Iron-Clad Swaps

By Stephen D. Simpson, CFA | July 09, 2010 AAA

However much the politicians in Washington, D.C. rail against swaps and derivatives, it amounts to about as much as the legends of Xerxes ordering his retainers to whip the ocean for disobeying him. Amidst the debate about how to limit the exposure of U.S. banks to derivatives, a brand new market is taking shape. This is not a new derivative, but rather applying old tricks to a new market - iron ore.

The global iron ore trade is huge, totaling about 840 million metric tons and $100 billion a year. Oddly enough, though, it was a market that for 40 years was managed by the major iron producers holding once-a-year negotiating sessions with major buyers (steel companies, mostly) to set the price for the year.

This approach has worked well enough for the major producers, names that include Brazil's Vale (Nasdaq:VALE) and Anglo-Australian giants BHP Billiton (NYSE:BHP) and Rio Tinto (NYSE:RTP). Customers, though, have been less pleased with this arrangement in recent years and the Chinese in particular have been looking for alternatives. Bowing to this pressure, the major companies began ditching the annual pricing concept earlier this year in favor of quarterly pricing.

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Enter The Swap
With quarterly resets to be based on sometimes-volatile spot markets, the need for a derivatives market in iron ore became more apparent. The first in line was the swap. In simple terms, a swap is an agreement between two parties to exchange cash flows, typically centered around some sort of variable like an interest rate or currency exchange rate. In this case, an iron ore swap allows one party to "lock in" a fixed price for iron ore while the other party assumes the risk of a floating price - if prices rise, the fixed price swap holder "wins" and the floating swap holder loses, and vice versa if prices decline. (For a refresher on this topic, check out An Introduction To Swaps.)

Not surprisingly, major banks were more than happy to step up to the plate and offer these services - for a fee, of course. Deutsche Bank (NYSE:DB) and Credit Suisse (NYSE:CS) have emerged as the early leaders in the market, but American banks like Morgan Stanley (NYSE:MS) are looking to get into the game as well.

The Next Logical Step
While swaps and other derivatives have entirely legitimate uses, they suffer from a pronounced lack of transparency. Because there is no exchange, no clearing house, and no formal clearing or margin process, nobody really knows the positions (and risk) held by the other counterparties. This opacity is a part of the reason we saw the big panics back in 2008 and even into this year with the European debt crisis - when you cannot see your counterparties books and times get tough, you may assume they are no longer a safe partner and pull your business away. (For more, see Finding Your Margin Investment Sweet Spot.)

Moving on, the CME Group (NYSE:CME) is now lending an even greater air of significance to the global iron ore derivatives market, creating an iron ore futures contract that will trade on the New York Merc starting next week and offering trading and clearing services. Although having an active futures market does not relieve the opacity of the swap market, it does at least represent another alternative for those looking to hedge their exposures. (To learn more, check out How Do Futures Contracts Work? from Investopedia Video.)

Who Wins?
It is hard for me to see how this is anything but a "win" for the financial services companies involved - it gives the banks another derivative to trade, it gives the CME another futures product and it gives more price transparency to those who finance projects relating to iron ore.

For the companies, it is a normal evolution to the market. The iron ore companies would probably rather have the certainty of annual pricing, but that was just not in the cards anymore (not many global commodities trade on that basis). The biggest potential side-effect here is greater volatility in the market. Clearly, almost anything would be more volatile than once a year price-setting, but open future markets can certainly lead to speculation here and there that decouples prices from economics (look at markets like oil in recent years).

For the steel companies it is likewise a mixed blessing - perhaps it breaks the price-setting power of the iron ore companies, but it adds a level of input price volatility that will make financial projections more difficult for the likes of POSCO (NYSE:PKX) and Arecelor Mittal (NYSE:MT) unless they get involved in these derivatives. (To learn more, check out Futures Fundamentals.)

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