store it until July. In this case, the airline company has to pay storage costs as well as
interest costs. Alternatively, it can hedge its position by taking a long position in one hundred CME WTI
June futures contracts (each contract is for delivery of 1 000 barrels of crude oil) and closing its position
before the expiration by selling one hundred such contracts.

Suppose that the spot price of oil on 1 July is $102/bbl, which should be very close to the future price.
The airline gains from futures contracts approximately
100 000×($102‐$99)=$300 000
In July, the airline pays $102×100 000=$10 200 000 for the crude oil, making the net cost approximately
$9 900 000. On the other hand, if the spot price in July turned out to be $90/bbl, then the airline
company loses from its futures contract approximately
100 000×($99‐$90)=$900 000
and pays $90×100 000=$9 000 000 for the crude oil in the spot market. Again here, the total net cost of
the oil for the airline company would be $9 900 000. No matter what happens to the spot price in July,
entering into a futures contract allows the airline company to fix its net cost to the number of oil barrels
times the price per barrel. Therefore, hedging using futures contracts eliminates the uncertainty over the
cost of funding.

A short hedge works in a similar way. Consider an oil producer, who wants to sell again 100 000 barrels
of crude oil in July. Assume that all the above information still holds. Since the oil producer wants to sell
its oil, it can hedge its cash position by taking a short position in one hundred CME WTI June contracts,
which will be delivered in July. The producer again offsets its short position by going long before the
expiration of contract.

Suppose that the spot price of oil on 1 July is $102/bbl, which should be very close to the futures price.
The producer loses from a futures contract approximately
100 000×($102‐$99)=$300 000
A PRIL 2011 21

In July, the producer gets $102×100 000=$10 200 000 for the crude oil, making a net revenue from its
sales of approximately $9 900 000. On the other hand, if the spot price in July turned out to be $90/bbl,
then the producer company gains from its futures contract approximately
100 000×($99‐$90)=$900 000
and gets $90×100 000=$9 000 000 for the crude oil in spot market. Again here, the total net revenue for
the oil for the producer would be $9 900 000. No matter what happens to the spot price in July, entering
into the futures contract allows the producer to fix its net revenue to the barrel of oil times the price per
barrel. Therefore, hedging using futures contracts eliminates the uncertainty over the revenue.

2.4 Basis Risk

Up until now, we assumed that hedgers can completely eliminate risks by taking futures positions
opposite to their cash positions. However, in reality it is difficult to eliminate all risks. In order to eliminate
all risks associated with cash positions, the hedger must know the precise date in the future when an asset
would be bought or sold. Even if the hedger knows the exact date of purchase or sale, he might have to
close his/her futures position before its delivery month, i.e. there might be a mismatch between the
hedge period and available delivery date. Even then, the hedger would need to find the same asset
underlying the futures contract as the asset s/he is planning to buy or sell. For all these reasons, the
hedger will face basis risk, which can be defined as the difference between the spot price of the asset to
be hedged and the futures price of the contract used.

If the asset to be hedged and the asset underlying the futures contract are the same, then we should
expect the basis risk to be zero at the expiration of the futures contract. Prior to expiration, the basis can
be negative or positive. If the basis is positive, i.e. the spot price is greater than the futures price, the
situation is known as backwardation. If, on the other hand, the basis is negative, i.e. spot price is less
than the futures price, the situation is known as contango.

If, on the other hand, the asset to be hedged and the asset underlying the futures contract are different‐‐
a situation known as cross hedging‐‐then we should expect the basis risk to be different from zero even
at expiration. Sometimes, it is not possible to find futures contracts for some commodities. Consider an
airline company, which is concerned about the future price of jet fuel oil, rather than crude oil. Since
there is no futures contract on jet fuel oil, the airline company tries to find an asset underlying the
futures contract which is highly correlated with the asset to be hedged. High correlation results in low
basis risk and high hedge effectiveness.
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I NTERNATIONAL E NERGY A GENCY ‐ T HE M ECHANICS OF THE D ERIVATIVES M ARKETS 3. S WAPS
3. SWAPS

Forward or futures contracts settle on a single date. However, many transactions occur repeatedly
For example, an airline company buys jet fuel oil on an ongoing basis. If a manager seeking to reduce risk
confronts a risky payment stream, what is the easiest way to hedge this risk? You can enter into a
separate forward contract for each payment you wish to hedge. However, it could be more convenient
and entail lower transaction costs, if there were a single transaction that we could use to hedge a stream
of payments. Swaps serve exactly this purpose.

Swaps are agreements between two companies to exchange cash flows in the future according to a
prearranged formula. Swaps, therefore, may be regarded as a portfolio of forward contracts. Swaps are
traded on over‐the‐counter derivatives markets and are most common in interest rates, currencies and
commodities. They often extend much further into the future than exchange contracts. The parties to a
swap set:
• the notional amount;
• the tenor or maturity of the swap;
• the payment dates;
• the floating price index; and
• the fixed price.

The following discussion on the swap market and development in the swap market excerpts from the
CFTC “Commodity Swap Dealers & Index Traders with Commission Recommendations” report.5

“The first swap contracts were negotiated in 1981. In order to reduce overall funding costs for
both parties, the World Bank and IBM entered into what has become known as a currency swap.
The swap essentially involved a loan in Swiss francs by IBM to the World Bank and a loan in U.S.
dollars by the World Bank to IBM. This structure of swapping cash flows ultimately served as the
template for swaps on any number of financial assets and commodities.

Swaps serve as an effective hedging vehicle in much the same way that financial futures
contracts do. For example, a typical futures contract has many of the same characteristics as a
swap in that it is essentially a contract where the buyer of the contract agrees at the outset to
pay a fixed price for a commodity in return for future delivery of the commodity, which will have
an uncertain or floating value at the time of expiration of the contract.
5
See http://www.cftc.gov/ucm/groups/public/@newsroom/documents/file/cftcstaffreportonswapdealers09.pdf
A PRIL 2011 23

3. S WAPS I NTERNATIONAL E NERGY A GENCY ‐ T HE M ECHANICS OF THE D ERIVATIVES M ARKETS
The party offering the swap, typically called a swap dealer, takes on any price risks associated
with the swap and thus must manage the risk of the commodity exposure. In the early
development of swap markets, investment banks often served in a brokering capacity to bring
together parties with opposite hedging needs. The currency swap between the World Bank and
IBM, for example, was brokered by Salomon Brothers. While brokering swaps eliminates market
price and credit risk to the broker, the process of matching and negotiating swaps between
counterparties with opposite hedging needs could be difficult. As a result, swap brokers (who
took on no market risk) evolved into swap dealers (who took the contract onto their books). As
noted, when a swap dealer takes a swap onto its books, it takes on any price risks associated
with the swap and thus must manage the risk of the commodity exposure. In addition, the
counterparty bears a credit risk that the swap dealer may not honour its commitment. This risk
can be significant in the case of a swap dealer because it is potentially entering into numerous
transactions involving many counterparties, each of which exposes the swap dealer to additional
credit risks.

As a result of these risks, there has been a natural tendency for financial intermediaries (e.g.,
commercial banks, investment banks, insurance companies) to become swap dealers. These
firms typically have the capitalisation to support their creditworthiness as well as the expertise
to manage the market price risks that they take on. In addition, for particular commodity classes,
such as agriculture and energy, large commercial companies that have the expertise to manage
market price risks have set up affiliates to specialise as swap dealers for those commodities. The
utility of swap agreements as a hedging vehicle has led to significant growth in both the size and
complexity of the swap market. During the early period in the development of the swap market,
the majority of swap agreements involved financial assets. In fact, even today the vast majority
of swaps outstanding involve either interest rates or currencies.

The OTC swap market has grown significantly because, for many financial entities, the OTC
derivatives products offered by swap dealers have distinct advantages relative to futures
contracts. While futures markets offer a high degree of liquidity (i.e., the ability to quickly
execute trades due to the high number of participants willing to buy and sell contracts), futures
contracts are more standardised, meaning that they may not meet the exact needs of a hedger.
Swaps, on the other hand, offer additional flexibility since the counterparties can tailor the terms
of the contract to meet specific hedging needs.

24 A PRIL 2011

As an example of the flexibility that swaps can offer, consider again the case of an airline wanting
to hedge future jet fuel purchases. Currently there is no jet fuel futures contract available to the
airlines to directly hedge their price exposure. Contracts for crude oil (from which jet fuel is
made) and heating oil (which is a fuel having similar chemical characteristics to jet fuel) do exist.
But while these contracts can be used to hedge jet fuel, the dissimilarities between jet fuel and
crude oil or heating oil mean that the airline will inevitably take on what was referred to above
as basis risk. That is, the price of jet fuel and the prices of these futures contracts will not tend to
move perfectly together, diminishing the utility of the hedge.

In contrast, swap dealers can offer the airline the alternative of entering into a contract that
directly references the cash price for jet fuel at the specific time and location where the product
is needed. By creating a customised OTC derivative product that specifically addresses the price
risks faced by the airline, by taking on the administrative costs associated with managing that
contract over time, and by assuming the price risks attendant to that contract, the swap dealer
facilitates the airline‘s risk management.

When a commercial entity uses a swap to offset its risk, the swap dealer assumes the price risk
of the commodity. For example, if the swap dealer enters into a jet fuel swap with an airline, the
airline agrees to periodically pay a fixed amount on the swap while the swap dealer pays a
floating amount based on a cash market price. At each point in time when the payments are due,
a netting of the obligations takes place and the party responsible for the larger payment pays the
difference to the other party. Thus, if prices rise, the floating payment will be larger than the
fixed price and the swap dealer pays the net amount to the airline. Conversely, if prices fall, the
airline will be required to make a payment to the swap dealer. Recall, however, that when the
airline makes a payment on the swap to the swap dealer, it means that at the same time, it is
paying a lower price to acquire jet fuel in the cash market. The swap dealer, however, has no
natural offsetting transaction to counterbalance the risk. That is why swap dealers will, in turn,
hedge this price risk in the regulated futures markets.

Swap agreements have also become a popular vehicle for noncommercial participants, such as
hedge funds, pension funds, large speculators, commodity index traders, and others with large
pools of cash, to gain exposure to commodity prices. Recently, portfolio managers have sought
to invest in commodities because of the lack of correlation, or even negative correlation, that
commodities tend to have with traditional investments in stocks and bonds. In addition, because
A PRIL 2011 25

3. S WAPS I NTERNATIONAL E NERGY A GENCY ‐ T HE M ECHANICS OF THE D ERIVATIVES M ARKETS
of the ability to tailor transactions, swaps can represent a more efficient means by which these
participants can enter the market. Hence, many of the benefits that swap agreements offer
commercial hedgers also attract noncommercial interests to the swap market. Since swap
dealers are willing to enter into swap contracts on either side of a market, at times they will
enter into swaps that create offsetting exposures, reducing the swap dealer‘s overall market
price risk associated with the firm‘s individual positions opposite its counterparties. Since it is
unlikely, however, that a swap dealer could completely offset the market price risks associated
with its swap business at all times, dealers often enter the futures markets to offset the residual
market price risk. As a result of the growth of the swap market and the dealers who support the
market, there has been an associated growth in the open interest of the futures markets related
to the commodities for which swaps are offered, as these swap dealers attempt to lay off the
residual risk of their swap book.

A more recent phenomenon in the derivatives market has been the development of commodity
index funds and exchange‐traded funds for commodities (ETFs) and exchange‐traded notes
(ETNs), which are mainly transacted through swap dealers. Both products are designed to
produce a return that mimics a passive investment in a commodity or group of commodities.
ETFs and ETNs are traded on securities exchanges and are backed by physical commodities or
long futures positions held in a trust. Commodity index funds are funds that enter into swap
contracts that track published commodity indexes such as the S&P Goldman Sachs Commodity
Index or the Dow Jones AIG Commodity Index.”

3.1 Mechanics of Swaps
When two parties enter a swap contract, one party makes a payment to the other depending upon
whether a price turns out to be greater or less than a reference price that is specified in the
swap contract.

For example by entering into an oil swap, an oil buyer confronting a stream of uncertain oil payments
can lock in a fixed price for oil over a period of time. The swap payments would be based on the fixed
price for oil and a market price that varies over time.

Suppose Untied Airlines (UA) is going to buy 100 000 barrels of oil one year from today and two years
from today. Suppose that the forward price for delivery in one year is $75/bbl and in two years is
$90/bbl. Suppose one‐year and two‐year zero coupon bond yields are 5% and 5.5%. UA can use a
26 A PRIL 2011

forward contract to guarantee the cost of buying oil for the next two years. The present value of this cost
will be
$75 $90
$152.29
1.05 1.055

UA could invest this amount to buy oil in one and two years, or it could pay an oil supplier $152.29 who
would commit to delivering one barrel in each of the next two years. This is a prepaid swap. If the
payment is done after two years, this is a postpaid swap.

Typically, a swap will call equal payments in each year, or $82.28/bbl. This is the price of a two‐year
swap. However, any payments that have a present value of $152.29 are acceptable. In exchange, the
swap counterparty delivers 100 000 barrels of crude oil each year. The notional value of the swap can be
calculated by multiplying all cash flows by 100 000.

Instead of delivery, if the swap counterparties settled with cash, the oil buyer, UA, pays the swap
counterparty the difference between $82.28/bbl and the spot price (if the difference is negative, the
counterparty pays the buyer), and the oil buyer then buys the oil in the spot market. For example, if the
spot price is $90/bbl, the swap counterparty pays the buyer
Spot price‐swap price=$90‐$82.28=$7.72
If the spot price is $80/bbl, then oil buyer makes a payment to the swap counterparty
Spot price‐swap price=$80‐$82.28=‐$2.28
Whatever the spot price, the net cost to the buyer is the swap price, $82.28/bbl
Although the swap price is close to the mean of forward prices ($82.50/bbl), it is not exactly the same.
Why? Suppose the swap price is $82.50/bbl, then the oil buyer would then be committing to pay more
than $7.50 more than the forward price the first year and would pay $7.50 less than the forward price
the second year. Thus relative to the forward curve, the buyer would have made an interest‐free loan to
the counterparty.

If the swap price is $82.28, then we are overpaying $7.28 in the first year and underpaying $7.72 in the
second year, relative to the forward curve. The swap is equivalent to being long on the two forward
contracts, coupled with an agreement to lend $7.28 to the counterparty in the first year, and receive
$7.72 in second year.

The interest rate on this loan is $7.72/$7.28‐1=6%. Where does 6% come from? 6% is the one year
implied forward yield from year one to year two.
A PRIL 2011 27

4. O PTIONS I NTERNATIONAL E NERGY A GENCY ‐ T HE M ECHANICS OF THE D ERIVATIVES M ARKETS
4. OPTIONS

An option is a contract that gives the option holder the right/option, but no obligation, to buy or sell a
security (or a futures contract) to the option writer/seller at (or up to) a given time in the future (the
expiry date or maturity date) for a pre‐specified price (the strike price or exercise price, K).

The option purchaser (holder) is the person who buys a call or a put option and pays the option
premium, i.e. the person who establishes a long options position. This is the party with the right, but not
the obligation, under the terms of the contract.

The option writer, or grantor, is the person who sells a call or put option and receives the option
premium, i.e. the person who establishes a short position. This party is obligated to perform under the
terms of such an option.

A call option gives the holder the right to buy a security and a put option gives the holder the right to sell
a security. Where the underlying interest is represented by a futures contract, the right to buy is actually
a right to be long on a futures contract at a specified price level. Conversely, the right to sell represents
the right to a short futures position at a specified price level. Options allow one to take advantage of
changes in futures prices without actually having a position in the futures market.

Options can be American, European or Bermudan. American options can be exercised at any time prior
to expiry. European options can only be exercised at the expiry. Bermudan option can only be exercised
during the specified period.

The price at which the futures contract underlying an option can be purchased (if a call) or sold (if a put)
is called the strike price or the exercise price. In the call and put definitions above, this is the
predetermined price.

It is important to note that for every option buyer there is an option seller. At any time before the option
expires, the option buyer can exercise the option. Since the buyer decides whether to exercise, the seller
cannot make money at expiration. To take this risk, the seller is compensated by the option premium,
which is agreed when the contract is signed. The option premium is determined through trading on an
exchange market. Therefore, we should expect to see different option premia for different strike prices.

Effectively, the exercise of a call gives the option purchaser a long position in the underlying futures
contract at the option’s strike price; the exercise of a put option gives the option purchaser a short
futures position at the option’s strike price. The option buyer can also sell the option to someone else or
28 A PRIL 2011

I NTERNATIONAL E NERGY A GENCY ‐ T HE M ECHANICS OF THE D ERIVATIVES M ARKETS 5. R EFERENCES
do nothing and let the option expire. The choice of action is left entirely up to the option buyer. The
option buyer obtains this right by paying the premium to the option seller.

A call option buyer will only choose to exercise if the stock price is greater/higher than the strike price. If
the stock price is less than the strike price, the investor would clearly choose not to exercise the option,
and the investor only loses the option premium. On the other hand, a put option buyer will only to
choose to exercise the option when the stock price is less than strike price. If the stock price is more than
the strike price, the investor would clearly choose not to exercise the option and would only lose the
option premium.

What about the option seller? The option seller receives the premium from the option buyer. If the
option buyer exercises the option, the option seller is obligated to take the opposite futures position at
the same strike price. Because of the seller’s obligation to take a futures position if the option is
exercised, an option seller must post a margin and faces the possibility that the margin will be called if
the market moves against his potential futures position.

4.1 Call Option
A call option is a contract where the buyer has the right, but not the obligation, to buy an underlying
security. Since the buyer decides whether or not to buy, the seller cannot make money at expiration. To take
this risk, the seller is compensated by the option premium, which is agreed when the contract is signed.

Consider a call option on the S&R index with six months to expiration and strike price of $1000 and
premium of $93.81.6 And assume that the risk free rate is 2% over six months. Suppose that the index in
six months is $1100. Clearly it is worthwhile to pay the $1000 strike price to acquire the index worth
$1100. If on the other hand the index is $900 at expiration, it is not worthwhile paying the $1000 strike
price to buy the index worth $900. In this case:
• The buyer is not obliged to buy the index and hence will only exercise the option if the payoff is
positive.
Purchased call payoff = max(0,ST‐K)
In our example, K=1000. If S=1100 then the call payoff
Purchased call payoff = max(0,1100‐1000)=$100
If S=900, then the call payoff is
Purchased call payoff = max(0,900‐1000)=$0
6
The discussions on call and put options draws upon McDonald (2006).
A PRIL 2011 29

The payoff does not take into account the initial cost (option premium) of acquiring the position. For a
purchased option, the premium is paid at the time the option is acquired. In computing profit at
expiration, we use the future value of the premium.
Purchased call profit = max(0,ST‐K)‐future value of option premium
Purchased call profit = Purchased call payoff‐future value of option premium
If the index at the expiration is 1100, then profit is
Purchased call profit=max(0, 1100‐1000)‐93.81×1.02=$4.32
If the index at the expiration is 900, then the owner does not exercise the option. The loss
will be future value of option premium. Maximum loss will be the option premium.
Purchased call profit=max(0, 900‐1000)‐93.81×1.02=‐$95.68

The Payoff at Expiration with a Strike Price of $1000
250
200
150
100
50
Payoff ($)
0
‐50
Call Payoff
‐100
‐150
‐200
‐250
800 850 900 950 1000 1050 1100 1150 1200
S&R Index Price ($)

30 A PRIL 2011

Profit at Expiration for Call Option with K=1000 and Long Forward
200
150
100
50
0 Index price=1095.68
Profit ($)
Call Profit
‐50
Long Forward Profit
‐100
‐150
‐200
‐250
800 850 900 950 1000 1050 1100 1150 1200
S&R Index Price ($)

• The option writer (seller of option) has a short position in a call option. The writer receives the
premium for the option and then has an obligation to sell the underlying security in exchange for
the strike price if the option buyer exercises the option.
The payoff and profit to a written call are just the opposite of those for a purchased call.
Written call payoff = ‐max(0,ST‐K) = min(0,K‐ST)
Written call profit = ‐max(0,ST‐K)+future value of option premium
In our example, if S=1100 then the option writer payoff will be ‐$100 and profit will be ‐
$4.32. If on the other hand, S=900, then payoff will be 0 and profit will be the future value of
premium, $95.68.
A PRIL 2011 31

Payoff for Option Writer with Strike Price of $1000
250
200
150
100
Payoff ($)
50
0
‐50
Written Call Payoff
‐100
‐150
‐200
‐250
800 850 900 950 1000 1050 1100 1150 1200
S&R Index Price ($)

Profit for Option Writer with Strike Price of $1000
250
200
150
100
Profit ($)
50 Index Price=1095.68
Written Call Profit
0
‐50 Short Forward
Index Price=
‐100
1020
‐150
‐200
800 850 900 950 1000 1050 1100 1150 1200
S&R Price Index ($)

4.2 Put Option
A put option is a contract where the buyer has the right to sell, but not the obligation. Since the buyer
decides whether to sell, the seller cannot make money at expiration. To take this risk, the seller is
compensated by the option premium, which is agreed when the contract is signed.

Example: Put Option
Consider a put option on the S&R index with six months to expiration and strike price of $1000 and
premium of $74.20. And assume that the risk free rate is 2% over six months. Suppose that the index in
32 A PRIL 2011

six months is $1100. Clearly it is not worthwhile to sell the index worth $1100 for the strike price of
$1000. If on the other hand the index is $900 at expiration, it is worthwhile selling the index for $1000.
• The buyer is not obliged to sell the index and hence will only exercise the option if the payoff is
positive.
Purchased put payoff = max(0,K‐ST)
In our example, K=1000. If S=1100 then the put payoff
Purchased put payoff = max(0,1000‐1100)=$0
If S=900, then the put payoff is
Purchased put payoff = max(0,1000‐900)=$100
The payoff does not take into account the initial cost of acquiring the position. For a purchased option,
the premium is paid at the time the option is acquired. In computing profit at expiration, we use the
future value of the premium.
Purchased put profit = max(0,K‐ST)‐future value of option premium
Purchased put profit = Purchased put payoff‐future value of option premium
If the index at the expiration is 1100, then the option buyer will not exercise his right to sell
and the maximum loss will be the future value of the option premium.
Purchased put profit = max(0,1000‐1100)‐74.2×1.02=‐$75.68
If the index at the expiration is 900, then the owner exercises the option i.e. sells. The profit
will be
Purchased put profit = max(0,1000‐900)‐74.2×1.02=$24.32
• The option writer (seller of option) has a long position in a put option. The writer receives the
premium for the option and then has an obligation to buy the underlying security in exchange for
the strike price if the option buyer exercises the option.
The payoff and profit to a written put are just the opposite of those for a purchased put.
Written put payoff = ‐max(0,K‐ST) = min(0,ST‐K)
Written put profit=‐max(0,K‐ST)+future value of option premium
In our example, if S=1100 then the put buyer will not exercise the put, thus put writer earns
profit, which will be option premium. If, on the other hand, S=900, then the option buyer
exercises the option and the option seller (writer) will lose $24.32 (‐100+$75.68).

4.3 “Moneyness” of Options
Options are generally referred to as in the money, at the money, or out of money. The “moneyness” of
an option depends on the strike price (K) relative to the spot (St)/forward (Ft) price of the
underlying asset.

A PRIL 2011 33

An option is said to be in‐the‐money if the option has positive value if exercised right now:
• St > K for call options and St < K for put options. Sometimes it is also defined in terms of
the forward price at the same maturity (in the money forward): Ft > K for call and Ft < K
for put.
• The option has positive intrinsic value (defined as the maximum of zero and the value the option
would have if it is exercised today) when in the money. The intrinsic value is (St − K)+ for call,
(K − St)+ for put options. We can also define intrinsic value in terms of the forward price.
An option is said to be out‐of‐the‐money when it has zero intrinsic value.
• St < K for call options and St > K for put options. Out‐of‐the‐money forward: Ft < K for
call and Ft > K for put.
An option is said to be at‐the‐money spot (or forward) when the strike is equal to the spot (or forward).

4.4 Hedging Using Options
Options can be used for hedging purposes. Consider a trader (an airline company) who thinks that oil
prices are going to move substantially higher in the near future and wants some protection. In this case,
the trader might buy a call option. Let us assume that it is 11 March and a July call contract with a $100
strike price is at $4 option premium. Assume that the July futures contract is currently trading at $100. If
the trader decides to buy the call option, he has to pay the premium of (1000×4=$4000) per contract. By
purchasing this call option, the trader has the right to buy a July futures contract at $100/bbl. The seller
of the contract receives a $4000 option premium per contract and is obligated to take a short futures
position at $100/bbl in the July contract if the option buyer chooses to exercise his option. Let’s say that
by May the July futures price has risen to $110/bbl. The trader’s July contract has a value of at least $10
($110‐$100). The trader at this point can sell his option to someone else for $10/bbl and be out of the
market. His total profit will be $6000 (1000×(10‐4)) per contract. Or alternatively, he will exercise his
option and he will get one long July futures contract. The hedger in this case limited his risk of a
substantial rise in prices. If, on the other hand, prices decline, the trader will not exercise his option and
he will lose only the premium he paid when he signed the contract.

34 A PRIL 2011

5. REFERENCES

CFTC (2008) “Commodity Swap Dealers & Index Traders with Commission Recommendations.”
http://www.cftc.gov/ucm/groups/public/@newsroom/documents/file/cftcstaffreportonswapdealers09.pdf
McDonald, Robert L. (2006). “Derivatives Markets.” 2nd Edition, Addison Wesley.
Weber, Ernst Juerg (2008). “A Short History of Derivative Security Markets.” Available at SSRN:
http://ssrn.com/abstract=1141689
A PRIL 2011 35

6. G LOSSARY OF THE D ERIVATIVES M ARKET I NTERNATIONAL E NERGY A GENCY ‐ T HE M ECHANICS OF THE D ERIVATIVES M ARKETS
6. GLOSSARY OF THE DERIVATIVES MARKET TERMS7

A
Abandon: To elect not to exercise or offset a long option position.
Accommodation Trading: Non‐competitive trading entered into by a trader, usually to assist another
with illegal trades.
Accumulator: A contract in which the seller agrees to deliver a specified quantity of a commodity or
other asset to the buyer at a pre‐determined price on a series of specified accumulation dates over a
specified period of time. The contract typically has a “knock‐out” price, which, if reached, will trigger the
cancellation of all remaining accumulations. Moreover, the amount of the commodity to be delivered
may be doubled or otherwise adjusted on those accumulation dates when the price of the asset reaches
a specified price different from the knockout price.
Actuals: The physical or cash commodity, as distinguished from a futures contract. See Cash and Spot
Commodity.
Agency Bond: A debt security issued by a government‐sponsored enterprise such as Fannie Mae or
Freddie Mac, designed to resemble a U.S. Treasury bond.
Agency Note: A debt security issued by a government‐sponsored enterprise such as Fannie Mae or
Freddie Mac, designed to resemble a U.S. Treasury note.
Aggregation: The principle under which all futures positions owned or controlled by one trader (or group
of traders acting in concert) are combined to determine reporting status and compliance with
speculative position limits.
Agricultural Trade Option Merchant: Any person that is in the business of soliciting or entering option
transactions involving an enumerated agricultural commodity that are not conducted or executed on or
subject to the rules of an exchange.
Algorithmic Trading: The use of computer programs for entering trading orders with the computer
algorithm initiating orders or placing bids and offers.
Allowances: (1) The discounts (premiums) allowed for grades or locations of a commodity lower (higher)
than the par (or basis) grade or location specified in the futures contract. See Differentials. (2) The
tradable right to emit a specified amount of a pollutant under a cap and trade system.
American Option: An option that can be exercised at any time prior to or on the expiration date. See
European Option.
Approved Delivery Facility: Any bank, stockyard, mill, storehouse, plant, elevator, or other depository
that is authorized by an exchange for the delivery of commodities tendered on futures contracts.
7
Source: CFTC. This glossary is available at http://www.cftc.gov/ucm/groups/public/@educationcenter/documents/file/cftcglossary.pdf
36 A PRIL 2011

I NTERNATIONAL E NERGY A GENCY ‐ T HE M ECHANICS OF THE D ERIVATIVES M ARKETS 6. G LOSSARY OF THE D ERIVATIVES M ARKET
Arbitrage: A strategy involving the simultaneous purchase and sale of identical or equivalent commodity
futures contracts or other instruments across two or more markets in order to benefit from a
discrepancy in their price relationship. In a theoretical efficient market, there is a lack of opportunity for
profitable arbitrage. See Spread.
Arbitration: A process for settling disputes between parties that is less structured than court
proceedings. The National Futures Association arbitration program provides a forum for resolving
futures‐related disputes between NFA members or between NFA members and customers. Other forums
for customer complaints include the American Arbitration Association.
Artificial Price: A cash market or futures price that has been affected by a manipulation and is thus
higher or lower than it would have been if it reflected the forces of supply and demand.
Asian Option: An exotic option whose payoff depends on the average price of the underlying asset
during a specified period preceding the option expiration date.
Ask: The price level of an offer, as in bid‐ask spread.
Assignable Contract: A contract that allows the holder to convey his rights to a third party. Exchange‐
traded contracts are not assignable.
Assignment: Designation by a clearing organization of an option writer who will be required to buy (in
the case of a put) or sell (in the case of a call) the underlying futures contract or security when an option
has been exercised, especially if it has been exercised early.
Associated Person (AP): An individual who solicits or accepts (other than in a clerical capacity) orders,
discretionary accounts, or participation in a commodity pool, or supervises any individual so engaged, on
behalf of a futures commission merchant, an introducing broker, a commodity trading advisor, a
commodity pool operator, or an agricultural trade option merchant.
At‐the‐Market: An order to buy or sell a futures contract at whatever price is obtainable when the order
reaches the trading facility. See Market Order.
At‐the‐Money: When an option's strike price is the same as the current trading price of the underlying
commodity, the option is at‐the‐money.
Auction Rate Security: A debt security, typically issued by a municipality, in which the yield is reset on
each payment date via a Dutch auction.
Audit Trail: The record of trading information identifying, for example, the brokers participating in each
transaction, the firms clearing the trade, the terms and time or sequence of the trade, the order receipt
and execution time, and, ultimately, and when applicable, the customers involved.
Automatic Exercise: A provision in an option contract specifying that it will be exercised automatically on
the expiration date if it is in‐the‐money by a specified amount, absent instructions to the contrary.
A PRIL 2011 37

B
Back Months: Futures delivery months other than the spot or front month (also called deferred months).
Back Office: The department in a financial institution that processes and deals and handles delivery,
settlement, and regulatory procedures.
Back pricing: Fixing the price of a commodity for which the commitment to purchase has been made in
advance. The buyer can fix the price relative to any monthly or periodic delivery using the futures markets.
Back Spread: A delta‐neutral ratio spread in which more options are bought than sold. A back spread will
be profitable if volatility increases. See Delta.
Backwardation: Market situation in which futures prices are progressively lower in the distant delivery
months. For instance, if the gold quotation for January is $960.00 per ounce and that for June is $945.00
per ounce, the backwardation for five months against January is $15.00 per ounce. (Backwardation is the
opposite of contango). See Inverted Market.
Banging the Close: A manipulative or disruptive trading practice whereby a trader buys or sells a large
number of futures contracts during the closing period of a futures contract (that is, the period during
which the futures settlement price is determined) in order to benefit an even larger position in an
option, swap, or other derivative that is cash settled based on the futures settlement price on that day.
Banker's Acceptance: A draft or bill of exchange accepted by a bank where the accepting institution
guarantees payment. Used extensively in foreign trade transactions.
Basis: The difference between the spot or cash price of a commodity and the price of the nearest futures
contract for the same or a related commodity (typically calculated as cash minus futures). Basis is usually
computed in relation to the futures contract next to expire and may reflect different time periods,
product forms, grades, or locations.
Basis Grade: The grade of a commodity used as the standard or par grade of a futures contract.
Basis Point: The measurement of a change in the yield of a debt security. One basis point equals 1/100 of
one percent.
Basis Quote: Offer or sale of a cash commodity in terms of the difference above or below a futures price
(e.g., 10 cents over December corn).
Basis Risk: The risk associated with an unexpected widening or narrowing of the basis (that is, the
difference between the futures price and the relevant cash price) between the time a hedge position is
established and the time that it is lifted.
Basis Swap: A swap whose cash settlement price is calculated based on the basis between a futures
contract (e.g., natural gas) and the spot price of the underlying commodity or a closely related
commodity (e.g., natural gas at a location other than the futures delivery location) on a specified date.
38 A PRIL 2011

Bear: One who expects a decline in prices. The opposite of a bull. A news item is considered bearish if it
is expected to result in lower prices.
Bear Market: A market in which prices generally are declining over a period of months or years. Opposite
of bull market.
Bear Market Rally: A temporary rise in prices during a bear market. See Correction.
Bear Spread: (1) A strategy involving the simultaneous purchase and sale of options of the same class
and expiration date, but different strike prices. In a bear spread, the option that is purchased has a lower
delta than the option that is bought. For example, in a call bear spread, the purchased option has a
higher exercise price than the option that is sold. Also called bear vertical spread. (2) The simultaneous
purchase and sale of two futures contracts in the same or related commodities with the intention of
profiting from a decline in prices but at the same time limiting the potential loss if this expectation does
not materialize. In agricultural products, this is accomplished by selling a nearby delivery and buying a
deferred delivery.
Bear Vertical Spread: See Bear Spread.
Bermuda Option: An exotic option which can be exercised on a specified set of predetermined dates
during the life of the option.
Beta (Beta Coefficient): A measure of the variability of rate of return or value of a stock or portfolio
compared to that of the overall market, typically used as a measure of riskiness.
Bid: An offer to buy a specific quantity of a commodity at a stated price.
Bid‐Ask Spread or Bid‐Offer Spread: The difference between the bid price and the ask or offer price.
Binary Option: A type of option whose payoff is either a fixed amount or zero. For example, there could
be a binary option that pays $100 if a hurricane makes landfall in Florida before a specified date and zero
otherwise. Also called a digital option.
Blackboard Trading: The practice, no longer used, of buying and selling commodities by posting prices on
a blackboard on a wall of a commodity exchange.
Black‐Scholes Model: An option pricing model initially developed by Fischer Black and Myron Scholes for
securities options and later refined by Black for options on futures.
Block Trade: A large transaction that is negotiated off an exchange’s centralized trading facility and then
executed on the trading facility, as permitted under exchange rules.
Board Order: See Market‐if‐Touched Order.
Board of Trade: Any organized exchange or other trading facility for the trading of futures and/or
option contracts.
A PRIL 2011 39

Boiler Room: An enterprise that often is operated out of inexpensive, low‐rent quarters (hence the term
“boiler room”), that uses high pressure sales tactics (generally over the telephone), and possibly false or
misleading information to solicit generally unsophisticated investors.
Booking the Basis: A forward pricing sales arrangement in which the cash price is determined either by
the buyer or seller within a specified time. At that time, the previously‐agreed basis is applied to the
then‐current futures quotation.
Book Transfer: A series of accounting or bookkeeping entries used to settle a series of cash market
transactions.
Box Spread: An option position in which the owner establishes a long call and a short put at one strike
price and a short call and a long put at another strike price, all of which are in the same contract month
in the same commodity.
Break: A rapid and sharp price decline.
Broad‐Based Security Index: Any index of securities that does not meet the legal definition of narrow‐
based security index.
Broker: A person paid a fee or commission for executing buy or sell orders for a customer. In commodity
futures trading, the term may refer to: (1) Floor broker, a person who actually executes orders on the
trading floor of an exchange; (2) Account executive or associated person, the person who deals with
customers in the offices of futures commission merchants; or (3) the futures commission merchant.
Broker Association: Two or more persons with exchange trading privileges who (1) share responsibility
for executing customer orders; (2) have access to each other's unfilled customer orders as a result of
common employment or other types of relationships; or (3) share profits or losses associated with their
brokerage or trading activity.
Bucketing: Directly or indirectly taking the opposite side of a customer's order into a broker’s own
account or into an account in which a broker has an interest, without open and competitive execution of
the order on an exchange. Also called trading against.
Bucket Shop: A brokerage enterprise that “books” (i.e., takes the opposite side of) retail customer orders
without actually having them executed on an exchange.
Bull: One who expects a rise in prices. The opposite of a bear. A news item is considered bullish if it is
expected to result in higher prices.
Bullion: Bars or ingots of precious metals, usually cast in standardized sizes.
Bull Market: A market in which prices generally are rising over a period of months or years. Opposite of a
bear market.
Bull Spread: (1) A strategy involving the simultaneous purchase and sale of options of the same class and
expiration date but different strike prices. In a bull vertical spread, the purchased option has a higher
40 A PRIL 2011

delta than the option that is sold. For example, in a call bull spread, the purchased option has a lower
exercise price than the sold option. Also called bull vertical spread. (2) The simultaneous purchase and
sale of two futures contracts in the same or related commodities with the intention of profiting from a
rise in prices but at the same time limiting the potential loss if this expectation is wrong. In agricultural
commodities, this is accomplished by buying the nearby delivery and selling the deferred.
Bull Vertical Spread: See Bull Spread.
Bust: To cancel a trade that was executed in error.
Buoyant: A market in which prices have a tendency to rise easily with a considerable show of strength.
Bunched Order: A discretionary order entered on behalf of multiple customers.
Bust: An executed trade cancelled by an exchange that is considered to have been executed in error.
Butterfly Spread: A three‐legged option spread in which each leg has the same expiration date but
different strike prices. For example, a butterfly spread in soybean call options might consist of one long
call at a $5.50 strike price, two short calls at a $6.00 strike price, and one long call at a $6.50 strike price.
Buyer: A market participant who takes a long futures position or buys an option. An option buyer is also
called a taker, holder, or owner.
Buyer’s Call: A purchase of a specified quantity of a specific grade of a commodity at a fixed number of
points above or below a specified delivery month futures price with the buyer allowed a period of time
to fix the price either by purchasing a futures contract for the account of the seller or telling the seller
when he wishes to fix the price. See Seller’s Call.
Buyer’s Market: A condition of the market in which there is an abundance of goods available and hence
buyers can afford to be selective and may be able to buy at less than the price that previously prevailed.
See Seller's Market.
Buying Hedge (or Long Hedge): Hedging transaction in which futures contracts are bought to protect
against possible increases in the cost of commodities. See Hedging.
Buy (or Sell) On Close: To buy (or sell) at the end of the trading session within the closing price range.
Buy (or Sell) On Opening: To buy (or sell) at the beginning of a trading session within the open price range.
C
C & F: “Cost and Freight” paid to a point of destination and included in the price quoted; same as C.A.F.
Calendar Spread: (1) The purchase of one delivery month of a given futures contract and simultaneous
sale of a different delivery month of the same futures contract; (2) the purchase of a put or call option
and the simultaneous sale of the same type of option with typically the same strike price but a different
expiration date. Also called a horizontal spread or time spread.
Call: (1) An option contract that gives the buyer the right but not the obligation to purchase a
commodity, security, or other asset or to enter into a long futures position at a given price (the “strike
A PRIL 2011 41

price”) prior to or on a specified expiration date; (2) a period at the opening and the close of some
futures markets in which the price for each futures contract was established by auction; or (3) the
requirement that a financial instrument such as a bond be returned to the issuer prior to maturity, with
principal and accrued interest paid off upon return. See Buyer’s Call, Seller’s Call.
Call Around Market: A market, commonly used for options on futures on European exchanges, in which
brokers contact each other outside of the exchange trading facility to arrange block trades.
Call Cotton: Cotton bought or sold on call. See Buyer’s Call, Seller’s Call.
Called: Another term for exercised when an option is a call. In the case of an option on a physical, the
writer of a call must deliver the indicated underlying commodity when the option is exercised or called.
In the case of an option on a futures contract, a futures position will be created that will require margin,
unless the writer of the call has an offsetting position.
Call Rule: An exchange regulation under which an official bid price for a cash commodity is competitively
established at the close of each day's trading. It holds until the next opening of the exchange.
Cap and Trade: A market based pollution control system in which total emissions of a pollutant are
capped at a specified level. Allowances (or the right to emit a specified amount of a pollutant) are issued
to firms and can be bought and sold on an organized market or OTC.
Capping: Effecting transactions in an instrument underlying an option shortly before the option's
expiration date to depress or prevent a rise in the price of the instrument so that previously written call
options will expire worthless, thus protecting premiums previously received. See Pegging.
Carrying Broker: An exchange member firm, usually a futures commission merchant, through whom
another broker or customer elects to clear all or part of its trades.
Carrying Charges: Also called Cost of Carry. Cost of storing a physical commodity or holding a financial
instrument over a period of time. These charges include insurance, storage, and interest on the
deposited funds, as well as other incidental costs. It is a carrying charge market when there are higher
futures prices for each successive contract maturity. If the carrying charge is adequate to reimburse the
holder, it is called “full carry.” See Negative Carry, Positive Carry, and Contango.
Carry Trade: A trade where one borrows a currency or commoidity commodity or currency with a low cost
of carry and lends a similar instrument with a high cost of carry in order to profit from the differential.
Cascade: A situation in which the execution of market orders or stop loss orders on an electronic trading
system triggers other stop loss orders which may, in turn, trigger still more stop loss orders. This may
lead to a very large price move if there are no safety mechanisms to prevent cascading.
Cash Commodity: The physical or actual commodity as distinguished from the futures contract,
sometimes called spot commodity or actuals.
Cash Forward Sale: See Forward Contract.
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Cash Market: The market for the cash commodity (as contrasted to a futures contract) taking the form
of: (1) an organized, self‐regulated central market (e.g., a commodity exchange); (2) a decentralized
over‐the‐counter market; or (3) a local organization, such as a grain elevator or meat processor, which
provides a market for a small region.
Cash Price: The price in the marketplace for actual cash or spot commodities to be delivered via
customary market channels.
Cash Settlement: A method of settling futures options and other derivatives whereby the seller (or
short) pays the buyer (or long) the cash value of the underlying commodity or a cash amount based on
the level of an index or price according to a procedure specified in the contract. Also called Financial
Settlement. Compare to physical delivery.
CCC: See Commodity Credit Corporation.
CD: See Certificate of Deposit.
CEA: Commodity Exchange Act or Commodity Exchange Authority.
Certificate of Deposit (CD): A time deposit with a specific maturity traditionally evidenced by a
certificate. Large denomination CDs are typically negotiable.
CFTC: See Commodity Futures Trading Commission.
CFTC Form 40: The form used by large traders to report their futures and option positions and the
purposes of those positions.
CFO: Cancel Former Order.
Centralized Counterparty (CCP): See Clearing Organization.
Certificated or Certified Stocks: Stocks of a commodity that have been inspected and found to be of a
quality deliverable against futures contracts, stored at the delivery points designated as regular or
acceptable for delivery by an exchange. In grain, called “stocks in deliverable position.” See
Deliverable Stocks.
Changer: Formerly, a clearing member of both the Mid‐America Commodity Exchange (MidAm) and
another futures exchange who, for a fee, would assume the opposite side of a transaction on MidAm by
taking a spread position between MidAm and the other futures exchange that traded an identical, but
larger, contract. Through this service, the changer provided liquidity for MidAm and an economical
mechanism for arbitrage between the two markets. MidAm was a subsidiary of the Chicago Board of
Trade (CBOT). MidAm was closed by the CBOT in 2003 after MidAm’s contracts were delisted on MidAm
and relisted on the CBOT as Mini contracts. The CBOT continued to use changers for former MidAm
contracts traded on an open outcry platform.
Charting: The use of graphs and charts in the technical analysis of futures markets to plot trends of price
movements, average movements of price, volume of trading, and open interest.
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Chartist: Technical trader who reacts to signals derived from graphs of price movements.
Cheapest‐to‐Deliver: Usually refers to the selection of a class of bonds or notes deliverable against an
expiring bond or note futures contract. The bond or note that has the highest implied repo rate is
considered cheapest to deliver.
Chooser Option: An exotic option that is transacted in the present, but that at some specified future
date is chosen to be either a put or a call option.
Churning: Excessive trading of a discretionary account by a person with control over the account for the
purpose of generating commissions while disregarding the interests of the customer.
Circuit Breakers: A system of coordinated trading halts and/or price limits on equity markets and equity
derivative markets designed to provide a cooling‐off period during large, intraday market declines. The
first known use of the term circuit breaker in this context was in the Report
of the Presidential Task Force on Market Mechanisms (January 1988), which recommended that circuit
breakers be adopted following the market break of October 1987.
C.I.F: Cost, insurance, and freight paid to a point of destination and included in the price quoted.
Class (of options): Options of the same type (i.e., either puts or calls, but not both) covering the same
underlying futures contract or other asset (e.g., a March call with a strike price of 62 and a May call with
a strike price of 58).
Clearing: The procedure through which the clearing organization becomes the buyer to each seller of a
futures contract or other derivative, and the seller to each buyer for clearing members.
Clearing Association: See Clearing Organization.
Clearing House: See Clearing Organization.
Clearing Member: A member of a clearing organization. All trades of a non‐clearing member must be
processed and eventually settled through a clearing member.
Clearing Organization: An entity through which futures and other derivative transactions are cleared and
settled. It is also charged with assuring the proper conduct of each contract’s delivery procedures and
the adequate financing of trading. A clearing organization may be a division of a particular exchange, an
adjunct or affiliate thereof, or a freestanding entity. Also called a clearing house, multilateral clearing
organization, or clearing association. See Derivatives Clearing Organization.
Clearing Price: See Settlement Price.
Close: The exchange‐designated period at the end of the trading session during which all transactions are
considered made “at the close.” See Call.
Closing‐Out: Liquidating an existing long or short futures or option position with an equal and opposite
transaction. Also known as Offset.
44 A PRIL 2011

Closing Price (or Range): The price (or price range) recorded during trading that takes place in the final
period of a trading session’s activity that is officially designated as the “close.”
Co‐Location: The placement of servers used by market participants in close physical proximity to an
electronic trading facility's matching engine in order to facilitate high‐frequency trading.
Combination: Puts and calls held either long or short with different strike prices and/or expirations.
Types of combinations include straddles and strangles.
Commercial: An entity involved in the production, processing, or merchandising of a commodity.
Commercial Grain Stocks: Domestic grain in store in public and private elevators at important markets
and grain afloat in vessels or barges in lake and seaboard ports.
Commercial Paper: Short‐term promissory notes issued in bearer form by large corporations, with
maturities ranging from 5 to 270 days. Since the notes are unsecured, the commercial paper market
generally is dominated by large corporations with impeccable credit ratings.
Commission: (1) The charge made by a futures commission merchant for buying and selling futures
contracts; or (2) the fee charged by a futures broker for the execution of an order. Note: when
capitalized, the word Commission usually refers to the CFTC.
Commitments of Traders Report (COT): A weekly report from the CFTC providing a breakdown of each
Tuesday's open interest for markets in which 20 or more traders hold positions equal to or above the
reporting levels established by the CFTC. Open interest is broken down by aggregate commercial,
non‐commercial, and non‐reportable holdings.
Commitments: See Open Interest.
Commodity: (1) A commodity, as defined in the Commodity Exchange Act, includes the agricultural
commodities enumerated in Section 1a(4) of the Commodity Exchange Act, 7 USC 1a(4), and all other
goods and articles, except onions as provided in Public Law 85‐839 (7 USC 13‐1), a 1958 law that banned
futures trading in onions, and all services, rights, and interests in which contracts for future delivery are
presently or in the future dealt in. (2) A physical commodity such as an agricultural product or a natural
resource as opposed to a financial instrument such as a currency or interest rate.
Commodity Credit Corporation: A government‐owned corporation established in 1933 to assist
American agriculture. Major operations include price support programs, foreign sales, and export credit
programs for agricultural commodities.
Commodity Exchange Act: The Commodity Exchange Act, 7 USC 1, et seq., provides for the federal
regulation of commodity futures and options trading and was enacted in 1936.
Commodity Exchange Authority: A regulatory agency of the U.S. Department of Agriculture established
to regulate futures trading under the 1936 Commodity Exchange Act prior to 1975. The Commodity
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Exchange Authority was the predecessor of the Commodity Futures Trading Commission. Before World
War II, this agency was known as the Commodity Exchange Administration.
Commodity Exchange Commission: A commission consisting of the Secretary of Agriculture, Secretary of
Commerce, and the Attorney General, responsible for administering the Commodity Exchange Act prior
to 1975. Among other things, the CEC was responsible for setting Federal speculative position limits.
Commodity Futures Trading Commission (CFTC): The Federal regulatory agency established by the
Commodity Futures Trading Act of 1974 to administer the Commodity Exchange Act.
Commodity Index: An index of a specified set of (physical) commodity prices or commodity futures prices.
Commodity Index Fund: An investment fund that enters into futures or commodity swap positions for
the purpose of replicating the return of an index of commodity prices or commodity futures prices.
Commodity Index Swap: A swap whose cash flows are intended to replicate a commodity index.
Commodity Index Trader: An entity that conducts futures trades on behalf of a commodity index fund or
to hedge commodity index swap positions.
Commodity‐Linked Bond: A bond in which payment to the investor is dependent to a certain extent on
the price level of a commodity, such as crude oil, gold, or silver, at maturity.
Commodity Option: An option on a commodity or a futures contract.
Commodity Pool: An investment trust, syndicate, or similar form of enterprise operated for the purpose
of trading commodity futures or option contracts. Typically thought of as an enterprise engaged in the
business of investing the collective or “pooled” funds of multiple participants in trading commodity
futures or options, where participants share in profits and losses on a pro rata basis.
Commodity Pool Operator (CPO): A person engaged in a business similar to an investment trust or a
syndicate and who solicits or accepts funds, securities, or property for the purpose of trading commodity
futures contracts or commodity options. The commodity pool operator either itself makes trading
decisions on behalf of the pool or engages a commodity trading advisor to do so.
Commodity Trading Advisor (CTA): A person who, for pay, regularly engages in the business of advising
others as to the value of commodity futures or options or the advisability of trading in commodity
futures or options, or issues analyses or reports concerning commodity futures or options.
Commodity Swap: A swap in which the payout to at least one counterparty is based on the price of a
commodity or the level of a commodity index.
Confirmation Statement: A statement sent by a futures commission merchant to a customer when a
futures or options position has been initiated which typically shows the price and the number of
contracts bought and sold. See P&S (Purchase and Sale Statement).
Congestion: (1) A market situation in which shorts attempting to cover their positions are unable to find
an adequate supply of contracts provided by longs willing to liquidate or by new sellers willing to enter
46 A PRIL 2011

the market, except at sharply higher prices (see Squeeze, Corner); (2) in technical analysis, a period of

time characterized by repetitious and limited price fluctuations.
Consignment: A shipment made by a producer or dealer to an agent elsewhere with the understanding
that the commodities in question will be cared for or sold at the highest obtainable price. Title to the
merchandise shipped on consignment rests with the shipper until the goods are disposed of according to
agreement.
Contango: Market situation in which prices in succeeding delivery months are progressively higher than
in the nearest delivery month; the opposite of backwardation.
Contract: (1) A term of reference describing a unit of trading for a commodity future or option or other
derivative; (2) an agreement to buy or sell a specified commodity, detailing the amount and grade of the
product and the date on which the contract will mature and become deliverable.
Contract Grades: Those grades of a commodity that have been officially approved by an exchange as
deliverable in settlement of a futures contract.
Contract Market: A board of trade or exchange designated by the Commodity Futures Trading
Commission to trade futures or options under the Commodity Exchange Act. A contract market can allow
both institutional and retail participants and can list for trading futures contracts on any commodity,
provided that each contract is not readily susceptible to manipulation. Also called designated contract
market. See Derivatives Transaction Execution Facility.
Contract Month: See Delivery Month.
Contract Size: The actual amount of a commodity represented in a contract.
Contract Unit: See Contract Size.
Controlled Account: An account for which trading is directed by someone other than the owner. Also
called a Managed Account or a Discretionary Account.
Convergence: The tendency for prices of physicals and futures to approach one another, usually during
the delivery month. Also called a “narrowing of the basis.”
Conversion: A position created by selling a call option, buying a put option, and buying the underlying
instrument (for example, a futures contract), where the options have the same strike price and the same
expiration. See Reverse Conversion.
Conversion Factors: Numbers published by a futures exchange to determine invoice prices for debt
instruments deliverable against bond or note futures contracts. A separate conversion factor is published
for each deliverable instrument. Invoice price = Contract Size × Futures Settlement Price × Conversion
Factor + Accrued Interest.
Core Principle: A provision of the Commodity Exchange Act with which a contract market, derivatives
transaction execution facility, or derivatives clearing organization must comply on an ongoing basis.
A PRIL 2011 47

There are 18 core principles for contract markets, 9 core principles for derivatives transaction execution
facilities, and 14 core principles for derivatives clearing organizations.
Corner: (1) Securing such relative control of a commodity that its price can be manipulated, that is, can
be controlled by the creator of the corner; or (2) in the extreme situation, obtaining contracts requiring
the delivery of more commodities than are available for delivery. See Squeeze, Congestion.
Corn‐Hog Ratio: See Feed Ratio.
Correction: A temporary decline in prices during a bull market that partially reverses the previous rally.
See Bear Market Rally.
Cost of Carry: See Carrying Charges.
Cost of Tender: Total of various charges incurred when a commodity is certified and delivered on a
futures contract.
COT: See Commitments of Traders Report.
Counterparty: The opposite party in a bilateral agreement, contract, or transaction, such as a swap. In the
retail foreign exchange (or Forex) context, the party to which a retail customer sends its funds; lawfully,
the party must be one of those listed in Section 2(c)(2)(B)(ii)(I)‐(VI) of the Commodity Exchange Act.
Counterparty Risk: The risk associated with the financial stability of the party entered into contract with.
Forward contracts impose upon each party the risk that the counterparty will default, but futures contracts
executed on a designated contract market are guaranteed against default by the clearing organization.
Counter‐Trend Trading: In technical analysis, the method by which a trader takes a position contrary to
the current market direction in anticipation of a change in that direction.
Coupon (Coupon Rate): A fixed dollar amount of interest payable per annum, stated as a percentage of
principal value, usually payable in semiannual installments.
Cover: (1) Purchasing futures to offset a short position (same as Short Covering); see Offset, Liquidation;
(2) to have in hand the physical commodity when a short futures sale is made, or to acquire the
commodity that might be deliverable on a short sale.
Covered Option: A short call or put option position that is covered by the sale or purchase of the
underlying futures contract or other underlying instrument. For example, in the case of options on
futures contracts, a covered call is a short call position combined with a long futures position. A covered
put is a short put position combined with a short futures position.
Cox‐Ross‐Rubinstein Option Pricing Model: An option pricing model developed by John Cox, Stephen
Ross, and Mark Rubinstein that can be adopted to include effects not included in the Black‐Scholes
Model (e.g., early exercise and price supports).
CPO: See Commodity Pool Operator.
48 A PRIL 2011

Crack Spread: (1) In energy futures, the simultaneous purchase of crude oil futures and the sale of
petroleum product futures to establish a refining margin. One can trade a gasoline crack spread, a
heating oil crack spread, or a 3‐2‐1 crack spread which consists of three crude oil futures contracts
spread against two gasoline futures contracts and one heating oil futures contract. The 3‐2‐1 crack
spread is designed to approximate the typical ratio of gasoline and heating oil that results from refining a
barrel of crude oil. See Gross Processing Margin. (2) Calculation showing the theoretical market value of
petroleum products that could be obtained from a barrel of crude after the oil is refined or cracked. This
does not necessarily represent the refining margin because a barrel of crude yields varying amounts of
petroleum products.
Credit Default Option: A put option that makes a payoff in the event the issuer of a specified reference
asset defaults. Also called default option.
Credit Default Swap: A bilateral over‐the‐counter (OTC) contract in which the seller agrees to make a
payment to the buyer in the event of a specified credit event in exchange for a fixed payment or series of
fixed payments; the most common type of credit derivative; also called credit swap; similar to credit
default option.
Credit Derivative: A derivative contract designed to assume or shift credit risk, that is, the risk of a credit
event such as a default or bankruptcy of a borrower. For example, a lender might use a credit derivative
to hedge the risk that a borrower might default or have its credit rating downgraded. Common credit
derivatives include, credit default swaps, credit default options, credit spread options, downgrade
options, and total return swaps.
Credit Event: An event such as a debt default or bankruptcy that will affect the payoff on a credit
derivative, as defined in the derivative agreement.
Credit Rating: A rating determined by a rating agency that indicates the agency’s opinion of the
likelihood that a borrower such as a corporation or sovereign nation will be able to repay its debt. The
rating agencies include Standard & Poor’s, Fitch, and Moody’s.
Credit Spread: The difference between the yield on the debt securities of a particular corporate or
sovereign borrower (or a class of borrowers with a specified credit rating) and the yield of similar
maturity Treasury debt securities.
Credit Spread Option: An option whose payoff is based on the credit spread between the debt of a
particular borrower and similar maturity Treasury debt.
Credit Swap: See Credit Default Swap.
Crop Year: The time period from one harvest to the next, varying according to the commodity
(e.g., July 1 to June 30 for wheat; September 1 to August 31 for soybeans).
A PRIL 2011 49

Cross‐Hedge: Hedging a cash market position in a futures or option contract for a different but
price‐related commodity.
Cross‐Margining: A procedure for margining related securities, options, and futures contracts jointly
when different clearing organizations clear each side of the position.
Cross Rate: In foreign exchange, the price of one currency in terms of another currency in the market of
a third country. For example, the exchange rate between Japanese yen and Euros would be considered a
cross rate in the U.S. market.
Cross Trading: Offsetting or noncompetitive match of the buy order of one customer against the sell
order of another, a practice that is permissible only when executed in accordance with the Commodity
Exchange Act, CFTC rules, and rules of the exchange.
Crush Spread: In the soybean futures market, the simultaneous purchase of soybean futures and the sale
of soybean meal and soybean oil futures to establish a processing margin. See Gross Processing Margin,
Reverse Crush Spread.
CTA: See Commodity Trading Advisor.
CTI (Customer Type Indicator) Codes: These consist of four identifiers that describe transactions by the
type of customer for which a trade is effected. The four codes are: (1) trading by a person who holds
trading privileges for his or her own account or an account for which the person has discretion;
(2) trading for a clearing member’s proprietary account; (3) trading for another person who holds trading
privileges who is currently present on the trading floor or for an account controlled by such other
person; and (4) trading for any other type of customer. Transaction data classified by the above codes is
included in the trade register report produced by a clearing organization.
Curb Trading: Trading by telephone or by other means that takes place after the official market has
closed and that originally took place in the street on the curb outside the market. Under the Commodity
Exchange Act and CFTC rules, curb trading is illegal. Also known as kerb trading.
Currency Swap: A swap that involves the exchange of one currency (e.g., U.S. dollars) for another
(e.g., Japanese yen) on a specified schedule.
Current Delivery Month: See Spot Month
D
Daily Price Limit: The maximum price advance or decline from the previous day's settlement price
permitted during one trading session, as fixed by the rules of an exchange.
Day Ahead: See Next Day.
Day Order: An order that expires automatically at the end of each day's trading session. There may be a
day order with time contingency. For example, an “off at a specific time” order is an order that remains
50 A PRIL 2011

in force until the specified time during the session is reached. At such time, the order is
automatically canceled.
Day Trader: A trader, often a person with exchange trading privileges, who takes positions and then
offsets them during the same trading session prior to the close of trading.
DCM: Designated Contract Market.
Dealer: An individual or firm that acts as a market maker in an instrument such as a security or
foreign currency.
Dealer/Merchant (AD): A large trader that declares itself a “Dealer/Merchant” on CFTC Form 40, which
provides as examples “wholesaler, exporter/importer, shipper, grain elevator operator,
crude oilmarketer.”
Deck: The orders for purchase or sale of futures and option contracts held by a floor broker. Also
referred to as an order book.
Declaration Date: See Expiration Date.
Declaration (of Options): See Exercise.
Default: Failure to perform on a futures contract as required by exchange rules, such as failure to meet a
margin call, or to make or take delivery.
Default Option: See Credit Default Option.
Deferred Futures: See Back Months.
Deliverable Grades: See Contract Grades.
Deliverable Stocks: Stocks of commodities located in exchange‐approved storage for which receipts may
be used in making delivery on futures contracts. In the cotton trade, the term refers to cotton certified
for delivery. Also see Certificated or Certified Stocks.
Deliverable Supply: The total supply of a commodity that meets the delivery specifications of a futures
contract. See Economically Deliverable Supply.
Delivery: The tender and receipt of the actual commodity, the cash value of the commodity, or of a
delivery instrument covering the commodity (e.g., warehouse receipts or shipping certificates), used to
settle a futures contract. See Notice of Delivery, Delivery Notice.
Delivery, Current: Deliveries being made during a present month. Sometimes current delivery is used as
a synonym for nearby delivery.
Delivery Date: The date on which the commodity or instrument of delivery must be delivered to fulfill
the terms of a contract.
Delivery Instrument: A document used to effect delivery on a futures contract, such as a warehouse
receipt or shipping certificate.
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Delivery Month: The specified month within which a futures contract matures and can be settled by
delivery or the specified month in which the delivery period begins.
Delivery, Nearby: The nearest traded month, the front month. In plural form, one of the nearer
trading months.
Delivery Notice: The written notice given by the seller of his intention to make delivery against an open
short futures position on a particular date. This notice, delivered through the clearing organization, is
separate and distinct from the warehouse receipt or other instrument that will be used to transfer title.
Also called Notice of Intent to Deliver or Notice of Delivery.
Delivery Option: A provision of a futures contract that provides the short with flexibility in regard to
timing, location, quantity, or quality in the delivery process.
Delivery Point: A location designated by a commodity exchange where stocks of a commodity
represented by a futures contract may be delivered in fulfillment of the contract. Also called Location.
Delivery Price: The price fixed by the clearing organization at which deliveries on futures are invoiced—
generally the price at which the futures contract is settled when deliveries are made. Also called
Invoice Price.
Delta: The expected change in an option's price given a one‐unit change in the price of the underlying
futures contract or physical commodity. For example, an option with a delta of 0.5 would change $.50
when the underlying commodity moves $1.00.
Delta Margining or Delta‐Based Margining: An option margining system used by some exchanges that
equates the changes in option premiums with the changes in the price of the underlying futures contract
to determine risk factors upon which to base the margin requirements.
Delta Neutral: Refers to a position involving options that is designed to have an overall delta of zero.
Deposit: See Initial Margin.
Depository Receipt: See Vault Receipt.
Derivative: A financial instrument, traded on or off an exchange, the price of which is directly dependent
upon (i.e., “derived from”) the value of one or more underlying securities, equity indices, debt
instruments, commodities, other derivative instruments, or any agreed upon pricing index or
arrangement (e.g., the movement over time of the Consumer Price Index or freight rates). They are used
to hedge risk or to exchange a floating rate of return for fixed rate of return. Derivatives include futures,
options, and swaps. For example, futures contracts are derivatives of the physical contract and options
on futures are derivatives of futures contracts.
Derivatives Clearing Organization: A clearing organization or similar entity that, in respect to a contract
(1) enables each party to the contract to substitute, through novation or otherwise, the credit of the
derivatives clearing organization for the credit of the parties; (2) arranges or provides, on a multilateral
52 A PRIL 2011

basis, for the settlement or netting of obligations resulting from such contracts; or (3) otherwise provides
clearing services or arrangements that mutualize or transfer among participants in the derivatives
clearing organization the credit risk arising from such contracts.
Derivatives Transaction Execution Facility (DTEF): A board of trade that is registered with the CFTC as a
DTEF. A DTEF is subject to fewer regulatory requirements than a contract market. To qualify as a DTEF,
an exchange can only trade certain commodities (including excluded commodities and other
commodities with very high levels of deliverable supply) and generally must exclude retail participants
(retail participants may trade on DTEFs through futures commission merchants with adjusted net capital
of at least $20 million or registered commodity trading advisors that direct trading for accounts
containing total assets of at least $25 million). See Derivatives Transaction Execution Facilities.
Designated Contract Market: See Contract Market.
Designated Self‐Regulatory Organization (DSRO): Self‐regulatory organizations (i.e., the commodity
exchanges and registered futures associations) must enforce minimum financial and reporting
requirements for their members, among other responsibilities outlined in the CFTC's regulations. When a
futures commission merchant (FCM) is a member of more than one SRO, the SROs may decide among
themselves which of them will assume primary responsibility for these regulatory duties and, upon
approval of the plan by the Commission, be appointed the “designated self‐regulatory organization” for
that FCM.
Diagonal Spread: A spread between two call options or two put options with different strike prices and
different expiration dates. See Horizontal Spread, Vertical Spread.
Differentials: The discount (premium) allowed for grades or locations of a commodity lower (higher)
than the par of basis grade or location specified in the futures contact. See Allowances.
Digital Option: See Binary Option.
Directional Trading: Trading strategies designed to speculate on the direction of the underlying market,
especially in contrast to volatility trading.
Disclosure Document: A statement that must be provided to prospective customers that describes
trading strategy, potential risk, commissions, fees, performance, and other relevant information.
Discount: (1) The amount a price would be reduced to purchase a commodity of lesser grade; (2)
sometimes used to refer to the price differences between futures of different delivery months, as in the
phrase “July at a discount to May,” indicating that the price for the July futures is lower than that of May.
Discretionary Account: An arrangement by which the holder of an account gives written power of
attorney to someone else, often a commodity trading advisor, to buy and sell without prior approval of
the holder; often referred to as a “managed account” or controlled account.
Distillates: A category of petroleum products that includes diesel fuels and fuel oils such as heating oil.
A PRIL 2011 53

DRT (“Disregard Tape”) or Not‐Held Order: Absent any restrictions, a DRT (Not‐Held Order) means any
order giving the floor broker complete discretion over price and time in execution of an order, including
discretion to execute all, some, or none of this order.
Distant or Deferred Months: See Back Month.
Dominant Future: That future having the largest amount of open interest.
Double Hedging: As used by the CFTC, it implies a situation where a trader holds a long position in the
futures market in excess of the speculative position limit as an offset to a fixed price sale, even though
the trader has an ample supply of the commodity on hand to fill all sales commitments.
DSRO: See Designated Self‐Regulatory Organization.
DTEF: See Derivatives Transaction Execution Facility.
Dual Trading: Dual trading occurs when: (1) a floor broker executes customer orders and, on the same
day, trades for his own account or an account in which he has an interest; or (2) a futures commission
merchant carries customer accounts and also trades or permits its employees to trade in accounts in
which it has a proprietary interest, also on the same trading day.
Dutch Auction: An auction of a debt instrument (such as a Treasury note) in which all successful bidders
receive the same yield (the lowest yield that results in the sale of the entire amount to be issued).
Duration: A measure of a bond's price sensitivity to changes in interest rates.
E
Ease Off: A minor and/or slow decline in the price of a market.
ECN: Electronic Communications Network, frequently used for creating electronic stock or futures
markets.
Economically Deliverable Supply: That portion of the deliverable supply of a commodity that is in
position for delivery against a futures contract, and is not otherwise unavailable for delivery. For
example, Treasury bonds held by long‐term investment funds are not considered part of the
economically deliverable supply of a Treasury bond futures contract.
Efficient Market: In economic theory, an efficient market is one in which market prices adjust rapidly to
reflect new information. The degree to which the market is efficient depends on the quality of
information reflected in market prices. In an efficient market, profitable arbitrage opportunities do not
exist and traders cannot expect to consistently outperform the market unless they have lower‐cost
access to information that is reflected in market prices or unless they have access to information before
it is reflected in market prices. See Random Walk.
EFP: See Exchange for Physical.
EIA: See Energy Information Administration.
54 A PRIL 2011

Electronic Trading Facility: A trading facility that operates by an electronic or telecommunications
network instead of a trading floor and maintains an automated audit trail of transactions.
Eligible Commercial Entity: An eligible contract participant or other entity approved by the CFTC that has
a demonstrable ability to make or take delivery of an underlying commodity of a contract; incurs risks
related to the commodity; or is a dealer that regularly provides risk management, hedging services, or
market‐making activities to entities trading commodities or derivative agreements, contracts, or
transactions in commodities.
Eligible Contract Participant: An entity, such as a financial institution, insurance company, or commodity
pool, that is classified by the Commodity Exchange Act as an eligible contract participant based upon its
regulated status or amount of assets. This classification permits these persons to engage in transactions
(such as trading on a derivatives transaction execution facility) not generally available to non‐eligible
contract participants, i.e., retail customers.
Elliot Wave: (1) A theory named after Ralph Elliot, who contended that the stock market tends to move
in discernible and predictable patterns reflecting the basic harmony of nature and extended by other
technical analysts to futures markets; (2) in technical analysis, a charting method based on the belief that
all prices act as waves, rising and falling rhythmically.
E‐Local: A person with trading privileges at an exchange with an electronic trading facility who trades
electronically (rather than in a pit or ring) for his or her own account, often at a trading arcade.
E‐Mini: A mini contract that is traded exclusively on an electronic trading facility. E‐Mini is a trademark of
the Chicago Mercantile Exchange.
Emergency: Any market occurrence or circumstance which requires immediate action and threatens or
may threaten such things as the fair and orderly trading in, or the liquidation of, or delivery pursuant to,
any contracts on a contract market.
Energy Information Administration (EIA): An agency of the US Department of Energy that provides
statistics, data, analysis on resources, supply, production, consumption for all energy sources. EIA data
includes weekly inventory statistics for crude oil and petroleum products as well as weekly natural
storage data.
Enumerated Agricultural Commodities: The commodities specifically listed in Section 1a(3) of the
Commodity Exchange Act: wheat, cotton, rice, corn, oats, barley, rye, flaxseed, grain sorghums, mill
feeds, butter, eggs, Solanum tuberosum (Irish potatoes), wool, wool tops, fats and oils (including lard,
tallow, cottonseed oil, peanut oil, soybean oil, and all other fats and oils), cottonseed meal, cottonseed,
peanuts, soybeans, soybean meal, livestock, livestock products, and frozen concentrated orange juice.
Equity: As used on a trading account statement, refers to the residual dollar value of a futures or option
trading account, assuming it was liquidated at current prices.
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ETF: See Exchange Traded Fund.
EURIBOR® (Euro Interbank Offered Rate): The euro denominated rate of interest at which banks borrow
funds from other banks, in marketable size, in the interbank market. Euribor is sponsored by the
European Banking Federation. See LIBOR, TIBOR.Euro: The official currency of most members of the
European Union.
Eurocurrency: Certificates of Deposit (CDs), bonds, deposits, or any capital market instrument issued
outside of the national boundaries of the currency in which the instrument is denominated (for example,
Eurodollars, Euro‐Swiss francs, or Euroyen).
Eurodollars: U.S. dollar deposits placed with banks outside the U.S. Holders may include individuals,
companies, banks, and central banks.
European Option: An option that may be exercised only on the expiration date. See American Option.
Even Lot: A unit of trading in a commodity established by an exchange to which official price quotations
apply. See Round Lot.
Event Market: A market in derivatives whose payoff is based on a specified event or occurrence such as
the release of a macroeconomic indicator, a corporate earnings announcement, or the dollar value of
damages caused by a hurricane.
Exchange: A central marketplace with established rules and regulations where buyers and sellers meet to
trade futures and options contracts or securities. Exchanges include designated contract markets and
derivatives transaction execution facilities.
Exchange for Physicals (EFP): A transaction in which the buyer of a cash commodity transfers to the
seller a corresponding amount of long futures contracts, or receives from the seller a corresponding
amount of short futures, at a price difference mutually agreed upon. In this way, the opposite hedges in
futures of both parties are closed out simultaneously. Also called Exchange of Futures for Cash, AA
(against actuals), or Ex‐Pit transactions.
Exchange of Futures for Cash: See Exchange for Physicals.
Exchange of Futures for Swaps (EFS): A privately negotiated transaction in which a position in a physical
delivery futures contract is exchanged for a cash‐settled swap position in the same or a related
commodity, pursuant to the rules of a futures exchange. See Exchange for Physicals.
Exchange Rate: The price of one currency stated in terms of another currency.
Exchange Risk Factor: The delta of an option as computed daily by the exchange on which it is traded.
Exchange Traded Fund (ETF): An investment vehicle holding a commodity or other asset that issues
shares that are traded like a stock on a securities exchange.
Excluded Commodity: In general, the Commodity Exchange Act defines an excluded commodity as: any
financial instrument such as a security, currency, interest rate, debt instrument, or credit rating; any
56 A PRIL 2011

economic or commercial index other than a narrow‐based commodity index; or any other value that is
out of the control of participants and is associated with an economic consequence. See the Commodity
Exchange Act definition of excluded commodity.
Exempt Board of Trade: A trading facility that trades commodities (other than securities or securities
indexes) having a nearly inexhaustible deliverable supply and either no cash market or a cash market so
liquid that any contract traded on the commodity is highly unlikely to be susceptible to manipulation. An
exempt board of trade’s contracts must be entered into by parties that are eligible contract participants.
Exempt Commercial Market: An electronic trading facility that trades exempt commodities on a
principal‐to‐principal basis solely between persons that are eligible commercial entities.
Exempt Commodity: The Commodity Exchange Act defines an exempt commodity as any commodity
other than an excluded commodity or an agricultural commodity. Examples include energy commodities
and metals.
Exempt Foreign Firm: A foreign firm that does business with U.S. customers only on foreign exchanges
and is exempt from registration under CFTC regulations based upon compliance with its home country’s
regulatory framework (also known as a “Rule 30.10 firm”).
Exercise Price (Strike Price): The price, specified in the option contract, at which the underlying futures
contract, security, or commodity will move from seller to buyer.
Exotic Options: Any of a wide variety of options with non‐standard payout structures or other features,
including Asian options and lookback options. Exotic options are mostly traded in the over‐the‐counter
market.
Expiration Date: The date on which an option contract automatically expires; the last day an option may
be exercised.
Extrinsic Value: See Time Value.
Ex‐Pit: See Transfer Trades and Exchange for Physicals
F
FAB (Five Against Bond) Spread: A futures spread trade involving the buying (selling) of a five‐year Treasury
note futures contract and the selling (buying) of a long‐term (15‐30 year) Treasury bond futures contract.
Fannie Mae: A corporation (government‐sponsored enterprise) created by Congress to support the
secondary mortgage market (formerly the Federal National Mortgage Association). It purchases and sells
residential mortgages insured by the Federal Home Administration (FHA) or guaranteed by the Veteran's
Administration (VA). See Freddie Mac.
FAN (Five Against Note) Spread: A futures spread trade involving the buying (selling) of a five‐year
Treasury note futures contract and the selling (buying) of a ten‐year Treasury note futures contract.
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Fast Market: An open outcry market situation where transactions in the pit or ring take place in such
volume and with such rapidity that price reporters fall behind with price quotations, label each quote as
“FAST” and show a range of prices. Also called a fast tape.
The Federal Energy Regulatory Commission: (FERC): An independent agency of the U.S. Government
that regulates the interstate transmission of natural gas, oil, and electricity. FERC also regulates natural
gas and hydropower projects.
Federal Limit: A speculative position limit that is established and administered by the CFTC rather than
an exchange.
Feed Ratio: The relationship of the cost of feed, expressed as a ratio to the sale price of animals, such as
the corn‐hog ratio. These serve as indicators of the profit margin or lack of profit in feeding animals to
market weight.
FERC: See Federal Energy Regulatory Commission.
FIA: See Futures Industry Association.
Fibonacci Numbers: A number sequence discovered by a thirteenth century Italian mathematician
Leonardo Fibonacci (circa 1170‐1250), who introduced Arabic numbers to Europe, in which the sum of
any two consecutive numbers equals the next highest number—i.e., following this sequence: 1, 1, 2, 3, 5,
8, 13, 21, 34, 55, and so on. The ratio of any number to its next highest number approaches 0.618 after
the first four numbers. These numbers are used by technical analysts to determine price objectives from
percentage retracements.
Fictitious Trading: Wash trading, bucketing, cross trading, or other schemes which give the appearance
of trading but actually no bona fide, competitive trade has occurred.
Fill: The execution of an order.
Fill or Kill Order (FOK): An order that demands immediate execution or cancellation. Typically involving a
designation, added to an order, instructing the broker to offer or bid (as the case may be) one time only;
if the order is not filled immediately, it is then automatically cancelled.
Final Settlement Price: The price at which a cash‐settled futures contract is settled at maturity, pursuant
to a procedure specified by the exchange.
Financial: Can be used to refer to a derivative that is financially settled or cash settled. See Physical.
Financial Commodity: Any futures or option contract that is not based on an agricultural commodity or a
natural resource such as energy or metals. It includes currencies, equity securities, fixed income
securities, and indexes of various kinds.
Financial Future: A futures contract on a financial commodity.
Financial Settlement: See Cash settlement
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First Notice Day: The first day on which notices of intent to deliver actual commodities against futures
market positions can be received. First notice day may vary with each commodity and exchange.
Fix, Fixing: See Gold Fixing.
Fixed Income Security: A security whose nominal (or current dollar) yield is fixed or determined with
certainty at the time of purchase, typically a debt security.
Floor Broker: A person with exchange trading privileges who, in any pit, ring, post, or other place
provided by an exchange for the meeting of persons similarly engaged, executes for another person any
orders for the purchase or sale of any commodity for future delivery.
Floor Trader: A person with exchange trading privileges who executes his own trades by being personally
present in the pit or ring for futures trading. See Local.
F.O.B. (Free On Board): Indicates that all delivery, inspection and elevation, or loading costs involved in
putting commodities on board a carrier have been paid.
Forced Liquidation: The situation in which a customer's account is liquidated (open positions are offset)
by the brokerage firm holding the account, usually after notification that the account is under‐margined
due to adverse price movements and failure to meet margin calls.
Force Majeure: A clause in a supply contract that permits either party not to fulfill the contractual
commitments due to events beyond their control. These events may range from strikes to export delays
in producing countries.
Foreign Exchange: Trading in foreign currency.
Forex: Refers to the over‐the‐counter market for foreign exchange transactions. Also called the foreign
exchange market.
Forwardation: See Contango.
Forward Contract: A cash transaction common in many industries, including commodity merchandising,
in which a commercial buyer and seller agree upon delivery of a specified quality and quantity of goods
at a specified future date. Terms may be more “personalized” than is the case with standardized futures
contracts (i.e., delivery time and amount are as determined between seller and buyer). A price may be
agreed upon in advance, or there may be agreement that the price will be determined at the time
of delivery.
Forward Market: The over‐the‐counter market for forward contracts.
Forward Months: Futures contracts, currently trading, calling for later or distant delivery. See Deferred
Futures, Back Months.
Forward Rate Agreement (FRA): An OTC forward contract on short‐term interest rates. The buyer of a
FRA is a notional borrower, i.e., the buyer commits to pay a fixed rate of interest on some notional
amount that is never actually exchanged. The seller of a FRA agrees notionally to lend a sum of money to
A PRIL 2011 59

a borrower. FRAs can be used either to hedge interest rate risk or to speculate on future changes in
interest rates.
Freddie Mac: A corporation (government‐sponsored enterprise) created by Congress to support the
secondary mortgage market (formerly the Federal Home Loan Mortgage Corporation). It purchases and
sells residential mortgages insured by the Federal Home Administration (FHA) or guaranteed by the
Veterans Administration (VA). See Fannie Mae.
Front Month: The spot or nearby delivery month, the nearest traded contract month. See Back Month.
Front Running: With respect to commodity futures and options, taking a futures or option position based
upon non‐public information regarding an impending transaction by another person in the same or
related future or option. Also known as trading ahead.
Front Spread: A delta‐neutral ratio spread in which more options are sold than bought. Also called ratio
vertical spread. A front spread will increase in value if volatility decreases.
Full Carrying Charge, Full Carry: See Carrying Charges.
Fund of Funds: A commodity pool that invests in other commodity pools rather than directly in futures
and options contracts.
Fundamental Analysis: Study of basic, underlying factors that will affect the supply and demand of the
commodity being traded in futures contracts. See Technical Analysis.
Fungibility: The characteristic of interchangeability. Futures contracts for the same commodity and
delivery month traded on the same exchange are fungible due to their standardized specifications for
quality, quantity, delivery date, and delivery locations.
Futures: See Futures Contract.
Futures Commission Merchant (FCM): Individuals, associations, partnerships, corporations, and trusts that
solicit or accept orders for the purchase or sale of any commodity for future delivery on or subject to the
rules of any exchange and that accept payment from or extend credit to those whose orders are accepted.
Futures Contract: An agreement to purchase or sell a commodity for delivery in the future: (1) at a price
that is determined at initiation of the contract; (2) that obligates each party to the contract to fulfill the
contract at the specified price; (3) that is used to assume or shift price risk; and (4) that may be satisfied
by delivery or offset.
Futures‐equivalent: A term frequently used with reference to speculative position limits for options on
futures contracts. The futures‐equivalent of an option position is the number of options multiplied by the
previous day's risk factor or delta for the option series. For example, ten deep out‐of‐money options with
a delta of 0.20 would be considered two futures‐equivalent contracts. The delta or risk factor used for
this purpose is the same as that used in delta‐based margining and risk analysis systems.
60 A PRIL 2011

Futures Industry Association (FIA): A membership organization for futures commission merchants
(FCMs) which, among other activities, offers education courses on the futures markets, disburses
information, and lobbies on behalf of its members.
Futures Option: An option on a futures contract.
Futures Price: (1) Commonly held to mean the price of a commodity for future delivery that is traded on
a futures exchange; (2) the price of any futures contract.
G
Gamma: A measurement of how fast the delta of an option changes, given a unit change in the
underlying futures price; the “delta of the delta.”
Ginzy Trading: A non‐competitive trade practice in which a floor broker, in executing an order—
particularly a large order—will fill a portion of the order at one price and the remainder of the order at
another price to avoid an exchange's rule against trading at fractional increments or "split ticks."
Give Up: A contract executed by one broker for the client of another broker that the client orders to be
turned over to the second broker. The broker accepting the order from the customer collects a fee from
the carrying broker for the use of the facilities. Often used to consolidate many small orders or to
disperse large ones.
Gold Certificate: A certificate attesting to a person's ownership of a specific amount of gold bullion.
Gold Fixing (Gold Fix): The setting of the gold price at 10:30 a.m. (first fixing) and 3:00 p.m. (second
fixing) in London by representatives of the London gold market.
Gold/Silver Ratio: The number of ounces of silver required to buy one ounce of gold at current spot prices.
Good This Week Order (GTW): Order which is valid only for the week in which it is placed.
Good 'Till Canceled Order (GTC): An order which is valid until cancelled by the customer. Unless
specified GTC, unfilled orders expire at the end of the trading day. See Open Order.
GPM: See Gross Processing Margin.
Grades: Various qualities of a commodity.
Grading Certificates: A formal document setting forth the quality of a commodity as determined by
authorized inspectors or graders.
Grain Futures Act: Federal statute that provided for the regulation of trading in grain futures, effective
June 22, 1923; administered by the Grain Futures Administration, an agency of the U.S. Department of
Agriculture. The Grain Futures Act was amended in 1936 by the Commodity Exchange Act and the Grain
Futures Administration became the Commodity Exchange Administration, later the Commodity
Exchange Authority.
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Grantor: The maker, writer, or issuer of an option contract who, in return for the premium paid for the
option, stands ready to purchase the underlying commodity (or futures contract) in the case of a put
option or to sell the underlying commodity (or futures contract) in the case of a call option.
Gross Processing Margin (GPM): Refers to the difference between the cost of a commodity and the
combined sales income of the finished products that result from processing the commodity. Various
industries have formulas to express the relationship of raw material costs to sales income from finished
products. See Crack Spread, Crush Spread, and Spark Spread.
GTC: See Good 'Till Canceled Order.
GTW: See Good This Week Order.
Guaranteed Introducing Broker: An introducing broker that has entered into a guarantee agreement
with a futures commission merchant (FCM), whereby the FCM agrees to be jointly and severally liable for
all of the introducing broker’s obligations under the Commodity Exchange Act. By entering into the
agreement, the introducing broker is relieved from the necessity of raising its own capital to satisfy
minimum financial requirements. In contrast, an independent introducing broker must raise its own
capital to meet minimum financial requirements.
H
Haircut: In computing the value of assets for purposes of capital, segregation, or margin requirements, a
percentage reduction from the stated value (e.g., book value or market value) to account for possible
declines in value that may occur before assets can be liquidated.
Hand Held Terminal: A small computer terminal used by floor brokers or floor traders on an exchange to
record trade information and transmit that information to the clearing organization.
Hardening: (1) Describes a price which is gradually stabilizing; (2) a term indicating a slowly
advancing market.
Hard Position Limit: A Speculative Position Limit, especially in contrast to a position accountability level.
Head and Shoulders: In technical analysis, a chart formation that resembles a human head and shoulders
and is generally considered to be predictive of a price reversal. A head and shoulders top (which is
considered predictive of a price decline) consists of a high price, a decline to a support level, a rally to a
higher price than the previous high price, a second decline to the support level, and a weaker rally to
about the level of the first high price. The reverse (upside‐down) formation is called a head and
shoulders bottom (which is considered predictive of a price rally).
Heavy: A market in which prices are demonstrating either an inability to advance or a slight tendency
to decline.
Hedge Exemption: An exemption from speculative position limits for bona fide hedgers and certain other
persons who meet the requirements of exchange and CFTC rules.
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Hedge Fund: A private investment fund or pool that trades and invests in various assets such as
securities, commodities, currency, and derivatives on behalf of its clients, typically wealthy individuals.
Some commodity pool operators operate hedge funds.
Hedge Ratio: Ratio of the value of futures contracts purchased or sold to the value of the cash
commodity being hedged, a computation necessary to minimize basis risk.
Hedger: A trader who enters into positions in a futures market opposite to positions held in the cash
market to minimize the risk of financial loss from an adverse price change; or who purchases or sells
futures as a temporary substitute for a cash transaction that will occur later. One can hedge either a long
cash market position (e.g., one owns the cash commodity) or a short cash market position (e.g., one
plans on buying the cash commodity in the future).
Henry Hub: A natural gas pipeline hub in Louisiana that serves as the delivery point for New York
Mercantile Exchange natural gas futures contracts and often serves as a benchmark for wholesale
natural gas prices across the U.S.
Hidden Quantity Order: An order placed on an electronic trading system whereby only a portion of the
order is visible to other market participants. As the displayed part of the order is filled, additional
quantities become visible. Also called Iceberg, Max Show.
High Frequency Trading: Computerized or algorithmic trading in which transactions are completed in
very small fractions of a second.
Historical Volatility: A statistical measure (specifically, the annualized standard deviation) of the volatility
of a futures contract, security, or other instrument over a specified number of past trading days.
Hog‐Corn Ratio: See Feed Ratio.
Horizontal Spread (also called Time Spread or Calendar Spread): An option spread involving the
simultaneous purchase and sale of options of the same class and strike prices but different expiration
dates. See Diagonal Spread, Vertical Spread.
Hybrid Instruments: Financial instruments that possess, in varying combinations, characteristics of
forward contracts, futures contracts, option contracts, debt instruments, bank depository interests, and
other interests. Certain hybrid instruments are exempt from CFTC regulation.
IJK
IB: See Introducing Broker.
Iceberg: See Hidden Quantity Order.
Implied Repo Rate: The rate of return that can be obtained from selling a debt instrument futures
contract and simultaneously buying a bond or note deliverable against that futures contract with
borrowed funds. The bond or note with the highest implied repo rate is cheapest to deliver.
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Implied Volatility: The volatility of a futures contract, security, or other instrument as implied by the
prices of an option on that instrument, calculated using an option pricing model.
Index Arbitrage: The simultaneous purchase (sale) of stock index futures and the sale (purchase) of some or
all of the component stocks that make up the particular stock index to profit from sufficiently large
intermarket spreads between the futures contract and the index itself. Also see Arbitrage, Program Trading.
Indirect Bucketing: Also referred to as indirect trading against. Refers to when a floor broker effectively
trades opposite his customer in a pair of non‐competitive transactions by buying (selling) opposite an
accommodating trader to fill a customer order and by selling (buying) for his personal account opposite
the same accommodating trader. The accommodating trader assists the floor broker by making it appear
that the customer traded opposite him rather than opposite the floor broker.
Inflation‐Indexed Debt Instrument: Generally a debt instrument (such as a bond or note) on which the
payments are adjusted for inflation and deflation. In a typical inflation‐indexed instrument, the principal
amount is adjusted monthly based on an inflation index such as the Consumer Price Index.
Initial Deposit: See Initial Margin.
Initial Margin: Customers' funds put up as security for a guarantee of contract fulfillment at the time a
futures market position is established. See Original Margin.
In Position: Refers to a commodity located where it can readily be moved to another point or delivered
on a futures contract. Commodities not so situated are "out of position." Soybeans in Mississippi are out
of position for delivery in Chicago, but in position for export shipment from the Gulf of Mexico.
In Sight: The amount of a particular commodity that arrives at terminal or central locations in or near
producing areas. When a commodity is “in sight,” it is inferred that reasonably prompt delivery can be
made; the quantity and quality also become known factors rather than estimates.
Instrument: A tradable asset such as a commodity, security, or derivative, or an index or value that
underlies a derivative or could underlie a derivative.
Intercommodity Spread: A spread in which the long and short legs are in two different but generally
related commodity markets. Also called an intermarket spread. See Spread.
Interdelivery Spread: A spread involving two different months of the same commodity. Also called an
intracommodity spread. See Spread.
Interest Rate Futures: Futures contracts traded on fixed income securities such as U.S. Treasury issues,
or based on the levels of specified interest rates such as LIBOR (London Interbank Offered Rate).
Currency is excluded from this category, even though interest rates are a factor in currency values.
Interest Rate Swap: A swap in which the two counterparties agree to exchange interest rate flows.
Typically, one party agrees to pay a fixed rate on a specified series of payment dates and the other party
64 A PRIL 2011

pays a floating rate that may be based on LIBOR (London Interbank Offered Rate) on those payment
dates. The interest rates are paid on a specified principal amount called the notional principal.
Intermarket Spread: See Spread and Intercommodity Spread.
Intermediary: A person who acts on behalf of another person in connection with futures trading, such as
a futures commission merchant, introducing broker, commodity pool operator, commodity trading
advisor, or associated person.
International Swaps and Derivatives Association (ISDA): A New York‐based group of major international
swaps dealers, that publishes the Code of Standard Wording, Assumptions and Provisions for Swaps, or
Swaps Code, for U.S. dollar interest rate swaps as well as standard master interest rate, credit, and
currency swap agreements and definitions for use in connection with the creation and trading of swaps.
In‐The‐Money: A term used to describe an option contract that has a positive value if exercised. A call
with a strike price of $390 on gold trading at $400 is in‐the‐money 10 dollars. See Intrinsic Value.
Intracommodity Spread: See Spread and Interdelivery Spread.
Intrinsic Value: A measure of the value of an option or a warrant if immediately exercised, that is, the
extent to which it is in‐the‐money. The amount by which the current price for the underlying commodity
or futures contract is above the strike price of a call option or below the strike price of a put option for
the commodity or futures contract.
Introducing Broker (IB): A person (other than a person registered as an associated person of a futures
commission merchant) who is engaged in soliciting or in accepting orders for the purchase or sale of any
commodity for future delivery on an exchange who does not accept any money, securities, or property
to margin, guarantee, or secure any trades or contracts that result therefrom.
Inverted Market: A futures market in which the nearer months are selling at prices higher than the more
distant months; a market displaying “inverse carrying charges,” characteristic of markets with supply
shortages. See Backwardation.
Invisible Supply: Uncounted stocks of a commodity in the hands of wholesalers, manufacturers, and
producers that cannot be identified accurately; stocks outside commercial channels but theoretically
available to the market. See Visible Supply.
Invoice Price: The price fixed by the clearing house at which deliveries on futures are invoiced—generally
the price at which the futures contract is settled when deliveries are made. Also called Delivery Price.
ISDA: See International Swaps and Derivatives Association.
Job Lot: A form of contract having a smaller unit of trading than is featured in a regular contract.
Kerb Trading or Dealing: See Curb Trading.
Knock‐In: A provision in an option or other derivative contract, whereby the contract is activated only if
the price of the underlying instrument reaches a specified level before a specified expiration date.
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Knock‐Out: A provision in an option or other derivative contract, whereby the contract is immediately
canceled if the price of the underlying instrument reaches a specified level during the life of the contract.
L
Large Order Execution (LOX) Procedures: Rules in place at the Chicago Mercantile Exchange that
authorize a member firm that receives a large order from an initiating party to solicit counterparty
interest off the exchange floor prior to open execution of the order in the pit and that provide for special
surveillance procedures. The parties determine a maximum quantity and an "intended execution price."
Subsequently, the initiating party's order quantity is exposed to the pit; any bids (or offers) up to and
including those at the intended execution price are hit (acceptable). The unexecuted balance is then
crossed with the contraside trader found using the LOX procedures.
Large Traders: A large trader is one who holds or controls a position in any one future or in any one
option expiration series of a commodity on any one exchange equaling or exceeding the exchange or
CFTC‐specified reporting level.
Last Notice Day: The final day on which notices of intent to deliver on futures contracts may be issued.
Last Trading Day: Day on which trading ceases for the maturing (current) delivery month. Latency: The
amount of time that elapses between the placement of a market order or marketable limit order on an
electronic trading system and the execution of that order.
Latency: The amount of time that elapses between the placement of a market order or marketable limit
order on an electronic trading system and the execution of that order.
Leaps: Long‐dated, exchange‐traded options. Stands for “Long‐term Equity Anticipation Securities.”
Leverage: The ability to control large dollar amounts of a commodity or security with a comparatively
small amount of capital.
LIBOR: The London Interbank Offered Rate. The rate of interest at which banks borrow funds
(denominated in U.S. dollars) from other banks, in marketable size, in the London interbank market.
LIBOR rates are disseminated by the British Bankers Association, which also disseminates LIBOR rates for
British pounds sterling. Some interest rate futures contracts, including Eurodollar futures, are cash
settled based on LIBOR. Also see EURIBOR® and TIBOR.
Licensed Warehouse: A warehouse approved by an exchange from which a commodity may be delivered
on a futures contract. See Regular Warehouse.
Life of Contract: Period between the beginning of trading in a particular futures contract and the
expiration of trading. In some cases, this phrase denotes the period already passed in which trading has
already occurred. For example, “The life‐of‐contract high so far is $2.50.” Same as life of delivery or life
of the future.
66 A PRIL 2011

Limit (Up or Down): The maximum price advance or decline from the previous day's settlement price
permitted during one trading session, as fixed by the rules of an exchange. In some futures contracts, the
limit may be expanded or removed during a trading session a specified period of time after the contract
is locked limit. See Daily Price Limit.
Limit Move: See Locked Limit.
Limit Only: The definite price stated by a customer to a broker restricting the execution of an order to
buy for not more than, or to sell for not less than, the stated price.
Limit Order: An order in which the customer specifies a minimum sale price or maximum purchase price,
as contrasted with a market order, which implies that the order should be filled as soon as possible at
the market price.
Liquidation: The closing out of a long position. The term is sometimes used to denote closing out a short
position, but this is more often referred to as covering. See Cover, Offset.
Liquid Market: A market in which selling and buying can be accomplished with minimal effect on price.
Local: An individual with exchange trading privileges who trades for his own account, traditionally on an
exchange floor, and whose activities provide market liquidity. See Floor Trader, E‐Local.
Location: A Delivery Point for a futures contract.
Locked‐In: A hedged position that cannot be lifted without offsetting both sides of the hedge (spread).
See Hedging. Also refers to being caught in a limit price move.
Locked Limit: A price that has advanced or declined the permissible limit during one trading session, as
fixed by the rules of an exchange. Also called Limit Move.
London Gold Market: Refers to the dealers in the London Bullion Market Association who set (fix) the
gold price in London. See Gold Fixing.
Long: (1) One who has bought a futures contract to establish a market position; (2) a market position
that obligates the holder to take delivery; (3) one who owns an inventory of commodities. See Short.
Long Hedge: See Buying Hedge.
Long the Basis: A person or firm that has bought the spot commodity and hedged with a sale of futures is
said to be long the basis.
Lookalike Option: An over‐the‐counter option that is cash settled based on the settlement price of a
similar exchange‐traded futures contract on a specified trading day.
Lookalike Swap: An over‐the‐counter swap that is cash settled based on the settlement price of a similar
exchange‐traded futures contract on a specified trading day.
Lookback Option: An exotic option whose payoff depends on the minimum or maximum price of the
underlying asset during some portion of the life of the option. Lookback options allow the buyer to pay
or receive the most favorable underlying price during the lookback period.
A PRIL 2011 67

Lot: A unit of trading. See Even Lot, Job Lot, and Round Lot.
M
Macro Fund: A hedge fund that specializes in strategies designed to profit from expected
macroeconomic events.
Maintenance Margin: See Margin.
Managed Account: See Controlled Account and Discretionary Account.
Managed Money Trader (MMTs): A futures market participant who engages in futures trades on behalf
of investment funds or clients. While MMTs are commonly equated with hedge funds, they may include
Commodity Pool Operators and other managed accounts as well as hedge funds. While CFTC Form 40
does not provide a place to declare oneself a Managed Money Trader, a large trader can declare itself a
“Hedge Fund (H)” or “Managed Accounts and Commodity Pools.”
Manipulation: Any planned operation, transaction, or practice that causes or maintains an artificial price.
Specific types include corners and squeezes as well as unusually large purchases or sales of a commodity
or security in a short period of time in order to distort prices, and putting out false information in order
to distort prices.
Manufacturer (AM): A large trader that declares itself a “Manufacturer” on CFTC Form 40, which
provides as examples “refiner, miller, crusher, fabricator, sawmill, coffee roaster, cocoa grinder.”
Many‐to‐Many: Refers to a trading platform in which multiple participants have the ability to execute or
trade commodities, derivatives, or other instruments by accepting bids and offers made by multiple
other participants. In contrast to one‐to‐many platforms, many‐to‐many platforms are considered
trading facilities under the Commodity Exchange Act. Traditional exchanges are many‐to‐many
platforms.
Margin: The amount of money or collateral deposited by a customer with his broker, by a broker with a
clearing member, or by a clearing member with a clearing organization. The margin is not partial
payment on a purchase. Also called Performance Bond. (1) Initial margin is the amount of margin
required by the broker when a futures position is opened; (2) Maintenance margin is an amount that
must be maintained on deposit at all times. If the equity in a customer's account drops to or below the
level of maintenance margin because of adverse price movement, the broker must issue a margin call to
restore the customer's equity to the initial level. See Variation Margin. Exchanges specify levels of initial
margin and maintenance margin for each futures contract, but futures commission merchants may
require their customers to post margin at higher levels than those specified by the exchange. Futures
margin is determined by the SPAN margining system, which takes into account all positions in a
customer’s portfolio.
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Margin Call: (1) A request from a brokerage firm to a customer to bring margin deposits up to initial
levels; (2) a request by the clearing organization to a clearing member to make a deposit of original
margin, or a daily or intra‐day variation margin payment because of adverse price movement, based on
positions carried by the clearing member.
Market‐if‐Touched (MIT) Order: An order that becomes a market order when a particular price is
reached. A sell MIT is placed above the market; a buy MIT is placed below the market. Also referred to as
a board order. Compare to Stop Order.
Market Maker: A professional securities dealer or person with trading privileges on an exchange who has
an obligation to buy when there is an excess of sell orders and to sell when there is an excess of buy
orders. By maintaining an offering price sufficiently higher than their buying price, these firms are
compensated for the risk involved in allowing their inventory of securities to act as a buffer against
temporary order imbalances. In the futures industry, this term is sometimes loosely used to refer to a
floor trader or local who, in speculating for his own account, provides a market for commercial users of
the market. Occasionally a futures exchange will compensate a person with exchange trading privileges
to take on the obligations of a market maker to enhance liquidity in a newly listed or lightly traded
futures contract. See Specialist System.
Market‐on‐Close: An order to buy or sell at the end of the trading session at a price within the closing
range of prices. See Stop‐Close‐Only Order.
Market‐on‐Opening: An order to buy or sell at the beginning of the trading session at a price within the
opening range of prices.
Market Order: An order to buy or sell a futures contract at whatever price is obtainable at the time it is
entered in the ring, pit, or other trading platform. See At‐the‐Market Limit Order.
Mark‐to‐Market: Part of the daily cash flow system used by U.S. futures exchanges to maintain a
minimum level of margin equity for a given futures or option contract position by calculating the gain or
loss in each contract position resulting from changes in the price of the futures or option contracts at the
end of each trading session. These amounts are added or subtracted to each account balance.
Maturity: Period within which a futures contract can be settled by delivery of the actual commodity.
Max Show: See Hidden Quantity Order.
Maximum Price Fluctuation: See Limit (Up or Down) and Daily Price Limit.
Member Rate: Commission charged for the execution of an order for a person who is a member of or
has trading privileges at the exchange.
Mini: Refers to a futures contract that has a smaller contract size than an otherwise identical
futures contract.
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Minimum Price Contract: A hybrid commercial forward contract for agricultural products that includes a
provision guaranteeing the person making delivery a minimum price for the product. For agricultural
commodities, these contracts became much more common with the introduction of exchange‐traded
options on futures contracts, which permit buyers to hedge the price risks associated with such contracts.
Minimum Price Fluctuation (Minimum Tick): Smallest increment of price movement possible in trading a
given contract.
Minimum Tick: See Minimum Price Fluctuation.
MMBTU: Million British Thermal Units, the unit of trading in the natural gas futures market.
MOB Spread: A spread between the municipal bond futures contract and the Treasury bond contract,
also known as munis over bonds.
Momentum: In technical analysis, the relative change in price over a specific time interval. Often
equated with speed or velocity and considered in terms of relative strength.
Money Market: The market for short‐term debt instruments.
Multilateral Clearing Organization: See Clearing Organization
N
Naked Option: The sale of a call or put option without holding an equal and opposite position in the
underlying instrument. Also referred to as an uncovered option, naked call, or naked put.
Narrow‐Based Security Index: In general, the Commodity Exchange Act defines a narrow‐based security
index as an index of securities that meets one of the following four requirements (1) it has nine or fewer
components; (2) one component comprises more than 30 percent of the index weighting; (3) the five
highest weighted components comprise more than 60 percent of the index weighting, or (4) the lowest
weighted components comprising in the aggregate 25 percent of the index’s weighting have an
aggregate dollar value of average daily volume over a six‐month period of less than $50 million
($30 million if there are at least 15 component securities). However, the legal definition in Section 1a(25)
of the Commodity Exchange Act, 7 USC 1a(25), contains several exceptions to this provision. See Broad‐
Based Security Index, Security Future.
National Futures Association (NFA): A self‐regulatory organization whose members include futures
commission merchants, commodity pool operators, commodity trading advisors, introducing brokers,
commodity exchanges, commercial firms, and banks, that is responsible—under CFTC oversight—for
certain aspects of the regulation of FCMs, CPOs, CTAs, IBs, and their associated persons, focusing
primarily on the qualifications and proficiency, financial condition, retail sales practices, and business
conduct of these futures professionals. NFA also performs arbitration and dispute resolution functions
for industry participants.
Nearbys: The nearest delivery months of a commodity futures market.
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Nearby Delivery Month: The month of the futures contract closest to maturity; the front month or
lead month.
Negative Carry: The cost of financing a financial instrument (the short‐term rate of interest), when the
cost is above the current return of the financial instrument. See Carrying Charges and Positive Carry.
Net Asset Value (NAV): The value of each unit of participation in a commodity pool.
Net Position: The difference between the open long contracts and the open short contracts held by a
trader in any one commodity.
NFA: National Futures Association.
Next Day: A spot contract that provides for delivery of a commodity on the next calendar day or the next
business day. Also called day ahead.
NOB (Note Against Bond) Spread: A futures spread trade involving the buying (selling) of a ten‐year
Treasury note futures contract and the selling (buying) of a Treasury bond futures contract.
Non‐Member Traders: Speculators and hedgers who trade on the exchange through a member or a
person with trading privileges but who do not hold exchange memberships or trading privileges.
Nominal Price (or Nominal Quotation): Computed price quotation on a futures or option contract for a
period in which no actual trading took place, usually an average of bid and asked prices or computed
using historical or theoretical relationships to more active contracts.
Notice Day: Any day on which notices of intent to deliver on futures contracts may be issued.
Notice of Intent to Deliver: A notice that must be presented by the seller of a futures contract to the
clearing organization prior to delivery. The clearing organization then assigns the notice and subsequent
delivery instrument to a buyer. Also notice of delivery.
Notional Principal: In an interest rate swap, forward rate agreement, or other derivative instrument, the
amount or, in a currency swap, each of the amounts to which interest rates are applied in order to
calculate periodic payment obligations. Also called the notional amount, the contract amount, the
reference amount, and the currency amount.
NYMEX Lookalike: A lookalike swap or lookalike option that is based on a futures contract traded on the
New York Mercantile Exchange (NYMEX).
O
OCO: See One Cancels the Other Order.
Offer: An indication of willingness to sell at a given price; opposite of bid, the price level of the offer may
be referred to as the ask.
Off Exchange: See Over‐the‐Counter.
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Offset: Liquidating a purchase of futures contracts through the sale of an equal number of contracts of
the same delivery month, or liquidating a short sale of futures through the purchase of an equal number
of contracts of the same delivery month. See Closing Out and Cover.
Omnibus Account: An account carried by one futures commission merchant, the carrying FCM, for
another futures commission merchant, the originating FCM, in which the transactions of two or more
persons, who are customers of the originating FCM, are combined and carried by the carrying FCM.
Omnibus account titles must clearly show that the funds and trades therein belong to customers of the
originating FCM. An originating broker must use an omnibus account to execute or clear trades for
customers at a particular exchange where it does not have trading or clearing privileges.
On Track (or Track Country Station): (1) A type of deferred delivery in which the price is set f.o.b. seller's
location, and the buyer agrees to pay freight costs to his destination; (2) commodities loaded in railroad
cars on tracks.
One Cancels the Other (OCO) Order: A pair of orders, typically limit orders, whereby if one order is filled,
the other order will automatically be cancelled. For example, an OCO order might consist of an order to
buy 10 calls with a strike price of 50 at a specified price or buy 20 calls with a strike price of 55 (with the
same expiration date) at a specified price.
One‐to‐Many: Refers to a proprietary trading platform in which the platform operator posts bids and
offers for commodities, derivatives, or other instruments and serves as a counterparty to every
transaction executed on the platform. In contrast to many‐to‐many platforms, one‐to‐many platforms
are not considered trading facilities under the Commodity Exchange Act.
Opening Price (or Range): The price (or price range) recorded during the period designated by the
exchange as the official opening.
Opening: The period at the beginning of the trading session officially designated by the exchange during
which all transactions are considered made “at the opening.”
Open Interest: The total number of futures contracts long or short in a delivery month or market that
has been entered into and not yet liquidated by an offsetting transaction or fulfilled by delivery. Also
called open contracts or open commitments.
Open Order (or Orders): An order that remains in force until it is canceled or until the futures contracts
expire. See Good 'Till Canceled and Good This Week orders.
Open Outcry: A method of public auction, common to most U.S. commodity exchanges during the
20th century, where trading occurs on a trading floor and traders may bid and offer simultaneously either
for their own accounts or for the accounts of customers. Transactions may take place simultaneously at
different places in the trading pit or ring. At most exchanges been replaced or largely replaced by
electronic trading platforms. See Specialist System.
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Open Trade Equity: The unrealized gain or loss on open futures positions.
Option: A contract that gives the buyer the right, but not the obligation, to buy or sell a specified
quantity of a commodity or other instrument at a specific price within a specified period of time,
regardless of the market price of that instrument. Also see Put and Call.
Option Buyer: The person who buys calls, puts, or any combination of calls and puts.
Option Delta: See Delta.
Option Writer: The person who originates an option contract by promising to perform a certain
obligation in return for the price or premium of the option. Also known as option grantor or
option seller.
Option Pricing Model: A mathematical model used to calculate the theoretical value of an option. Inputs
to option pricing models typically include the price of the underlying instrument, the option strike price,
the time remaining till the expiration date, the volatility of the underlying instrument, and the risk‐free
interest rate (e.g., the Treasury bill interest rate). Examples of option pricing models include
Black‐Scholes and Cox‐Ross‐Rubinstein.
Original Margin: Term applied to the initial deposit of margin money each clearing member firm is
required to make according to clearing organization rules based upon positions carried, determined
separately for customer and proprietary positions; similar in concept to the initial margin or security
deposit required of customers by exchange rules. See Initial Margin.
OTC: See Over‐the‐Counter.
Out of Position: See In Position.
Out‐Of‐The‐Money: A term used to describe an option that has no intrinsic value. For example, a call
with a strike price of $400 on gold trading at $390 is out‐of‐the‐money 10 dollars.
Outright: An order to buy or sell only one specific type of futures contract; an order that is not a
spread order.
Out Trade: A trade that cannot be cleared by a clearing organization because the trade data submitted
by the two clearing members or two traders involved in the trade differs in some respect (e.g., price
and/or quantity). In such cases, the two clearing members or traders involved must reconcile the
discrepancy, if possible, and resubmit the trade for clearing. If an agreement cannot be reached by the
two clearing members or traders involved, the dispute would be settled by an appropriate exchange
committee.
Overbought: A technical opinion that the market price has risen too steeply and too fast in relation to
underlying fundamental factors. Rank and file traders who were bullish and long have turned bearish.
Overnight Trade: A trade which is not liquidated during the same trading session during which it
was established.
A PRIL 2011 73

Oversold: A technical opinion that the market price has declined too steeply and too fast in relation to
underlying fundamental factors; rank and file traders who were bearish and short have turned bullish.
Over‐the‐Counter (OTC): The trading of commodities, contracts, or other instruments not listed on any
exchange. OTC transactions can occur electronically or over the telephone. Also referred to as
Off‐Exchange.
P
P&S (Purchase and Sale Statement): A statement sent by a futures commission merchant to a customer
when any part of a futures position is offset, showing the number of contracts involved, the prices at
which the contracts were bought or sold, the gross profit or loss, the commission charges, the net profit
or loss on the transactions, and the balance. FCMs also send P&S Statements whenever any other event
occurs that alters the account balance including when the customer deposits or withdraws margin and
when the FCM places excess margin in interest bearing instruments for the customer’s benefit.
Paper Profit or Loss: The profit or loss that would be realized if open contracts were liquidated as of a
certain time or at a certain price.
Par: (1) Refers to the standard delivery point(s) and/or quality of a commodity that is deliverable on a
futures contract at contract price. Serves as a benchmark upon which to base discounts or premiums for
varying quality and delivery locations; (2) in bond markets, an index (usually 100) representing the face
value of a bond.
Path Dependent Option: An option whose valuation and payoff depends on the realized price path of
the underlying asset, such as an Asian option or a Lookback option.
Pay/Collect: A shorthand method of referring to the payment of a loss (pay) and receipt of a gain
(collect) by a clearing member to or from a clearing organization that occurs after a futures position has
been marked‐to‐market. See Variation Margin.
Pegged Price: The price at which a commodity has been fixed by agreement.
Pegging: Effecting transactions in an instrument underlying an option to prevent a decline in the price of
the instrument shortly prior to the option’s expiration date so that previously written put options will
expire worthless, thus protecting premiums previously received. See Capping.
Performance Bond: See Margin.
Physical: A contract or derivative that provides for the physical delivery of a commodity rather than cash
settlement. See Financial.
Physical Commodity: A commodity other than a financial commodity, typically an agricultural
commodity, energy commodity or a metal.
Physical Delivery: A provision in a futures contract or other derivative for delivery of the actual
commodity to satisfy the contract. Compare to cash settlement.
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Pip: The smallest price unit of a commodity or currency.
Pit: A specially constructed area on the trading floor of some exchanges where trading in a futures
contract or option is conducted. On other exchanges, the term ring designates the trading area for
commodity contract.
Pit Brokers: See Floor Broker.
Point‐and‐Figure: A method of charting that uses prices to form patterns of movement without regard to
time. It defines a price trend as a continued movement in one direction until a reversal of a
predetermined criterion is met.
Point Balance: A statement prepared by futures commission merchants to show profit or loss on all open
contracts using an official closing or settlement price, usually at calendar month end.
Ponzi Scheme: Named after Charles Ponzi, a man with a remarkable criminal career in the early
20th century, the term has been used to describe pyramid arrangements whereby an enterprise makes
payments to investors from the proceeds of a later investment rather than from profits of the underlying
business venture, as the investors expected, and gives investors the impression that a legitimate profit‐
making business or investment opportunity exists, where in fact it is a mere fiction.
Pork Bellies: One of the major cuts of the hog carcass that, when cured, becomes bacon.
Portfolio Insurance: A trading strategy that uses stock index futures and/or stock index options to
protect stock portfolios against market declines.
Portfolio Margining: A method for setting margin requirements that evaluates positions as a group or
portfolio and takes into account the potential for losses on some positions to be offset by gains on others.
Specifically, the margin requirement for a portfolio is typically set equal to an estimate of the largest
possible decline in the net value of the portfolio that could occur under assumed changes in market
conditions. Sometimes referred to as risked‐based margining. Also see Strategy‐Based Margining.
Position: An interest in the market, either long or short, in the form of one or more open contracts.
Position Accountability: A rule adopted by an exchange requiring persons holding a certain number of
outstanding contracts to report the nature of the position, trading strategy, and hedging information of
the position to the exchange, upon request of the exchange. See Speculative Position Limit.
Position Limit: See Speculative Position Limit.
Position Trader: A commodity trader who either buys or sells contracts and holds them for an extended
period of time, as distinguished from a day trader, who will normally initiate and offset a futures position
within a single trading session.
Positive Carry: The cost of financing a financial instrument (the short‐term rate of interest), where the
cost is less than the current return of the financial instrument. See Carrying Charges and Negative Carry.
A PRIL 2011 75

Posted Price: An announced or advertised price indicating what a firm will pay for a commodity or the
price at which the firm will sell it.
Prearranged Trading: Trading between brokers in accordance with an expressed or implied agreement
or understanding, which is a violation of the Commodity Exchange Act and CFTC regulations.
Premium: (1) The payment an option buyer makes to the option writer for granting an option contract;
(2) the amount a price would be increased to purchase a better quality commodity; (3) refers to a futures
delivery month selling at a higher price than another, as “July is at a premium over May.”
Price Banding: A CME Group and ICE‐instituted mechanism to ensure a fair and orderly market on an
electronic trading platform. This mechanism subjects all incoming orders to price verification and rejects
all orders with clearly erroneous prices. Price bands are monitored throughout the day and adjusted if
necessary.
Price Basing: A situation where producers, processors, merchants, or consumers of a commodity
establish commercial transaction prices based on the futures prices for that or a related commodity
(e.g., an offer to sell corn at 5 cents over the December futures price). This phenomenon is commonly
observed in grain and metal markets.
Price Discovery: The process of determining the price level for a commodity based on supply and
demand conditions. Price discovery may occur in a futures market or cash market.
Price Movement Limit: See Limit (Up or Down).
Primary Market: (1) For producers, their major purchaser of commodities; (2) to processors, the market
that is the major supplier of their commodity needs; and (3) in commercial marketing channels, an
important center at which spot commodities are concentrated for shipment to terminal markets.
Producer (AP): A large trader that declares itself a “Producer” on CFTC Form 40, which provides as
examples, “farmer” and “miner.” A firm that extracts crude oil or natural gas from the ground would also
be considered a Producer.
Program Trading: The purchase (or sale) of a large number of stocks contained in or comprising a
portfolio. Originally called program trading when index funds and other institutional investors began to
embark on large‐scale buying or selling campaigns or “programs” to invest in a manner that replicates a
target stock index, the term now also commonly includes computer‐aided stock market buying or selling
programs, and index arbitrage.
Prompt Date: The date on which the buyer of an option will buy or sell the underlying commodity (or
futures contract) if the option is exercised.
Prop Shop: A proprietary trading group, especially one where the group's traders trade electronically at a
physical facility operated by the group.
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Proprietary Account: An account that a futures commission merchant carries for itself or a closely
related person, such as a parent, subsidiary or affiliate company, general partner, director, associated
person, or an owner of 10 percent or more of the capital stock. The FCM must segregate customer funds
from funds related to proprietary accounts.
Proprietary Trading Group: An organization whose owners, employees, and/or contractors trade in the
name of accounts owned by the group and exclusively use the funds of the group for all of their
trading activity.
Public: In trade parlance, non‐professional speculators as distinguished from hedgers and professional
speculators or traders.
Public Elevators: Grain elevators in which bulk storage of grain is provided to the public for a fee. Grain
of the same grade but owned by different persons is usually mixed or commingled as opposed to storing
it "identity preserved." Some elevators are approved by exchanges as regular for delivery on futures
contracts, see Regular Warehouse.
Purchase and Sale Statement: See P&S.
Put: An option contract that gives the holder the right but not the obligation to sell a specified quantity
of a particular commodity, security, or other asset or to enter into a short futures position at a given
price (the "strike price") prior to or on a specified expiration date.
Pyramiding: The use of profits on existing positions as margin to increase the size of the position,
normally in successively smaller increments.
QR
Qualified Eligible Person (QEP): The definition of QEP is too complex to summarize here; please see CFTC
Regulation 4.7(a)(2) and (a)(3), 17 CFR 4.7(a)(2) and (a)(3), for the full definition.
Quick Order: See Fill or Kill Order.
Quotation: The actual price or the bid or ask price of either cash commodities or futures contracts.
Rally: An upward movement of prices.
Random Walk: An economic theory that market price movements move randomly. This assumes an
efficient market. The theory also assumes that new information comes to the market randomly.
Together, the two assumptions imply that market prices move randomly as new information is
incorporated into market prices. The theory implies that the best predictor of future prices is the current
price, and that past prices are not a reliable indicator of future prices. If the random walk theory is
correct, technical analysis cannot work.
Range: The difference between the high and low price of a commodity, futures, or option contract during
a given period.
A PRIL 2011 77

Ratio Hedge: The number of options compared to the number of futures contracts bought or sold in
order to establish a hedge that is neutral or delta neutral.
Ratio Spread: This strategy, which applies to both puts and calls, involves buying or selling options at one
strike price in greater number than those bought or sold at another strike price. Ratio spreads are
typically designed to be delta neutral. Back spreads and front preads are types of ratio spreads.
Ratio Vertical Spread: See Front Spread.
Reaction: A downward price movement after a price advance.
Recovery: An upward price movement after a decline.
Reference Asset: An asset, such as a corporate or sovereign debt instrument, that underlies a credit
derivative.
Regular Warehouse: A processing plant or warehouse that satisfies exchange requirements for financing,
facilities, capacity, and location and has been approved as acceptable for delivery of commodities against
futures contracts. See Licensed Warehouse.
Replicating Portfolio: A portfolio of assets for which changes in value match those of a target asset. For
example, a portfolio replicating a standard option can be constructed with certain amounts of the asset
underlying the option and bonds. Sometimes referred to as a synthetic asset.
Repo or Repurchase Agreement: A transaction in which one party sells a security to another party while
agreeing to repurchase it from the counterparty at some date in the future, at an agreed price. Repos
allow traders to short‐sell securities and allow the owners of securities to earn added income by lending
the securities they own. Through this operation the counterparty is effectively a borrower of funds to
finance further. The rate of interest used is known as the repo rate.
Reporting Level: Sizes of positions set by the exchanges and/or the CFTC at or above which commodity
traders or brokers who carry these accounts must make daily reports about the size of the position by
commodity, by delivery month, and whether the position is controlled by a commercial or non‐
commercial trader. See the Large Trader Reporting Program.
Resistance: In technical analysis, a price area where new selling will emerge to dampen a continued rise.
See Support.
Resting Order: A limit order to buy at a price below or to sell at a price above the prevailing market that
is being held by a floor broker. Such orders may either be day orders or open orders.
Retail Customer: A customer that does not qualify as an eligible contract participant under Section
1a(12) of the Commodity Exchange Act, 7 USC 1a(12). An individual with total assets that do not exceed
$10 million, or $5 million if the individual is entering into an agreement, contract, or transaction to
manage risk, would be considered a retail customer.
78 A PRIL 2011

Retender: In specific circumstances, some exchanges permit holders of futures contracts who have
received a delivery notice through the clearing organization to sell a futures contract and return the
notice to the clearing organization to be reissued to another long; others permit transfer of notices to
another buyer. In either case, the trader is said to have retendered the notice.
Retracement: A reversal within a major price trend.
Reversal: A change of direction in prices. See Reverse Conversion.
Reverse Conversion or Reversal: With regard to options, a position created by buying a call option,
selling a put option, and selling the underlying instrument (for example, a futures contract). See
Conversion.
Reverse Crush Spread: The sale of soybean futures and the simultaneous purchase of soybean oil and
meal futures. See Crush Spread.
Riding the Yield Curve: Trading in an interest rate futures contract according to the expectations of
change in the yield curve.
Ring: A circular area on the trading floor of an exchange where traders and brokers stand while
executing futures trades. Some exchanges use pits rather than rings.
Risked‐Based Margining: See Portfolio Margining.
Risk Factor: See Delta.
Risk/Reward Ratio: The relationship between the probability of loss and profit. This ratio is often used as
a basis for trade selection or comparison.
Roll‐Over: A trading procedure involving the shift of one month of a straddle into another future month
while holding the other contract month. The shift can take place in either the long or short straddle
month. The term also applies to lifting a near futures position and re‐establishing it in a more deferred
delivery month.
Round Lot: A quantity of a commodity equal in size to the corresponding futures contract for the
commodity. See Even Lot.
Round Trip Trading: See Wash Trading.
Round Turn: A completed transaction involving both a purchase and a liquidating sale, or a sale followed
by a covering purchase.
Rules: The principles for governing an exchange. In some exchanges, rules are adopted by a vote of the
membership, while in others, they can be imposed by the governing board.
Runners: Messengers or clerks who deliver orders received by phone clerks to brokers for execution in
the pit.
A PRIL 2011 79

S
Sample Grade: Usually the lowest quality of a commodity, too low to be acceptable for delivery in
satisfaction of futures contracts.
Scale Down (or Up): To purchase or sell a scale down means to buy or sell at regular price intervals in a
declining market. To buy or sell on scale up means to buy or sell at regular price intervals as the market
advances.
Scalper: A speculator often with exchange trading privileges who buys and sells rapidly, with small profits
or losses, holding his positions for only a short time during a trading session. Typically, a scalper will
stand ready to buy at a fraction below the last transaction price and to sell at a fraction above, e.g., to
buy at the bid and sell at the offer or ask price, with the intent of capturing the spread between the two,
thus creating market liquidity. See Day Trader, Position Trader, High Frequency Trading.
Seasonality Claims: Misleading sales pitches that one can earn large profits with little risk based on
predictable seasonal changes in supply or demand, published reports or other well‐known events.
Seat: An instrument granting trading privileges on an exchange. A seat may also represent an ownership
interest in the exchange.
Securities and Exchange Commission (SEC): The Federal regulatory agency established in 1934 to
administer Federal securities laws.
Security: Generally, a transferable instrument representing an ownership interest in a corporation
(equity security or stock) or the debt of a corporation, municipality, or sovereign. Other forms of debt
such as mortgages can be converted into securities. Certain derivatives on securities (e.g., options on
equity securities) are also considered securities for the purposes of the securities laws. Security futures
products are considered to be both securities and futures products. Futures contracts on broad‐based
securities indexes are not considered securities.
Security Deposit: See Margin.
Security Future: A contract for the sale or future delivery of a single security or of a narrow‐based
security index.
Security Futures Product: A security future or any put, call, straddle, option, or privilege on any security
future.
Self‐Regulatory Organization (SRO): Exchanges and registered futures associations that enforce financial
and sales practice requirements for their members. See Designated Self‐Regulatory Organizations.
Seller's Call: Seller's call, also referred to as call purchase, is the same as the buyer's call except that the
seller has the right to determine the time to fix the price. See Buyer’s Call.
Seller's Market: A condition of the market in which there is a scarcity of goods available and hence
sellers can obtain better conditions of sale or higher prices. See Buyer's Market.
80 A PRIL 2011

Seller's Option: The right of a seller to select, within the limits prescribed by a contract, the quality of the
commodity delivered and the time and place of delivery.
Selling Hedge (or Short Hedge): Selling futures contracts to protect against possible decreased prices of
commodities. See Hedging.
Series (of Options): Options of the same type (i.e., either puts or calls, but not both), covering the same
underlying futures contract or other underlying instrument, having the same strike price and
expiration date.
Settlement: The act of fulfilling the delivery requirements of the futures contract.
Settlement Price: The daily price at which the clearing organization clears all trades and settles all
accounts between clearing members of each contract month. Settlement prices are used to determine
both margin calls and invoice prices for deliveries. The term also refers to a price established by the
exchange to even up positions which may not be able to be liquidated in regular trading.
Shipping Certificate: A negotiable instrument used by several futures exchanges as the futures delivery
instrument for several commodities (e.g., soybean meal, plywood, and white wheat). The shipping
certificate is issued by exchange‐approved facilities and represents a commitment by the facility to
deliver the commodity to the holder of the certificate under the terms specified therein. Unlike an issuer
of a warehouse receipt, who has physical product in store, the issuer of a shipping certificate may honor
its obligation from current production or through‐put as well as from inventories.
Shock Absorber: A temporary restriction in the trading of certain stock index futures contracts that
becomes effective following a significant intraday decrease in stock index futures prices. Designed to
provide an adjustment period to digest new market information, the restriction bars trading below a
specified price level. Shock absorbers are generally market specific and at tighter levels than
circuit breakers.
Short: (1) The selling side of an open futures contract; (2) a trader whose net position in the futures
market shows an excess of open sales over open purchases. See Long.
Short Covering: See Cover.
Short Hedge: See Selling Hedge.
Short Selling: Selling a futures contract or other instrument with the idea of delivering on it or offsetting
it at a later date.
Short Squeeze: See Squeeze.
Short the Basis: The purchase of futures as a hedge against a commitment to sell in the cash or spot
markets. See Hedging.
A PRIL 2011 81

Significant Price Discovery Contract (SPDC): A contract traded on an Exempt Commercial Market (ECM)
which performs a significant price discovery function as determined by the CFTC pursuant to CFTC
Regulation 36.3 (c). ECMs with SPDCs are subject to additional regulatory and reporting requirements.
Single Stock Future: A futures contract on a single stock as opposed to a stock index. Single stock futures
were illegal in the U.S. prior to the passage of the Commodity Futures Modernization Act in 2000. See
Security Future, Security Futures Product.
Small Traders: Traders who hold or control positions in futures or options that are below the reporting
level specified by the exchange or the CFTC.
Soft: (1) A description of a price that is gradually weakening; or (2) this term also refers to certain “soft”
commodities such as sugar, cocoa, and coffee.
Sold‐Out‐Market: When liquidation of a weakly‐held position has been completed, and offerings become
scarce, the market is said to be sold out.
SPAN® (Standard Portfolio Analysis of Risk®): As developed by the Chicago Mercantile Exchange, the
industry standard for calculating performance bond requirements (margins) on the basis of overall
portfolio risk. SPAN calculates risk for all enterprise levels on derivative and non‐derivative instruments
at numerous exchanges and clearing organizations worldwide.
Spark Spread: The differential between the price of electricity and the price of natural gas or other fuel
used to generate electricity, expressed in equivalent units. See Gross Processing Margin.
SPDC: See Significant Price Discovery Contract.
Specialist System: A type of trading formerly used for the exchange trading of securities in which one
individual or firm acts as a market‐maker in a particular security, with the obligation to provide fair and
orderly trading in that security by offsetting temporary imbalances in supply and demand by trading for
the specialist’s own account. Like open outcry, the specialist system was supplanted by electronic trading
during the early 21st century. In 2008, the New York Stock Exchange replaced the specialist system with
a competitive dealer system. Specialists were converted into Designated Market Makers who have a
different set of privileges and obligations than specialists had.
Speculative Bubble: A rapid run‐up in prices caused by excessive buying that is unrelated to any of the
basic, underlying factors affecting the supply or demand for a commodity or other asset. Speculative
bubbles are usually associated with a “bandwagon” effect in which speculators rush to buy the
commodity (in the case of futures, “to take positions”) before the price trend ends, and an even greater
rush to sell the commodity (unwind positions) when prices reverse.
Speculative Limit: See Speculative Position Limit.
Speculative Position Limit: The maximum position, either net long or net short, in one commodity future
(or option) or in all futures (or options) of one commodity combined that may be held or controlled by
82 A PRIL 2011

one person (other than a person eligible for a hedge exemption) as prescribed by an exchange and/or by
the CFTC.
Speculator: In commodity futures, a trader who does not hedge, but who trades with the objective of
achieving profits through the successful anticipation of price movements.
Split Close: A condition that refers to price differences in transactions at the close of any market session.
Spot: Market of immediate delivery of and payment for the product.
Spot Commodity: (1) The actual commodity as distinguished from a futures contract; (2) sometimes used
to refer to cash commodities available for immediate delivery. See Actuals or Cash Commodity.
Spot Month: The futures contract that matures and becomes deliverable during the present month. Also
called Current Delivery Month.
Spot Price: The price at which a physical commodity for immediate delivery is selling at a given time and
place. See Cash Price.
Spread (or Straddle): The purchase of one futures delivery month against the sale of another futures
delivery month of the same commodity; the purchase of one delivery month of one commodity against
the sale of that same delivery month of a different commodity; or the purchase of one commodity in one
market against the sale of the commodity in another market, to take advantage of a profit from a change
in price relationships. The term spread is also used to refer to the difference between the price of a
futures month and the price of another month of the same commodity. A spread can also apply to
options. See Arbitrage.
Squeeze: A market situation in which the lack of supplies tends to force shorts to cover their positions by
offset at higher prices. Also see Congestion, Corner.
SRO: See Self‐Regulatory Organization.
Stop‐Close‐Only Order: A stop order that can be executed, if possible, only during the closing period of
the market. See also Market‐on‐Close Order.
Stop Limit Order: A stop limit order is an order that goes into force as soon as there is a trade at the
specified price. The order, however, can only be filled at the stop limit price or better.
Stop Logic Functionality: A provision applicable to futures traded on the CME’s Globex electronic trading
system designed to prevent excessive price movements caused by cascading stop orders. Stop Logic
Functionality introduces a momentary pause in matching (Reserved State) when triggered stops would
cause the market to trade outside predefined values. The momentary pause provides an opportunity for
additional bids or offers to be posted
Stop Loss Order: See Stop Order.
A PRIL 2011 83

Stop Order: This is an order that becomes a market order when a particular price level is reached. A sell
stop is placed below the market, a buy stop is placed above the market. Sometimes referred to as stop
loss order. Compare to market‐if‐touched order.
Straddle: (1) See Spread; (2) an option position consisting of the purchase of put and call options having
the same expiration date and strike price.
Strangle: An option position consisting of the purchase of put and call options having the same
expiration date, but different strike prices.
Strategy‐Based Margining: A method for setting margin requirements whereby the potential for gains on
one position in a portfolio to offset losses on another position is taken into account only if the portfolio
implements one of a designated set of recognized trading strategies as set out in the rules of an
exchange or clearing organization. Also see Portfolio Margining.
Street Book: A daily record kept by futures commission merchants and clearing members showing
details of each futures and option transaction, including date, price, quantity, market, commodity,
future, strike price, option type, and the person for whom the trade was made.
Strike Price (Exercise Price): The price, specified in the option contract, at which the underlying futures
contract, security, or commodity will move from seller to buyer.
Strip: A sequence of futures contract months (e.g., the June, July, and August natural gas futures
contracts) that can be executed as a single transaction.
STRIPS (Separate Trading of Registered Interest and Principal Securities): A book‐entry system operated
by the Federal Reserve permitting separate trading and ownership of the principal and coupon portions
of selected Treasury securities. It allows the creation of zero coupon Treasury securities from designated
whole bonds.
Strong Hands: When used in connection with delivery of commodities on futures contracts, the term
usually means that the party receiving the delivery notice probably will take delivery and retain
ownership of the commodity; when used in connection with futures positions, the term usually means
positions held by trade interests or well‐financed speculators.
Support: In technical analysis, a price area where new buying is likely to come in and stem any decline.
See Resistance.
Swap: In general, the exchange of one asset or liability for a similar asset or liability for the purpose of
lengthening or shortening maturities, or otherwise shifting risks. This may entail selling one securities
issue and buying another in foreign currency; it may entail buying a currency on the spot market and
simultaneously selling it forward. Swaps also may involve exchanging income flows; for example,
exchanging the fixed rate coupon stream of a bond for a variable rate payment stream, or vice versa,
84 A PRIL 2011

while not swapping the principal component of the bond. Swaps are generally traded over‐the‐counter.
See Commodity Swap.
Swap Dealer (AS): An entity such as a bank or investment bank that markets swaps to end users. Swap
dealers often hedge their swap positions in futures markets. Alternatively, an entity that declares itself a
“Swap/Derivatives Dealer” on CFTC Form 40.
Swaption: An option to enter into a swap—i.e., the right, but not the obligation, to enter into a specified
type of swap at a specified future date.
Switch: Offsetting a position in one delivery month of a commodity and simultaneous initiation of a
similar position in another delivery month of the same commodity, a tactic referred to as
“rolling forward.”
Synthetic Futures: A position created by combining call and put options. A synthetic long futures position
is created by combining a long call option and a short put option for the same expiration date and the
same strike price. A synthetic short futures contract is created by combining a long put and a short call
with the same expiration date and the same strike price.
Systematic Risk: Market risk due to factors that cannot be eliminated by diversification.
Systemic Risk: The risk that a default by one market participant will have repercussions on other
participants due to the interlocking nature of financial markets. For example, Customer A’s default in X
market may affect Intermediary B’s ability to fulfill its obligations in Markets X, Y, and Z.
T
Taker: The buyer of an option contract.
TAS: See Trading at Settlement.
T‐Bond: See Treasury Bond.
Technical Analysis: An approach to forecasting commodity prices that examines patterns of price
change, rates of change, and changes in volume of trading and open interest, without regard to
underlying fundamental market factors. Technical analysis can work consistently only if the theory that
price movements are a random walk is incorrect. See Fundamental Analysis.
TED Spread: (1) The difference between the interest rate on three‐month U.S. Treasury bills and three‐
month LIBOR; (2) the difference between the price of the three‐month U.S. Treasury bill futures contract
and the price of the three‐month Eurodollar time deposit futures contract with the same expiration
month (Treasury Over Eurodollar).
Tender: To give notice to the clearing organization of the intention to initiate delivery of the physical
commodity in satisfaction of a short futures contract. Also see Retender.
Tenderable Grades: See Contract Grades.
A PRIL 2011 85

Terminal Elevator: An elevator located at a point of greatest accumulation in the movement of
agricultural products that stores the commodity or moves it to processors.
Terminal Market: Usually synonymous with commodity exchange or futures market, specifically in the
United Kingdom.
TIBOR (Tokyo Interbank Offered Rate): A daily reference rate based on the interest rates at which banks
offer to lend unsecured funds to other banks in the Japan wholesale money market (or interbank
market). TIBOR is published daily by the Japanese Bankers Association (JBA). See EURIBOR, LIBOR.
Tick: Refers to a minimum change in price up or down. An up‐tick means that the last trade was at a
higher price than the one preceding it. A down‐tick means that the last price was lower than the one
preceding it. See Minimum Price Fluctuation.
Time Decay: The tendency of an option to decline in value as the expiration date approaches, especially
if the price of the underlying instrument is exhibiting low volatility. See Time Value.
Time‐of‐Day Order: This is an order that is to be executed at a given minute in the session. For example,
“Sell 10 March corn at 12:30 p.m.”
Time Spread: The selling of a nearby option and buying of a more deferred option with the same strike
price. Also called Horizontal Spread.
Time Value: That portion of an option's premium that exceeds the intrinsic value. The time value of an
option reflects the probability that the option will move into‐the‐money. Therefore, the longer the time
remaining until expiration of the option, the greater its time value. Also called Extrinsic Value.
Total Return Swap: A type of credit derivative in which one counterparty receives the total return
(interest payments and any capital gains or losses) from a specified reference asset and the other
counterparty receives a specified fixed or floating cash flow that is not related to the creditworthiness of
the reference asset. Also called total rate of return swap, or TR swap.
To‐Arrive Contract: A transaction providing for subsequent delivery within a stipulated time limit of a
specific grade of a commodity.
Trade Option: A commodity option transaction in which the purchaser is reasonably believed by the
writer to be engaged in business involving use of that commodity or a related commodity.
Trader: (1) A merchant involved in cash commodities; (2) a professional speculator who trades for his
own account and who typically holds exchange trading privileges.
Trading Ahead: See Front Running.
Trading Arcade: A facility, often operated by a clearing member that clears trades for locals, where e‐
locals who trade for their own account can gather to trade on an electronic trading facility (especially if
the exchange is all‐electronic and there is no pit or ring).
86 A PRIL 2011

Trading at Settlement (TAS): An exchange rule which permits the parties to a futures trade during a
trading day to agree that the price of the trade will be that day’s settlement price (or the settlement
price plus or minus a specified differential).
Trading Facility: A person or group of persons that provides a physical or electronic facility or system in
which multiple participants have the ability to execute or trade agreements, contracts, or transactions by
accepting bids and offers made by other participants in the facility or system. See Many‐to‐Many.
Trading Floor: A physical trading facility where traders make bids and offers via open outcry or the
specialist system.
Transaction: The entry or liquidation of a trade.
Transfer Trades: Entries made upon the books of futures commission merchants for the purpose of:
(1) transferring existing trades from one account to another within the same firm where no change in
ownership is involved; (2) transferring existing trades from the books of one FCM to the books of another
FCM where no change in ownership is involved. Also called Ex‐Pit transactions.
Transferable Option (or Contract): A contract that permits a position in the option market to be offset by
a transaction on the opposite side of the market in the same contract.
Transfer Notice: A term used on some exchanges to describe a notice of delivery. See Retender.
Treasury Bills (or T‐Bills): Short‐term zero coupon U.S. government obligations, generally issued with
various maturities of up to one year.
Treasury Bonds (or T‐Bonds): Long‐term (more than ten years) obligations of the U.S. government that
pay interest semiannually until they mature, at which time the principal and the final interest payment is
paid to the investor.
Treasury Notes: Same as Treasury bonds except that Treasury notes are medium‐term (more than one
year but not more than ten years).
Trend: The general direction, either upward or downward, in which prices have been moving.
Trendline: In charting, a line drawn across the bottom or top of a price chart indicating the direction or
trend of price movement. If up, the trendline is called bullish; if down, it is called bearish.
UV
Unable: All orders not filled by the end of a trading day are deemed “unable” and void, unless they are
designated GTC (Good Until Canceled) or open.
Uncovered Option: See Naked Option.
Underlying Commodity: The cash commodity underlying a futures contract. Also, the commodity or
futures contract on which a commodity option is based, and which must be accepted or delivered if the
option is exercised.
A PRIL 2011 87

Variable Price Limit: A price limit schedule, determined by an exchange, that permits variations above or
below the normally allowable price movement for any one trading day.
Variation Margin: Payment made on a daily or intraday basis by a clearing member to the clearing
organization based on adverse price movement in positions carried by the clearing member, calculated
separately for customer and proprietary positions.
Vault Receipt: A document indicating ownership of a commodity stored in a bank or other depository
and frequently used as a delivery instrument in precious metal futures contracts.
Vega: Coefficient measuring the sensitivity of an option value to a change in volatility.
Vertical Spread: Any of several types of option spread involving the simultaneous purchase and sale of
options of the same class and expiration date but different strike prices, including bull vertical spreads,
bear vertical spreads, back spreads, and front spreads. See Horizontal Spread and Diagonal Spread.
Visible Supply: Usually refers to supplies of a commodity in licensed warehouses. Often includes floats
and all other supplies “in sight” in producing areas. See Invisible Supply.
Volatility: A statistical measurement (the annualized standard deviation of returns) of the rate of price
change of a futures contract, security, or other instrument underlying an option. See Historical Volatility,
Implied Volatility.
Volatility Quote Trading: Refers to the quoting of bids and offers on option contracts in terms of their
implied volatility rather than as prices.
Volatility Spread: A delta‐neutral option spread designed to speculate on changes in the volatility of the
market rather than the direction of the market.
Volatility Trading: Strategies designed to speculate on changes in the volatility of the market rather than
the direction of the market.
Volume: The number of contracts traded during a specified period of time. It is most commonly quoted
as the number of contracts traded, but for some physical commodities may be quoted as the total of
physical units, such as bales, bushels, or barrels.
Volume Weighted Average Price (VWAP): A method of determining the settlement price in certain
futures contracts. It is the average futures transaction price, weighted by volume, during a specified
period of time.
WXYZ
Warehouse Receipt: A document certifying possession of a commodity in a licensed warehouse that is
recognized for delivery purposes by an exchange.
Warrant: An issuer‐based product that gives the buyer the right, but not the obligation, to buy (in the
case of a call) or to sell (in the case of a put) a stock or a commodity at a set price during a specified
period.
88 A PRIL 2011

Warrant or Warehouse Receipt for Metals: Certificate of physical deposit, which gives title to physical
metal in an exchange‐approved warehouse.
Wash Sale: See Wash Trading.
Wash Trading: Entering into, or purporting to enter into, transactions to give the appearance that
purchases and sales have been made, without incurring market risk or changing the trader's market
position. The Commodity Exchange Act prohibits wash trading. Also called Round Trip Trading, Wash Sales.
Weak Hands: When used in connection with delivery of commodities on futures contracts, the term
usually means that the party probably does not intend to retain ownership of the commodity; when used
in connection with futures positions, the term usually means positions held by small speculators.
Weather Derivative: A derivative whose payoff is based on a specified weather event, for example, the
average temperature in Chicago in January. Such a derivative can be used to hedge risks related to the
demand for heating fuel or electricity.
Wild Card Option: Refers to a provision of any physical delivery Treasury bond or Treasury note futures
contract that permits shorts to wait until as late as 8:00 p.m. Chicago time on any notice day to
announce their intention to deliver at invoice prices that are fixed at 2:00 p.m., the close of futures
trading, on that day.
Winter Wheat: Wheat that is planted in the fall, lies dormant during the winter, and is harvested
beginning about May of the next year.
Writer: The issuer, grantor, or seller of an option contract.
Yield Curve: A graphic representation of market yield for a fixed income security plotted against the
maturity of the security. The yield curve is positive when long‐term rates are higher than short‐term rates.
Yield to Maturity: The rate of return an investor receives if a fixed income security is held to maturity.
Zero Coupon: Refers to a debt instrument that does not make coupon payments, but, rather, is issued at
a discount to par and redeemed at par at maturity.

A PRIL 2011 89

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Swaps: Dodd-Frank Memories
Amid repeated Dodd-Frank extensions, swaps end-users may need an aide-mémoire

2013-07-02, by Gordon E. Goodman
Things are seldom what they seem,

Skim milk masquerades as cream;
Highlows pass as patent leathers;
Jackdaws strut in peacock's feathers.
-- "HMS Pinafore," Gilbert & Sullivan, 1878
At this point in the process of implementing the changes that were required by the Dodd-Frank
Wall Street Reform and Consumer Protection Act -- with respect to recordkeeping, reporting and
governance -- almost everything was supposed to have been completed by now. A final piece of
the puzzle was to have occurred during April 2013, when real-time and general reporting was to
have begun. However, as with many of the early Dodd-Frank schedules, the reporting deadline
was extended through a "no-action" letter issued by the Commodity Futures Trading
Commission (CFTC) during early April.
The CFTC's repeated extensions may have lulled the risk community into a sense that perhaps
it would all go away. This is not the case. So, for risk managers who may have forgotten the
many changes required by Dodd Frank (and in particular for the non-swap dealers, non-major
swap participants, non-financial entities and end-users), the following is a refreshed to-do list,
an aide-mémoire.
This article is intended to cover many of the issues and questions confronted by "end-users."
End-user is the generic term that I will use in this article when talking about the "nons" generally,
but please note that though speculative traders and end-users are both "nons," they have quite
different requirements under Dodd-Frank with respect to mandatory clearing.
Each end-user should consider its own circumstances in designing an appropriate compliance
program, because this article does not cover every minute detail.
End-User Qualification
To begin, in order to qualify as an end-user (Category 3), a company must be neither a swap
dealer nor a major swap participant (Category 1). Nor can the company be a "financial entity"
(Category 2). In a subsequent article, I will provide more detail on financial entities (one of the
less discussed terms in Dodd-Frank), but for present purposes, they are persons predominantly
engaged in activities that are financial in nature, as defined by the Federal Reserve under the
Bank Holding Company Act.
With respect to the first part of the end-user requirement (i.e., being neither a swap dealer nor
an MSP), this can only be determined by running the "de minimis" tests that determine whether
a company is a swap dealer and the various MSP tests that determine whether a company is a
major swap participant.
In particular, end-users should make sure that they are not dealing in significant quantities of
swaps with "special entities" (primarily government organizations) under Dodd-Frank. At a
minimum, end-users should stay well under the de minimis thresholds that apply to swap trades
with special entities. The $8 billion threshold that generally applies under the de minimis test
drops to $800 million for special entities that engage in utility operations and to just $25 million
for non-utility special entities (all calculated on gross notional amounts).
One additional point for foreign companies to keep in mind is that the definition of a "financial
entity" is based on the percentage of their assets and income that are derived from financial
activities (sometimes called the "85/85" test). This calculation can be significantly influenced by
how derivatives are treated within the company's financial statements -- U.S. Generally
Accepted Accounting Principles present derivatives on a net basis while the European
International Financial Reporting Standards present derivatives on a gross basis.
End-User Next Steps
Assuming a company qualifies for the end-user exemption from mandatory clearing (see
above), companies that are subject to SEC reporting obligations (generally, U.S. public
companies) must then adopt annual board resolutions to make this election. These resolutions
can be adopted by the board itself or by a suitable committee of the board -- e.g., the audit
committee or the finance committee.
Though there is no statement within Dodd-Frank about companies that are not subject to SEC
reporting obligations, it is a best risk practice for all companies that claim end-user status to
adopt these same board resolutions. Swap dealers will probably be asking for proof of end-user
status to all of their customers under Dodd-Frank's "know your counterparty" (KYC) rules that
apply to swap dealers, so companies claiming end-user status should adopt appropriate board
resolutions.
Under CFTC rules, the annual board resolution must be filed with a swap data repository (SDR).
For non-reporting end-users (i.e., end-users whose counterparties will do the swap reporting),
this may be an issue if they do not have an existing relationship with an SDR. Based on recent
discussions, at least one of the SDRs is working on providing a filing mechanism for the non-
reporting end-users at this time.
Keep in mind that the purpose of filing a board resolution with an SDR is to claim an exemption
from the mandatory clearing requirement, but to date there have been few swap categories
listed by the CFTC that are actually subject to mandatory clearing. In particular, the CFTC has
yet to include any of the energy commodity swaps in the list of swaps subject to mandatory
clearing -- so the timing for adoption of a board resolution has been extended (originally, this
was due to be in place by September 2013).
Hedging
As part of this board resolution, a company claiming end-user exemption from mandatory
clearing must represent that it uses swaps to hedge or mitigate commercial risk arising from its
underlying physical business -- e.g., oil and gas production or gasoline refining. An important
point to consider is that the board resolution itself is necessary, but not sufficient, to receive an
exemption from mandatory clearing.
The transactions themselves must be used for hedging purposes. What this means is that even
after making an election and filing the annual board resolution with an SDR, a company can still
only be exempted from mandatory clearing if its swaps are really being used for hedging
purposes.
Assume for a moment that a company uses swaps for two purposes within its business: to
hedge its physical oil and gas production and to engage in some limited speculative trading
activity. In effect, it is an end-user when it is hedging its physical transactions, but it is a trader
when it engages in speculative activity (for which the exemption from mandatory clearing is not
available).
A company like this should still proceed to pass an appropriate board resolution claiming
exemption from mandatory clearing, but only for those transactions that are being used as
hedges (and not for its speculative trading activity). Remember that end-users and speculative
traders are both "nons," but they have different results under Dodd-Frank with respect to the
mandatory clearing exemption rules.
Another point to consider is that qualifying swaps are also excluded from certain parts of the de
minimis and MSP tests. In order to qualify as a hedge, swaps must come under one of the
following standards: the "mitigation of commercial risk" standard (the Dodd-Frank standard), the
"bona fide hedge" standard (the Commodities Exchange Act standard) or the accounting hedge
standards set by FASB.
De Minimis and MSP Tests
Going forward, the de minimis and MSP tests described previously have to be run on a regular
basis. A company that passes these tests today (and therefore can initially qualify for end-user
status) may fail these same tests next year or the year after. So building a robust mechanism for
running these tests as part of a company's base risk system is an important consideration.
The de minimis calculations are run on a trailing 12-month basis in relation to the gross notional
amount of a company's dealing swaps, while MSP tests are run on a quarterly basis looking at
current and expected future exposures (MTMs) of the company's swaps (but only looking at the
negative MTM values).
The de minimis tests currently have three thresholds: an $8 billion threshold for all entities, an
$800 million threshold for utility special entities and a $25 million threshold for non-utility special
entities. The CFTC has indicated that these thresholds will apply during a "phase-in" period that
will last about five years. At the end of the phase-in period, the CFTC may reduce its de minimis
thresholds to lower levels.
The MSP tests are more complicated than the de minimis tests, but they have been set at levels
that should only capture the very largest swap market participants. The details of the MSP tests
will be studied in more detail in a subsequent article.
It is logical to anticipate that if any company expects to fail the MSP test for a quarterly period, it
would probably file an election to become a swap dealer, since the MSP status carries most of
the burdens with few of the benefits associated with swap dealer status.
Meeting Financial Obligations
In the board resolution electing end-user exemption from mandatory clearing, a company must
indicate how it will meet its financial obligations. For companies that have historically set the
margin thresholds in their ISDA credit support annex (CSA) at relatively high levels in order to
avoid the need for daily exchanges of margin, they may want to reconsider the best levels to set
under Dodd-Frank.
One of the surprising issues to consider is that unused thresholds within CSAs (i.e., the
difference between a company's actual exposure and its collateral threshold levels) are
considered to be a form of credit facility that can get included in some of the MSP test
calculations. (The MSP tests can also be calculated under an alternative methodology that
excludes these unused thresholds, but this alternative methodology has some of its own issues,
which will be discussed further in a subsequent article.)
There are five methods set by the CFTC for meeting financial obligations within a board
resolution under Dodd-Frank: (1) a written credit support agreement (this could be the CSA
attached to the ISDA); (2) pledged or segregated assets (including posting or receiving margin
pursuant to a credit support agreement or otherwise); (3) a written third-party guarantee; (4) the
electing counterparty's available financial resources (this is an alternative to the CSA route); or
(5) means other than those described.
Who Has the Reporting Obligation?
In general, if a transaction is concluded on an exchange, no further reporting is required.
For off-exchange (OTC) transactions, one of the two parties to a swap must report the
transaction to an SDR. If a Category 3 entity (i.e., an end-user) does a swap transaction with a
Category 1 entity (swap dealers and MSPs) or a Category 2 entity (a financial entity), then the
Category 1 or Category 2 counterparty has the reporting obligation (and not the end-user).
The question arises: what happens when two end-users do a swap with each other? The
answer is that if one of the end-users is a "U.S. entity" (as that term is defined under Dodd-
Frank) and the other is not a U.S. entity, then the end-user that is a U.S. entity has the reporting
obligation.
A second question naturally arises: what happens when both are U.S. entities or both are not
U.S. entities? The answer is that the parties have to agree on who will do the reporting. The
main point to keep in mind is that for all swaps, someone has to do the reporting to the SDR.
There is no free lunch.
When is the Reporting Required?
Originally, all swaps were subject to reporting requirements that were to have begun on 4/10/13.
This included "pre-enactment" swaps (swaps that were in effect on 7/21/10, when Dodd-Frank
was enacted) and "transition" swaps (swaps that were executed after 7/21/10 but before
4/10/13).
This original schedule was revised for non-financial counterparties (i.e., end-users) under a "no-
action" letter issued by the CFTC during early April 2013 (Letter No. 13-10).
The revised Dodd-Frank reporting schedule for end-users is now as follows (please note that
the Dodd-Frank standard for reporting transaction data is generally in "real time," but this term is
defined differently for different types of swap participants):
• Credit/interest rate swaps entered into after 7/21/13: subject to Dodd-Frank standards
• Credit/interest rate swaps entered into from 4/10/13 to 7/21/13: 8/1/13
• Equity/FX/ commodity swaps entered into after 8/19/13: subject to Dodd-Frank
standards
• Equity/FX/ commodity swaps entered into from 4/10/13 to 8/19/13: 9/19/13
• All historical swaps that were in existence from 7/21/10 to 4/10/13: 10/31/13
Dodd-Frank Recordkeeping for End-Users
End-users must keep full, complete and systematic records of all their swap transactions. The
recordkeeping requirements apply to pre-enactment, transition and post-4/10/13
records. Records should be kept in electronic format unless they were originally created in
paper format and have been maintained as such. Records must be kept for five years from the
termination date of the swap, with the exception of audio records, which must be kept for one
year from termination date.
Please note that these same recordkeeping requirements apply to certain related physical
transactions. Specifically, these are the physical transactions that are the hedged items for
which hedge treatment is being claimed with respect to an end-user's hedging swaps.
Final Issues and Parting Thoughts
End-users should obtain legal entity identifiers (LEIs or CICIs) for each corporate entity that
trades in swaps. End-users should also consider possible adherence to the August 2012 ISDA
protocol.
Though this article has discussed many of the more common issues that have arisen for end-
users trying to comply with the new Dodd-Frank requirements, inevitably there will be some
important issues that have not been covered.
There will also inevitably be additional "no-action" letters and further changes in the Dodd-Frank
regulatory structure before all is said and done. For this reason, this article is intended only as
the first in a series of similar articles dealing with additional specific Dodd-Frank issues.
Dodd-Frank’s Impact on Financial Entities, Financial Activities and
Treasury Affiliates
Swaps compliance requirements are complex

2013-10-23, by Gordon E. Goodman
The compliance requirements for the Dodd-Frank Act (DFA) are complex. On one end of the
spectrum, we have DFA "end users" that are not subject to the act's mandatory clearing rules,
but are subject to certain reporting and record-keeping requirements. On the opposite end,
there are swap dealers, major swap participants and "financial entities" -- three categories of
companies that are subject to mandatory clearing, along with much more rigorous reporting and
record-keeping requirements.
The financial entities category is perhaps the most intriguing, partly because it is the least
discussed of the types of companies under the DFA that cannot seek exceptions from the
mandatory clearing requirement. Mandatory clearing is the obligation to clear swaps at a
regulated entity (like an exchange or derivatives clearing organization (DCO)) and post full
collateral. Financial entities also have the obligation to report swaps to swap data repositories
(SDRs) when they are trading with end-users and other non-financial entities.
In the DFA, a "financial entity" is described by Congress as any company that is " …
predominantly engaged in activities … that are financial in nature, as defined in the Bank
Holding Company Act of 1956." The DFA, in turn, requires the Board of Governors of the
Federal Reserve System (the Board) to establish the requirements for determining whether a
company is "predominantly engaged in financial activities."
Given the broadness of the Board's definition of "financial activities," the financial entities
category may actually include more companies than the two more widely-discussed DFA
categories of swap dealers and major swap participants.
Moreover, for many purposes, being labeled a "financial entity" under the DFA may be
burdensome -- especially for companies that do not particularly consider themselves to be
"financial" companies. Surprisingly, a significant number of subsidiary companies that centrally
execute financial instruments for large diversified corporations may be considered financial
entities under the DFA, but they may also qualify for an exception under the CFTC's recent no-
action letter on "treasury affiliates."
What is a Financial Entity?
Under the DFA, just like swap dealers and major swap participants, financial entities (most of
them, at least) are excluded from making an election that is otherwise available to end-users to
be exempt from the DFA's mandatory clearing requirements.
The broader term "financial company" within the DFA includes not only financial entities but also
bank holding companies and certain non-bank financial companies that are supervised by the
Board.
Very large (or significant) non-bank financial companies can also be determined to be
systemically important under the DFA. As a result, they can become subject to additional
regulation, like the Orderly Liquidation Act (OLA).
What are Financial Activities?
In its final rule on the definition of "Predominantly Engaged in Financial Activities," issued in
April 2013, the Board determined that certain investing and trading activities should be
considered activities that are financial in nature under the Bank Holding Company Act.
Since the Board's definition of financial activities also covers activities that are not regulated
under the DFA (e.g., trading in forward contracts), it is not yet clear how these two sets of
related regulations (i.e., the Board's rules on financial activities and the CFTC's rules on the
exception from clearing) will be interpreted. For example, should trading in forward contracts be
included or excluded from the "predominantly engaged" tests that are described below?
The DFA provides that a company will be considered to be predominantly engaged in financial
activities if more than 85% of its annual gross revenues or if more than 85% of its consolidated
assets are financial in nature. For companies that do not have a centralized subsidiary used for
their corporate hedging activities, the two 85% tests may not be a problem, but a review should
be conducted for all corporations that trade in swaps.
What are Captive Finance Companies and Treasury Affiliates?
In its so-called final rule for the "End-User Exception to the Clearing Requirement for Swaps,"
the DFA provides a potential exception for captive finance companies that have been deemed
financial entities. That rule states that a financial entity does not include any company whose
"primary business is providing financing."
In order to qualify for this fairly limited exception for captive finance companies, a company must
use derivatives for the purpose of hedging its underlying commercial risks related to interest rate
or foreign exchange exposures. In addition, 90% or more of these risks must arise from
financing that facilitates the purchase or lease of products manufactured by the parent company
or a subsidiary of the parent company.
More importantly for many diversified companies, in June 2013, the CFTC's Division of Clearing
and Risk issued a no-action relief letter for certain treasury affiliates. If not for this letter, these
affiliates might have been categorized as financial entities, and would therefore have been
ineligible for an exception from the mandatory clearing requirement.
The no-action letter basically expands the existing exception within DFA that originally only
covered treasury affiliates that act as agents for related subsidiaries. It includes treasury
affiliates that act as principals when executing swaps for related subsidiaries. In order to claim
the exception from mandatory clearing for treasury affiliates, a company must comply with all
the requirements described in the no-action letter and also make the necessary filings with an
SDR (similar to the annual filings that are required of end-users).
A final exception to consider for certain cooperatives is one that the CFTC announced in August
2013. The CFTC, in its "Final Rule on the Clearing Exemption for Certain Swaps Entered Into by
Cooperatives," determined that a cooperative whose members were all end-users would not be
deemed a financial entity only because of the swaps that it executed for its member companies
(even when acting as a principal).
Closing Thoughts
The definition of financial entities is the least well understood of the three categories of
companies (swap dealers, major swap participants and financial entities) that are the most
heavily regulated under the DFA. But for the CFTC's recent no-action letter on treasury
affiliates, many diversified companies with centralized subsidiaries that execute financial
instruments would have been subject to the DFA restrictions placed on financial entities.
Companies should carefully review their use of swaps to determine whether they will be
considered financial entities, as well as whether they may qualify for the treasury affiliate
exception.
Gordon E. Goodman is currently a consultant with the Alliance Risk Group. He previously held senior
positions at both E.I. DuPont de Nemours & Co., where he served as president of its DuPont Power
Marketing subsidiary, and at Occidental Petroleum Corporation, where he served as the trading control
officer for its Occidental Energy Marketing subsidiary. He was the founding chairman of the American
Petroleum Institute's (API's) Risk Control Committee, and he also served on the API's General Committee
on Finance. He was a member of the Financial Accounting Standards Board's (FASB's) Valuation
Resource Group (VRG) and earlier was a member of its Energy Trading Working Group (ETWG). He is
currently on GARP's Energy Oversight Committee, which administers the Energy Risk Professional (ERP)
certificate. His prior contributions to GARP's "Risk Review," "Risk Professional," and "Risk News &
Resources" publications have included the following articles: "Dodd Frank Memories" (2013); "The
Liquidity Risk Sweepstakes" (2012); "The Ethics of Business" (2012); "How to Value Guarantees" (2008);
and "Credit Risk: Will the Bubble Burst?" (2007).

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2015 Energy Risk Professional

ERP Exam Course Pack

REQUIRED ONLINE READINGS

1. Craig Pirrong, “The Economics of Commodity Trading Firms” (March 2014).

© 2015 Global Association of Risk Professionals. All rights reserved.

REQUIRED ONLINE READINGS

3. Gordon Goodman. “Swaps: Dodd-Frank Memories.”

© 2015 Global Association of Risk Professionals. All rights reserved.

REQUIRED ONLINE READINGS

4. Gordon Goodman. “Dodd-Frank’s Impact on Financial Entities, Financial Activities and

© 2015 Global Association of Risk Professionals. All rights reserved.

© Craig Pirrong, March 2014. All rights reserved.

I THE BASICS OF COMMODITY TRADING 6

II THE RISKS OF COMMODITY TRADING 12

III RISK MANAGEMENT BY COMMODITY TRADING FIRMS 21

IV COMMODITY FIRM FINANCING,

V COMMODITY FIRM ASSET OWNERSHIP

VI SYSTEMIC RISK AND COMMODITY TRADING:

This whitepaper is intended to help demystify the commodity trading

• Commodity trading firms exhibit considerable diversity in their investments in physical

THE REMAINDER OF THIS PAPER IS ORGANIZED AS FOLLOWS:

Section III describes the risk management process at Trafigura.

Section V analyzes asset ownership by commodity firms.

The paper concludes with a brief afterword.

• in space - using logistics

Physical and regulatory bottlenecks may act as constraints on these transformations.

B. VALUE CREATION IN COMMODITY TRADING

Developments in oil markets in North America illustrate how dynamic transformation

The process of making transformations is constrained by technology and available

Value creation opportunities in commodity trading depend on the economic environment.

C. COMMODITY TRADING FIRMS

Other commodity traders are subsidiaries or affiliates of other kinds of firms.

CTFs have various kinds of liquidity risk:

• Hedging liquidity. CTFs use futures exchanges to hedge commodities. Loss-making

CTFs can reduce risk:

• Through diversification. There is little correlation between basis risks in different

Market Liquidity Risk. Commodity trading (including specifically hedging) frequently

Given the current environment in which manipulation generally, and commodity

Diversification across commodities makes firm financial performance less dependent

Diversification and integration are primarily useful in managing risks idiosyncratic to

Risk measurement is a crucial component of risk management. Most commodity trading

III. RISK MANAGEMENT BY COMMODITY

It manages operational risks through a combination of liability insurance, best practice

B. THE RISK MANAGEMENT PROCESS

C. MANAGING FLAT PRICE RISK AND BASIS RISK

1 Base Prospectus, Trafigura Funding S.A. (14 November, 2013) F-31-F-33.

Another approach to measuring extreme risks that is employed by Trafigura is Extreme

E. MANAGING CREDIT RISK

Specifically, it implements a formal credit process. Based on financial information, it establishes

If a transaction or transactions with a counterparty would result in a credit exposure to

F. MANAGING LIQUIDITY RISK

Conversely, in high-price environments, credit lines can be insufficient to fund potentially

G. MANAGING FREIGHT RISK

H. MANAGING OTHER RISKS

IV. COMMODITY FIRM FINANCING,

A. THE FINANCING OF COMMODITY TRADING FIRMS

An examination of the available information on the financing of commodity trading firms

Arcadia Energy Pte 17.51 Louis Dreyfus B.V. 3.74

Data from Bureau van Dijk

B. THE LIABILITY STRUCTURES OF COMMODITY TRADING FIRMS

A scaling back of lending by traditional suppliers of commodity finance would create

C. THE OWNERSHIP OF COMMODITY TRADING FIRMS: PUBLIC VS. PRIVATE

D. COMMODITY TRADING FIRMS AS FINANCIAL INTERMEDIARIES