China's planned iron ore futures a threat to dominant swaps market

Tue Oct 8, 2013 7:23am EDT

* Dalian exchange may launch iron ore futures before year-end

* Latest China effort to influence iron ore pricing

* Yuan-denominated contract seen key to liquidity

By Manolo Serapio Jr and Ruby Lian

SINGAPORE/SHANGHAI, Oct 8 (Reuters) - China's imminent launch of its first iron ore futures contract could pose a threat to the $28 billion swaps market in the commodity by exploiting massive untapped hedging potential at home.

The contract to be offered by the Dalian Commodity Exchange likely before year-end will be China's latest stab at boosting its power to price the world's second-largest traded commodity after oil as a more volatile iron ore market exposes its legion of steel mills to more risks.

By being the first yuan-denominated iron ore futures contract, the Dalian exchange can easily draw on the growing hedging appetite in China, a market that bourses in Singapore, the United States and Europe have been trying to tap for years.

Beijing has kept a tight rein on overseas derivatives trading by state-owned firms after many lost billions of dollars in offshore futures during the global financial crisis.

The lack of a domestic hedging tool has led Chinese companies to increase their use of the U.S. dollar-denominated cash-settled swaps offered by the Singapore Exchange (SGX) and CME Group.

"The market is in China, so Dalian's futures will attract a big number of domestic companies because this can help them avoid currency volatilities and restrictions which is a big challenge to Singapore's swaps," said Zhao Qian, a senior broker with CITIC Securities Futures in Shanghai.

"In the longer term, Beijing hopes to gain more pricing power via its own futures and it is hoping it can become a market benchmark."

China buys at least 60 percent of the world's seaborne iron ore and last year that reached a record 744 million tonnes, almost seven times the size of swaps cleared by the Singapore Exchange, pointing to the huge hedging opportunity in China.

"There's no doubt the Dalian exchange will do a lot because there is a hell of a lot of untapped liquidity in China that is not trading iron ore swaps," said a Singapore-based broker.

With more than 127 million tonnes traded last year, the swaps market accounts for just over a tenth of the 1.1 billion tonnes of seaborne iron ore sold annually.

But the volume is rapidly increasing. In January to September this year, nearly 210 million tonnes of swaps have been traded, valued at $28.3 billion based on the average price of about $135 a tonne. SGX clears over 90 percent of global iron ore swaps.

A launch of the futures contract may happen before the year ends after the Dalian Commodity Exchange secured regulatory approval in mid-September. It will be the first iron ore futures contract that is backed by physical delivery.

If the strong debut of China's thermal coal futures on the Dalian bourse is any indication, the iron ore contract should see brisk demand.

China is also the world's top consumer of coal.

COMPLEMENTARY PRODUCT?

The iron ore futures contract adds to China's suite of hedging tools for steelmaking raw materials that includes coking coal and coke. Its Shanghai Futures Exchange has rebar, the world's most liquid steel futures, that iron ore swaps traders closely track for trading cues.

SGX, on its part, is not worried about the Dalian contract launch, saying it is a complementary product to its swaps and that there is a market for swaps outside of China.

"If liquidity grows onshore in China, liquidity offshore is able to grow because you're leaning on another layer," Michael Syn, head of derivatives at SGX, told Reuters.

"And the Chinese aren't the only ones playing on iron ore. There's still as many people outside of China who need to hedge as there are in China," Syn said.

SGX began offering cash-settled iron ore futures in April in response to regulatory changes in the United States where some of its clients are. But bulk of its business remained in swaps.

Some market participants say the size of each lot - 100 tonnes based on Dalian's plan - may be too small for big Chinese mills to hedge and may only draw retail investors looking to make quick cash. In comparison, each lot of SGX's swaps is 500 tonnes.

Providing adequate liquidity may be a tough task for a fledgling futures market. Previous attempts to launch iron ore futures have suffered from low liquidity, including contracts from the Singapore Mercantile Exchange, India's Multi Commodity Exchange and Indian Commodity Exchange and CME.

Nonetheless, the market looks headed towards futures, traders say.

"Swaps brokers are very well aware that this will eventually happen, futures is the way to go. These brokers should start looking for jobs," said a Singapore trader who handles physical trades.

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