By David Hughes –
SHIPPING is risky business. Apart from the physical dangers in carrying people and goods across the oceans, the shipping market is volatile and subject to cyclical booms and slumps.
Owners, at least those in the bulk trades, have always had to worry about either being locked into comparatively unprofitable use of their vessels or being unable to find charters for their vessels when demand is weak.
Traditionally the way to reduce risk is to split fleets between the spot market and time charters. This ensures predictable income for part of the fleet but it can also mean missing out on potential gains when the market is high.
Freight futures or swaps, offer the another way of managing risk, or hedging. They have been around for some time. It was possible once to fix futures on the floor of the Baltic Exchange, just like physical charters, but very little business was actually done.
Then in the early 1990s, the Baltic International Freight Futures Exchange (Biffex) was established as a cleared market working through the London Clearing House. The Baltic Freight Index, a basket of spot freight rates designed to reflect the daily movement in rates across a wide selection of dry bulk spot voyage and time charter rates, was used as the standard for settling contracts.
The London Clearing House was absorbed into the bigger market, the London International Financial Futures and Options Exchange (Liffe), which continued with freight futures for a while but volumes decreased and Biffex was discontinued in 2001.
While Biffex did not meet the expectations of its originators, trading in Forward Freight Agreements (FFAs), direct deals between principals, usually arranged through brokers, had by that time started to take off.
Ironically, just as Biffex was being wound up, a Norwegian cleared market for futures, Imarex, was established.
The past four years, and especially the past 12 months have seen a massive increase in futures trading, both FFAs and freight futures through Imarex.
Imarex’s managing director, Tom Mortensen, says that volatility in freight rates drives the need for financial tools for risk management, and attracts speculation on the future price movements of freight. The market is regulated by Norway’s Ministry of Finance and offers online and voice-assisted trading of freight futures contracts based on the physical freight routes in the market.
Imarex offers optional clearing of customer trades with Norwegian Futures and Options Clearing House acting as central counterpart to all cleared transactions. It now claims to be ‘the central marketplace in a growing market for maritime freight derivatives’.
Estimates of the size of the freight derivatives market vary. Mr Mortensen puts the value of shipping derivatives at about 30 per cent of physical transactions but does say that it depends on how you measure it.
Andy Lucey of UK freight derivatives broker, Freight Investor Services, is also chairman of the Forward Freight Agreement Brokers’ Association (FFABA). He believes the derivatives market is now bigger than its physical counterpart, pointing out that this is normal for mature derivatives markets, such as for bonds or commodities like grain and crude oil.
FFABA’s membership consists of brokers who are members of the Baltic Exchange. They use the Baltic Exchange’s market information while the exchange provides the administration for the association.
Mr Lucey says the experience of more mature derivatives markets suggests that the majority of futures deals will continue to be principal-to-principal rather than through cleared markets. He believes that a cleared market, or markets, is vital to the development of shipping derivatives but that such trading will plateau at about 20 to 25 per cent of the total futures market.
Mr Mortensen is, not surprisingly, more bullish about the extent to which cleared exchanges will expand into the sector. He also expects other exchanges to develop and sees competition as healthy. He expects brokers to continue to keep a significant share of the total market but feels smaller brokers could be squeezed.
While there are different views on how the shipping derivatives market is developing, both Mr Mortensen and Mr Lucey agree that futures have become an inescapable fact of life for shipowners, whether or not they actually trade in them.
But there are some voices of caution. In Feb 2004, major international accountancy firm Moore Stephens warned that the freight futures market remained immature and illiquid, and that shipowners should enter it with care.
Moore Stephen’s shipping group partner David Anstis said that a lot of owners and charterers were seeing big physical gains and losses in the freight markets magnified by paper trading. ‘Some brokers are reporting that freight futures have recently been turning over as much in a month as they used to in a year, and a number of well-known owners and charterers are thought to have massive losses in futures.’
Mr Anstis warned that shipowners and charterers were not used to the multiplying effects of the derivatives market. ‘In a large mature futures market,’ he said, ‘it is almost always possible to trade out positions which are moving away from the underlying risk which the hedge is supposed to protect, because there are large numbers of active speculators in the market. But, the freight derivatives market is very illiquid and when the real market moves suddenly and quickly, parties holding paper can find themselves locked into either major gains or major losses. Often, fast-moving traders gain, while shipping interests lose.’ That opinion caused quite a stir and Mr Lucey actually wrote a reply refuting the notion that a lack of liquidity was still a major problem in the shipping derivatives market.
In any case, assuming that the current trend of an increasing spot market and fewer time charters continues, owners wishing to manage risk may have little choice but to use derivatives.
The message from the brokers and Imarex appears to be much the same. Owners need to educate themselves on how the derivatives market operates and also be very clear whether they are entering it to hedge their risks or to speculate. Large financial institutions interested in trading and speculating, are moving into the market which will add to liquidity but the ways they and the owners use the market are quite different.
Like it or loathe it, the shipping futures market is here to stay and owners and charterers in Singapore and Hong Kong will soon have the opportunity to find out more. The Baltic Exchange and FFABA will be running freight derivatives forums in Singapore on Sept 23 (on tanker futures) and Hong Kong on Sept 27 (on dry bulk futures). The forums will include a series of practical workshops enabling participants to gain an understanding of the practicalities involved with freight derivatives trading.
Courtesy Portview Singapore
Source: Business Times, Asia