* Volatility attracts players from other commodity classes
* Citadel, Vermillion among the active funds- sources
* Competition among exchanges increases in iron ore
By Silvia Antonioli and Jacqueline Cowhig
LONDON, Oct 26 Growing liquidity in iron ore derivatives is attracting hedge funds who have up until recently ignored a market which is becoming a leading indicator of underlying growth in China, the world's second largest economy.
A few pioneer funds have started to trade in this small but fast-growing sector and many others are "watching it like a hawk", waiting for further liquidity growth more before entering, sources said.
"We want more exposure to iron ore to better express our views on China," said a US-based manager of a fund, which has recently started to trade iron ore swaps.
"We think iron ore is a better indicator of real demand. It is more directly linked to China's underlying economy compared with other commodities because it's still dominated by physical players."
A manager at a second U.S.-based firm which currently focuses on base metals futures, said its fund is also active in iron ore swaps, although this still represents less than 5 percent of its portfolio.
Volumes in the four-year-old cash-settled iron ore swaps market have more than doubled every year so far to reach an estimated level of about 100 million tonnes in 2012.
This is still small when compared with physical trade of over 1 billion tonnes per year, second in physical volumes only to oil, but the contract is now liquid enough for financial players to take meaningful positions.
Among the funds currently trading iron ore swaps, market sources mentioned energy-focused Vermillion and Citadel, and Black River, a fund owned by agriculture commodity giant Cargill.
Contacted by Reuters, Vermillion, Citadel and Black River declined to comment.
At least 4 more funds are also said to be participating already.
"For sure there are more funds coming into the market, that's one of the key growth areas right now," said Kerry Deal, head of iron ore and bulk derivatives at brokerage Jefferies Hong Kong Limited.
"It was just a question of when liquidity was going to grow high enough to be suitable for hedge fund style of trading: larger clips (deals), quickly. I think we are just starting to see this now."
A fully developed derivatives market generally records trading volumes between 5 and 10 times as big as the underlying good but iron ore is a very large market so the growth seen so far is extremely encouraging, market players said.
Adding to the appeal of iron ore derivatives is the increasing volatility this product has registered.
The peaks and troughs seen in the last year have offered better return potential than other more consolidated markets such as copper which has been "dully" trading sideways most of this year, traders said.
Iron ore swap volumes on the Singapore Exchange (SGX) hit record levels of 17.7 million tonnes in September this year, after a summer of violent price swings.
"Players generally involved in coal and freight are looking to trade iron ore too, attracted by the higher volatility," FIS broker Ian Thompson said.
SGX currently clears over 90 percent of the globally traded iron ore swaps, with other clearers such as CME and LCH still far behind.
Lured by the expansion of this market, the new owners of the London Metal Exchange, the biggest market place for base metals, are also eager to launch a rival iron ore contract.
Stronger competition among exchanges can help move towards a more sophisticated, screen-traded product, some argue.
"Iron ore swaps are all voice brokered (over the telephone) and funds prefer the transparency and speed of getting in and out of positions you get trading on screen," said a derivatives trader at a European bank.
The entry of funds could also help reduce imbalances in the iron ore swaps market.
While many large and small miners and traders have embraced this market, some players still lament low levels of participation of the natural buyers: the steelmakers.
Steel producers, especially the large ones, have often been against iron ore and steel derivatives fearing that these might take away their pricing negotiating power.
Brokers admit that there are still some problems with liquidity on the buy side but swear the steelmakers' attitude has greatly changed in the last few months.
"Now I see, all of a sudden, end users looking for means to hedge, especially those who don't have their own mines," a third broker said. "Until a year ago or so it was only chit-chat but now it's actual business."