Looking into the future of derivatives

Looking into the future of derivatives    There’s hardly a hotter topic in the world of container shipping these days than the idea of freight forward contracts, or the container freight rate derivatives market.
   We've covered it extensively in American Shipper in recent months ('Hedging your box bets' and 'Singapore to clear container swaps), with the development of the Shanghai Shipping Exchange and its Shanghai Containerized Freight Index.
   Yet there’s such little understanding of the topic within the industry that it’s tough to gauge just how pervasive these financial instruments will be in the long run. At their essence, ocean freight rate derivatives are a way for carriers and shippers to hedge their revenue and costs, respectively. That’s not necessarily unusual — carriers have done it before by hedging on fuel costs.
   But derivatives also represent a chance for those outside the industry to make a buck, effectively betting on which way rates will go based on economic indicators. That's part of what makes the situation a little scary for those on the inside. Buyers and sellers of ocean freight transportation have doubtless read the accounts of banks and finance guys scheming their way to millions and billions (or losing millions and billions) in derivative markets.
   That those in the industry have little understanding of derivatives markets makes it that much scarier. At the TPM Asia conference in Shenzhen last week, held by the Journal of Commerce, Barry Horowitz, principal of CMS Consulting Services, asked who in the audience had a firm grasp about ocean freight derivatives. Few hands, among the hundreds in attendance, went up.
   Horowitz correctly pointed out that the people intimately involved in ocean freight transactions — that is, sales reps with the liner carriers and logistics executives for shippers — are not yet equipped to make decisions about forward hedging. So that leaves carriers and shippers in a position where different teams within their companies are tasked with setting freight rates and hedging. These derivative products are based on a rate index — not any one or two carriers' or shippers' rates — but individual negotiations eventually feed into the way freight rates move, and thus the direction those indexes move.
   That decision-making gap on rate-setting and hedging could make it hard for the derivatives market to aid those who it is ostensibly aimed at. What's clear, however, is that the market is attracting interest, and a few takers.
   CSAV became the first line to actively engage in container swaps in August. Others, like Maersk Line, have been quick to downplay them. Maersk Chief Executive Officer Eivind Kolding compared the futures market to a casino earlier this year.
   But proponents of the futures market suggest that carriers and shippers who ignore the benefits of hedging are the ones who are gambling.
   'Projecting supply and demand with no risk management, that is the real casino,' said Brian Nixon, executive director for Morgan Stanley Commodities, and a former liner executive with APL and OOCL.
   To help understand how the market actually works, Benjamin Gibson, freight derivatives broker for Clarkson Securities, and the man who executed the first successful container freight swap, said a transaction requires two elements:
   ' An unpriced service contract (i.e. a contract to carry X number of boxes from point A to point B).
   ' A spot-settled derivative contract behind it.
   If that's not entirely clear, don't be alarmed. You're not alone.
   'Derivatives are a difficult sell even for the banking community,' said Thomas Kim, executive director of Asia investment research for Goldman Sachs. 'It's a much tougher sell to a non-banking-oriented industry.'
   If the industry seems so lukewarm towards derivatives, why all the momentum to establish the market? Yes, banks and brokerages are keen to find new sources of revenue, but let's not ignore the fact that the development of container freight rate indexes — like ones published by Drewry and the benchmark Shanghai Shipping Exchange — are what have made the futures market viable. For them to blossom, it will take more than few willing participants, but the mere fact these indexes exist show there's interest in having an insight into the future and potentially having the ability to hedge against it.
   Another thought from Kim makes for interesting fodder when considering how successful the futures market could be.
   'The ups and downs of a cycle may seem like a lot to shippers, but container shipping is the least volatile shipping industry,' he said. 'The pricing tends to be pretty understandable through the cycles.'
   Given that the derivatives market is a huge presence in more volatile shipping segments, like bulk shipping, his comment could be read one of two ways. First, if container shipping is so relatively unvolatile, is there even a need for a futures market in which participants can hedge their losses? Or second, would the lack of volatility make a container rate futures market more attractive to those who want to play the game, but don't have the appetite for the risk of more volatile shipping segments?
   Is it possible that the success (or failure) of the ocean freight rate derivatives market could finally determine whether container shipping is, indeed, a commodity? That phrase gets thrown out quite a bit, but if the futures market succeeds, it would be harder to argue that space on a containership is little more than a commodity, no matter what services carriers try to attach.
   Alternatively, if the futures market fails, it would give weight to the argument made by carriers that each contract is a different species and can't be lumped together.
   As Eng Aik Meng, president of APL, put it: 'I see a struggle as to how you can put a rate into a derivative instrument, because each rate is different.'
   Time will tell if he is right. ' Eric Johnson