Why create freight futures contracts?
Freight transportation is a huge component in the costs of goods that everyone consumes, and like energy and raw commodities, freight cost are extremely volatile. Between January 2016 and January 2018, U.S. trucking rates were up more than 25 percent.
In North America, trucking is the largest mode of freight transportation, representing more than 73 percent of all freight transportation services. The reason that trucking rates are so volatile is as simple as Economics 101 – supply and demand. On a given day, there are a finite number of trucks in the market and there are a finite number of loads in the market. Truckers adjust their rates based on current market conditions and competition for capacity.
In markets that are volatile, participants have significant exposure to their cash-flows as prices move up or down. If the market is big enough, futures contracts are established to help participants de-risk their exposure to volatility by creating hedging instruments that they can use to have more predictable cash-flow streams.
Trucking is certainly big enough – the $725 billion dollar U.S. trucking market is 30 percent bigger than oil, natural gas and coal – combined. It is also about twice the size of the agriculture, forestry and fishery industries, all of which enjoy vibrant futures markets.
The freight market operates similarly to the electric power industry; it is capacity-constrained, priced on geography, and not easy to store. The electricity has had a robust futures market for nearly two decades. The electricity market generates around $320 billion annually, so it less than half the size of the U.S. trucking market.
In addition to providing a risk management option through hedging, Trucking Freight Futures contracts will help bring transparency to the industry by giving market participants a sense for where rates are headed in the near- and long-term. Once the Trucking Freight Futures contracts start to trade, a forward curve will be visible which will help participants understand the market’s expectation of forward/contract rates. This will help them plan their operations, make better capital expenditure decisions (should they buy trucks now or not) and price freight more accurately to the market.
How does the financial market hedge against the physical market work?
A participant is concerned (or expects) that rates in the physical market are going to move in an unfavorable direction (up or down).
Depending on which directional move (rates rising or falling) they want to protect against, the participant will BUY or SELL financially settled Trucking Freight Futures contracts to hedge against rate changes in the physical market.
Why should a company want to trade Trucking Freight Futures?
As a freight market participant, a company is exposed to the volatility of rates in the trucking market. Unstable prices create cash flow management issues. By trading Trucking Freight Futures, a participant can mitigate some of its exposure to the volatility of trucking spot-rates and therefore more accurately forecast its forward cash flows.
What are the roles of the companies involved in the Trucking Freight Futures market?
FreightWaves is responsible for educating the freight market about futures and educating the financial market about freight. FreightWaves will not trade in the market and will not have access to any participant trading activity.
DAT Solutions is the leading authority for spot market freight rates in the trucking market, and is responsible for publishing daily spot dry van price assessments which will be used for the final settlement of the Trucking Freight Futures contracts. DAT will not have access to any participant trading activity.
Nodal Exchange and Nodal Clear are the regulated exchange and clearing house respectively for the Trucking Freight Futures market. Nodal’s role is to provide the trading platform and risk management for Trucking Freight Futures trading. The system is fully electronic; there will be no physical trading floor. Nodal also provides the regulatory compliance for the market, exchange activities and clearing house.
Why is DAT’s index being used?
A comprehensive due diligence process validated that DAT’s freight rate data was reflective of actual market conditions and the defacto industry benchmark. Moreover, their rigorous process met the principles required of a regulated market. Established in 1978, DAT is the largest freight marketplace in the world, handling over 277 million loads annually. Their size, longevity and reputation made them an attractive partner.
Why will Trucking Freight Futures be settled against spot rates?
Most carriers have at least two types of freight rates (contract and spot).
Compared to spot rates, contract rates are far more stable in the market. Spot rates can fluctuate throughout the day, week and year. In fact, on a given lane, a rate may increase or decrease 10-15 percent within a given week. Contract rates are not subject to this sort of volatility. Contract rates normally stay in place for a year.
Unfortunately, for carriers or shippers with any exposure to trucking spot rates, there is no way to manage the volatility. That volatility wreaks havoc on cash flows, even if exposure is limited. By settling the futures contracts against spot rates, Trucking Freight Futures participants can enjoy more predictability.
How is the index created?
DAT has an annualized database size of $65 billion, from over 800 contributors. These are confirmed loads that brokers, carriers and shippers participated in and reported to DAT. Most of the transactions that are reported come directly from the contributors’ TMS systems. The DAT Freight Rate Indices are price assessments developed specifically for the futures market and are derived from a subset of DAT data. DAT’s methodology limits the impact any one participant can have on the price assessments.
Why are there only a few lanes that have futures contracts?
FreightWaves and DAT staff worked together over the course of two years to determine which lanes are most representative of the trucking market. The companies wanted to make sure that the lanes had enough density (i.e., high levels of freight transported on them) and were representative of the overall market. The lanes were chosen specifically because they represented the entire market or regions in the entire market.
The chosen lanes represent over 20 percent of the truckload spot volume that is reported to DAT from the entire country. Additionally, when modelled based on historical patterns, the rate movement in the chosen lanes is predictive of the movement in the broader market.
Moreover, those buying Trucking Freight Futures can choose among futures on directional lanes, regional corridors and the national market.
Which lanes and modes are being traded?
Los Angeles to Seattle Van
Seattle to Los Angeles Van
Los Angeles to Dallas Van
Dallas to Los Angeles Van
Chicago to Atlanta Van
Atlanta to Philadelphia Van
Philadelphia to Chicago Van
West US Van (Los Angeles to Seattle Van + Seattle to Los Angeles Van)/2
South US Van (Los Angeles to Dallas Van + Dallas to Los Angeles Van)/2
East US Van (Chicago to Atlanta Van + Atlanta to Philadelphia Van + Philadelphia to Chicago Van)/3
National US Van (West US Van + South US Van + East US Van)/3
What is the expiration cycle and frequency?
When they begin trading, Trucking Freight Futures contracts will be traded in calendar month increments as far out as 16 consecutive months.
What is the difference between hedging and speculating?
Futures markets participants have two primary reasons for trading – hedging and speculating.
Hedgers are protecting a degree of exposure against an unfavorable price move that will impact the value of future cash flows.
In the physical market, there are two sides – buyers and sellers. Buyers naturally want prices to decline, while sellers naturally want prices to go up. In trucking, shippers are naturally short (their profits reduce as prices rise), and trucking carriers are naturally long (their profits increase as prices rise). In general, shippers will want to buy futures contracts and carriers will want to sell futures contracts to offset their natural risks. (Carriers want the price for trucking services to go up, while shippers want the price for trucking services to go down.)
All markets have supply/demand fluctuations that impact price. This is exacerbated in markets like trucking where the product cannot be stored for future use. The price fluctuations make companies’ cash flows difficult to predict, so they look for opportunities to manage these risks. This is the definition of hedging.
Futures markets are tools to do exactly this in an efficient manner – they are established to help participants offset their risk by trading opposite of their natural position (hedging). No matter what a futures market participant expects or wants the market to do, a participant that hedges executes the contracts to ensure that it is less exposed if the market goes against them. The moment the participant trades in the same direction as its natural exposure, it is speculating.
Trucking Freight Futures will be cash-settled only (there will be no actual trucks involved) and participants will be trading against an index (an average of prices), which means its hedges are unlikely to be perfectly aligned to the actual physical market price.
Speculators are often portrayed negatively. However, speculators add depth and liquidity to a market. Put simply, speculators primary motivation is to profit on the direction of a price move in the market. They may or may not be in the physical market. Speculators use information and instincts about the market to predict direction and make their trades accordingly. If they are right and the market goes in the direction they traded, they profit. If not, their futures contracts will lose value and they will suffer a loss.
A participant can hedge and speculate in the market at the same time. A participant could have a position in the futures market that is hedged and speculate on an entirely different futures contact at the same time.
Example: Executives at a trucking company that operates only on the East Coast are concerned that rates may drop after the holidays. They decide to hedge their exposure to a rate drop by shorting the trucking futures market on the East Coast lanes. At the same time, they believe that rates on West Coast lanes will increase. They trade futures contracts on the West Coast lanes by going long. They are hedging on East Coast contracts and speculating using West Coast contracts.
When will Trucking Freight Futures be available?
Trucking Freight Futures contracts are expected to be listed and begin trading early in 2019 on the Nodal Exchange.