The Winnipeg Commodity Exchange is encouraging the growth of the over-the-counter market by permitting Exchange For Risk agreements.
The exchange thinks the growth of the over-the-counter, or OTC, market will increase trading volume, even though these agreements happen outside the exchange.
“By allowing this type of transaction we may see more volume come to the exchange because now the players in the OTC market will be more comfortable structuring deals that include the use of futures,” said Bruce Love, the exchange marketing manager.
Unlike commodity exchange markets, where all trades are public, recorded and announced, the OTC market exists in a confidential world of private party-to-party contracts.
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They are often used in the Canadian grain industry to make customized arrangements that go beyond the simple specifications and structure of publicly traded futures and options contracts.
Love said some financial institutions offer OTC arrangements to grain companies and want to increase that business.
But there is more price risk in these arrangements than some would like, Love said. The parties in OTC commodity arrangements often protect their exposure by buying and selling futures contracts as hedges.
Each side will commonly take a futures position to offset the risk the OTC arrangement puts them in, resulting in the two sides taking opposing but equal futures positions.
When they complete their arrangement, each side will cancel out its futures position because the hedge is no longer needed. To do this, the two parties independently have to go to the exchange to close out their positions. If they arrive at the same time they can trade the futures positions to each other.
But the buyer and seller of these positions won’t always match up, and one might complete a transaction before the other. That can see the price change, causing an unexpected loss or gain.
This danger, called “execution risk,” is an element of the risk and uncertainty that most banks and grain companies are trying to avoid by entering the OTC agreements and futures contracts.
By allowing Exchange For Risk, or EFR, to be part of OTC arrangements, the exchange is giving the two sides of the transaction the right to exchange futures positions without having to return to the floor of the commodity exchange. The futures trade occurs only at the clearinghouse level.
EFRs will only be allowed for OTC arrangements that use futures as a hedge. Speculators will not be allowed to use them to skirt the trading pit’s fees.
Love said the use of EFRs will be similar to the widespread use of Exchange For Physicals deals in the canola business.
Grain companies and those who buy their grain often enter purchase agreements that each side hedges with futures contracts. When the grain physically changes hands, the companies are allowed to transfer their matching futures positions to each other, thereby cancelling the positions.
EFRs are already allowed by the Kansas City Board of Trade and are being tried for oats and rice contracts at the Chicago Board of Trade. The Winnipeg exchange began allowing EFRs on all of its futures contracts on Jan. 1.
