FACTBOX-What is an iron ore swap contract?

RIO DE JANEIRO/LONDON, April 15 (Reuters) - The breakdown of the decades-old annual benchmark system in iron ore pricing is likely to boost the popularity of iron ore swaps contracts.

The world's top three iron ore miners -- Brazil's Vale (VALE.N)(VALE5.SA), Anglo-Australian BHP Billiton (BHP.AX) and Rio Tinto (RIO.L) -- have all said they have moved the bulk of their contracts to quarterly pricing, mainly based on spot market prices. [ID:nSGE62B0DU] .IO62-CNI=SI

The trio controls nearly 70 percent of the 850 million tonne annual seaborne iron ore trade, effectively dominating the price talks, where analysts bet a doubling in the spot iron ore since September will be reflected in the contract prices.

The new system that miners are advocating faces fierce resistance from European steelmakers, who may have to renegotiate their annual contracts with their own customers, and from China, the world's top iron ore buyer. [ID:nSGE62B0DU]

The following are basic details about the developing iron swaps market.

WHAT IS AN IRON ORE SWAP?

An iron ore swap contract is a cash-settled derivative, between a seller and a buyer of iron ore at a fixed price for a set amount of time that provides price certainty for both the buyer and the seller.

They could be priced against any of the three iron ore reference indices published by information providers -- Platt's, The Steel Index (TSI) and Metal Bulletin Iron Ore Index -- which all say the index prices are based on actual transactions.

There are no physical deliveries in the cash-settled swaps but the most commonly used indexes are based on spot physical iron ore delivered in China.

Swaps settled against the TSI can be cleared by Singapore Exchange Limited (SGCX) or LCH.Clearnet while swaps settled against Platts can be cleared by IntercontinentalExchange (ICE).

These contracts would allow price and period differentiation throughout the market because they are negotiated between specific buyers and sellers.

This provides price stability without the rigidity of the benchmark system, in which the world's three biggest miners sit down with a handful of steel mills to agree on prices that are then applied across the market.

In markets for many other commodities, hedging can be done through futures markets -- which do not yet exist for iron ore but markets experts say several exchanges are studying the possibility of a futures contract.

WHO IS INTERESTED?

At present, the financial community -- banks and brokers -- are the major drivers of the market, although increasingly interest is seen from the steel industry, particularly Asia.

Market players say there is significant interest from small to mid-sized Asian steel mills, which lack pricing power in steel and never got a seat at the negotiation process of the iron ore prices.

A steel mill about to clinch a large steel contract -- maybe with a automotive consumer wanting a fixed price for half a year -- would appreciate the option to fix its input cost, which it can do through the paper iron ore market.

Chinese private steel mills which are not part of the current iron ore negotiations and Japanese and Korean steel mills, which prefer to fix a price for a longer period of time, could also benefit. Brokers have mentioned they have traded cleared swap contracts with Indian mining companies, as well as physical traders across Asia.

POSSIBLE CHALLENGES

Liquidity, as expected, is the major challenge as it is still mainly banks, brokers and physical traders leading the market.

The conservative steel industry is notorious for its opposition towards sophisticated hedging instruments in steel, which it says would distort prices due to the involvement of financial players.

But analysts expect a much swifter take-off for these contracts, compared to steel futures, as the major iron ore producers are actively promoting the shift towards more flexible pricing mechanisms.

Currently the estimates for trading volume of the swaps market is around 30-40 million tonnes, equivalent to around 3.5-5 percent of the annual seaborne iron ore trade.

Brokers see the volumes rising to 60-70 million by the end of the year and say they could well exceed 100 million tonnes by end-2011. [ID:nLDE62E1P9]

(Reporting by Humeyra Pamuk and Brian Ellsworth in Rio de Janeiro, Editing by Keiron Henderson)