Articles
Futures Exchange - ECX Faces Bumpy Road towards Greater Efficiency
FORTUNE: A range of ups and downs in the market were witnessed in the 2010/11 fiscal year, largely due to regulatory changes implemented by the government. How do you evaluate the performance of the exchange this fiscal year in light of these changes?
ELENI: We have had a spectacular year in terms of trading volume as well as our own internal target. Our trading volume has more than doubled from 221,00tn last year to 502,000tn this year. The value of the trading volume reached a record 18.2 billion Br this year, as compared to 6.7 billion Br last year.
High prices on international commodity markets increased our trading value by 179pc, almost tripling.
Our revenue also increased dramatically, while our warehouse capacity nearly doubled from 1.4 million bags to 2.7 million bags.
We are growing, and our members have also grown their own businesses. We started with 100 founding members; today we have 245 permanent members and another 200 limited members. Together, they have 7,500 clients, starting from zero three years ago. Just between December 2010 and June 2011, the number of clients has doubled from 3,500 to 7,500.
The reach of the exchange to the smaller actors is growing very fast. The number of direct participation by farmers, last year, was 1.4pc of total trading volume. This year, it is about five per cent, so it has more than tripled. The direct participation by farmers’ cooperatives has followed the same trend.
We have also been doing much on the internal aspects of how we do business. We have implemented a policy of putting people, our staff, first. We have been working on empowering the employees of the exchange and reorganising the management structure.
We have also established the ECX Institute as a knowledge management arm. It would be engaged in research, training, and advisory services. It is a very important new initiative that we expect a lot from.
In many ways we are evolving very fast but maintaining our commitment to excellence.
Q: What is the progress in fitting the ECX Institute you are creating into the dream of the exchange and linking it with potential partners in and out of the country?
The ECX Institute would really put us back into the knowledge business. When we started the ECX, in addition to the nuts and bolts of the trading system, the most important thing we brought to this country was knowledge.
To be a cutting edge institution, we have to focus on understanding and analysing our business environment. We thus need research and analytical capacity. At the same time, the increasing range of market actors, including our staff, regulators, policymakers, farmers, and traders could speak the same language if they receive continuous training and certification standards.
Our institute is going to start offering certification programmes on commodity marketing, advanced quality analysis, and advanced trading. We are increasing professionalism in our market with the systematic training arm.
We have had an overwhelming demand to provide advisory services from all over Africa. Many countries visited our exchange and have reached the stage of writing project papers saying they want commodity exchanges in their countries.
Ethiopian Airlines established a flight management and maintenance training centre for other African countries as part of its business model. In the same manner, we would keep ourselves sharp in interacting with the new entrants around the continent and providing our counterparts with service through advisory services.
Aside from staying connected, this would help all of us remain up to date with new knowledge. We are at a very exciting stage now. The ECX Institute is about to go on the road.
It would be the new means to connect African commodity markets, in which ECX would play a pivotal role. This would even be a springboard for more integration at the systemic level, which would be good for all of us.
Q: What were the principal challenges faced by the exchange over the past year?
Although we are happy with the performance of the past year, we could do even more. There are things still constraining the expansion of our exchange. One is the area of telecommunications. We are so dependent on telecommunications that you could say it is the backbone of our business.
For the past few years, we have tried to work around the constraints in the sector, but we remain frustrated that we are not seeing sufficient improvement in the infrastructure.
At any given time, almost 50pc of our warehouse network system is not connected as the network is down. Out of the 16 warehouse sites, seven were not connected [on Monday, June 20, 2011]. This is a big problem.
Electronic price tickers pose the same problem. We have been getting only about 45pc reliable connection, which is very damaging for our business.
We would also like to roll out our services and products much more aggressively. We have established a call-in service called Interactive Voice Response (IVR), where anybody can call on a toll free number and obtain real-time prices in four different languages. Today, we are getting 44,000 phone calls daily, four months after establishing the new service.
If the telecommunications system was performing optimally, we would have four times that volume, because so many calls are seen to be dropped from the line’s inability to handle the call volume.
The same goes for mobile phones. We send around 156,000 text messages to people who want real-time price updates. This would also have been at least four times more, if the telecommunications capacity had been better.
We have also set up a warehouse receipt financing system, which electronically links the central depository of our clearing house with banks so people can access loans using the receipt. Unfortunately, we only had 10 million Br in loans given against our warehouse receipt since January. So there is a big disconnect.
The market really wants it. The banks think this is a new product they should be offering as they would not be looking for collateral. Yet, the service is not taking off because of the credit cap and the regulatory policy around the lending of banks.
Another challenge is the warehouse infrastructure. We have reached the limit of the existing storage infrastructure in the country. No modern agricultural economy has grown without a systematic investment in storage and logistics. This is a specialised industry that needs to be created in this country.
ECX cannot continue being the warehouse operator for our system. We need to devolve to private or public third party warehouse operators. Just like banks handle people’s money, we need to have certified warehouse operators to handle people’s commodities.
This investment is not happening for many reasons.
We need a policy push to attract and create investment, both foreign as well as domestic. Kenya, Uganda, and South Africa have modern facilities that can store several million tonnes. Our maize production is the second largest in Africa, double the combined volume of Tanzania, Kenya, and Uganda, but our storage facilities are a tiny fraction of the total.
This disconnect is playing against us. We are racing against time, with the GTP planning an increase in commodity production by over 300pc. Handling and transporting all the upcoming production demands an investment.
The government must devote sufficient investment for storage and transport, otherwise the growth of agriculture and this market would come to a halt.
The last one has to do with the sudden regulatory changes over the past few months. The regulation about hoarding for exporters specifies that if an exporter holds coffee beyond a certain number of months before they export it, they would be barred from trading in the exchange.
Linking this regulation to trading on the exchange is problematic, as is mixing behaviour outside the exchange with a penalty on the ECX. The only way one should be barred from trading on the exchange is if one has violated the rules of the exchange. Other measures might be taken to penalise these traders.
In fear of the regulation, people are buying less on the exchange. We have seen a dramatic drop in the volume of coffee traded, even though the supply is there.
The second regulatory challenge is the new directive that requires intermediary members to essentially be owners of their own business as traders. This contradicts the concept of intermediation. Intermediation is a service in itself, separate from buying and selling commodities.
Seeing that our exchange model is based on the concept of intermediation as an independent service, the new regulation is a significant challenge.
The new regulation limits members to one commodity. As the competence certification requires them to have a warehouse for every commodity, they would be limited to one commodity instead of investing in a series of warehouses they would not use. This undermines intermediation, the lifeblood of the ECX.
This is very compromising for the system we have created. There needs to be a policy discussion on it. Otherwise, it would reduce the liquidity in the market and the reach of the market and take us backwards.
Q: The government knows how the ECX works. Where is the disconnect in policymaking for you not to partake in the enactment of these restrictive regulations?
To a large extent we participate in the policymaking process, but not in these particular cases. There is a need for further discussion on these issues. That is what we are hoping to see happening soon.
Q: Last week, you announced that the exchange would expand its operations to include forward and future contracts in three years. This might become the first derivatives market in Ethiopia. Given that the exchange is only three years old, what makes you think it is time to transform from spot trading to a commodity futures market?
From the very beginning we planned for this to be a spot and futures exchange. When we designed our contract of spot trading, we designed it in a very unique way.
Spot trading will be done as if it is a futures contract with only one difference: the delivery period. This will be immediate, in 10 days, instead of three or six months, making the cash payment also 100pc.
For futures trading, you only put up five per cent of the amount, like a deposit, and you do not give the 100pc until you receive the commodity in three months or more. Everything else, such as quality grading, payment terms, the price quotation terms, and payment settlement clearing, are created in the same manner as a futures contract.
In this sense, we have already laid the groundwork for the futures market, but we will not immediately start with futures. It has to be phased in. We would start with forward contracts, in which the commodity has to be delivered after three or six months.
With futures trading, you have the option to pay cash with the value of the commodity without actually delivering it.
It is one step removed from the physical delivery. Meanwhile, we would have time for the market and policies to adapt.
It will require some regulatory changes because the way we will manage risks requires new rules and regulations. Of course, it has its own risks and the policy environment should also be very comfortable that it is not going to lead to too much speculation or gambling. I am very confident that we would avoid excessive speculation.
The reason we think the time is right for forward contracts is because ours is a zero default market. We have created and effectively managed a system that manages contract risks. Yet, there are still price risks plugging out the market.
The forward market is urgently needed by all the market actors, who find themselves in an enormous price risk situation.
The opportunity to lock in the price of supply over a period of six month or one year and reliably get the supply has to be opened for the domestic processing industry. This would enable them to continue to make investments in their technology, factory, or capacity.
I would have liked to see the forward market start last year, but we were very busy rapidly expanding and had to postpone it. Now we will pursue building this new system.
Q: What opportunities and risks do these present to the farmers producing these commodities?
Farmers are one of the biggest beneficiaries of a forward market.
For the past few years, there have been attempts to do forward contracting outside of an exchange; out of a grower scheme. A cooperative society or union would approach the local processor, such as a milling factory, and offer to deliver a certain amount of wheat at a certain time for a set price.
These contracts have a mixed success rate because the farmers would not be interested in respecting the contract if the price increased to above the contract price. The buyer or the processor would no longer be interested in the contract if the price goes down.
Future contracts would help to avoid parties defaulting on these kinds of contracts. The exchange will become a valuable system for the farmers to use the forward market.
The reason we always talk about forward and futures is because somewhere down the line somebody has to take the risk. The farmer does not want to take the risk and that is why they want to lock in the price. The flour factory also does not want to take the risk, so it also wants to lock in the price.
The person who does not want the risk has to be able to sell or transfer their risk to somebody who thinks they can make money from the risk. These actors in the system are called risk absorbers.
They are not the producers or the end buyers, but intermediary traders who are simply buying and selling in order to provide a market for the buyers and sellers. By being in-between, they are taking the risk.
It is a bit of an art and definitely a detailed science for an exchange to get the balance right between those who are absorbing the risk and transferring the risk. If the market is made up only of the risk takers, it is a speculative market, it is a casino. Everybody is just selling and buying without any interest in the commodity.
This was what happened to China’s Commodity Exchange, forcing the government to shut it down in the late 1990s. A few years ago there was a concern that India’s futures market was becoming too speculative.
Our market is populated with people with an interest in the commodity and our forward market will require them to take delivery at the time of the conclusion of the trade. Our market needs to manage risk better and we are confident that we can come up with a design that is appropriate for the need of our country without encouraging excessive speculation.
Q: Do you think the country has the necessary regulatory framework and social mindset to successfully implement the newly proposed plans?
Like everything else, we will start slowly and we will do a lot of capacity building as we proceed. Our regulator, the ECXA, is aware of the interests to move towards a forward and futures market. We will all grow together in this system.
The ECXA seems to be committed to learning. It is already in discussions with its US counterpart, the Commodity Futures Trading Commission. Its staff members have been receiving training in futures trade regulation. It is also networking with India and China.
The other side is the capacity of the actors. In order to build that capacity, ECX Institute will be our primary vehicle to give systematic training on how to go into this new system. Intuitively, every farmer, processor, and exporter understands it because it makes sense.
A futures market is not a theoretical concept; it is a very practical concept for everybody in the market, but its successful implementation demands teaching the actors and learning ourselves.
Q: In past efforts to introduce secondary market instruments, the government resisted the establishment of the market, claiming that excessive speculation was a principal hitch for systemic sustainability. What makes you optimistic that it will be done right and that the government would accept the proposal this time?
The government is interested in doing things that makes sense for the country. Doing something that simply encourages speculation without adding value to the lives of farmers or the export sector is not desirable.
In this particular case, there has always been an understanding that we will start with spot trading and evolve to futures trading. Even when the laws pertaining to the exchange were enacted, it was recognised that futures and spot trading will be done in the exchange. We have been discussing it for the past few years.
Having laid the foundation, we will go into a new round of discussions and policy dialogue to ensure it is in line with the country’s interests. There is no special interest on the part of the exchange. We are sponsored and promoted by the government, and we are trying to move together.
The idea of price risk management is recognised by policy makers. If it is something that enables farmers, factory owners, and exporters to manage price risk in a positive way.
It is not so much about whether we do it, but about how we do it. There is trust that we will proceed in a very careful way so as not to encourage undesirable or unproductive behaviour.
Q: Regulating secondary markets such as future commodity markets demands advanced instruments of risk identification, quantification, and management. Do you think the ECXA has the capacity to do this?
I do not really want to comment on the capacity of the ECXA.
Around the globe, regulators are always playing catch-up with the market. The market is always trying to find a new way to cut corners. Sometimes the way is legal and legitimate, while, at other times, it is not legitimate. Either way, the market is always at the front.
In the United States (US), the exchange existed for 75 years before a regulator was created. The exchange, therefore, had a lot more knowledge on how the market worked than the regulator. In the case of the stock market, the US Securities Exchange Commission came 122 years after the stock markets were created.
At some point, the market started to hurt the interests of society. Hence, there is a need for regulators in any country.
It is normal for the exchange to have more knowledge of the market than the regulator. This in itself is not a problem. The problem is whether the regulator has the capacity to catch up and if this can be built. It is not insurmountable for the regulators to cope with.
The concept of forward trading and futures trading has existed for hundreds of years. Our regulator has the full means at its disposal; it does not have to create something new. It can learn from how the rest of the world has regulated futures markets.
Q: Increasing the number and capacity of warehouses forms part of your expansion plan, but operating and managing an expanding network of warehouses is complicated. Do you plan to privatise or outsource the operation and management of warehouses?
A strategy of third-party warehouse operators involving three aspects was approved by our board in January 2011. The first is that the exchange must build up its internal capacity to monitor the partners that issue receipts on our behalf.
For example, the commodity exchange in South Africa has 14 certified warehouse operators. The ECX would only do regular audits and inspection to ensure the operator is providing a good service. They would link the systems for that purpose.
Secondly, we have to identify willing and capable warehouse operators. We must have detailed certification requirements such as bonding, insurance, and financial capacity.
It is a very risky and big business so we have to ensure that we have viable operators. Some of those operators may not exist in the country; it might require technical knowledge that comes from abroad. Creating abroad. Creating a viable industrial knowledge of inventory management would be imperative.
The warehouse industry has to be created, as it does not exist. We are in discussions with the United Nations Development Programme (UNDP) and USAID to set up projects in private sector development of the industry.
The third part is regulation. We are very lucky in Ethiopia that a warehouse receipt proclamation was enacted in 2003 as you cannot have a system without appropriate regulations. A regulatory body to oversee the warehouse operators, private or public, is required.
We look forward to entirely passing our warehouse operation business to third party warehouse operators in three years, but we want someone who works at a higher standard than we have been doing.
Q: Is there any demand from the market to provide third party warehouse operation services?
Yes, but we doubt whether they have the right experience. We do not want many small operators. We want big operators with the capacity to run big and modern warehouse silos around the country. We have none and we really need it.
For the industry to flourish, the policy must be accommodating and the investment climate must be encouraging. It needs to be done urgently and we are pushing for it very much. Yet, the market exists and it is attractive for both local and foreign investors.
Q: What requirements from the policy side have to be met to realise a viable storage and logistics industry in the country?
The main thing about creating this warehouse industry is to strengthen the regulatory capacity of the Ministry of Trade (MoT). Many years ago, there was an inventory warehouse receipt regulating section in the ministry. That unit was not very strong. Yet, if that unit still exists, it should be strengthened through a series of capacity building efforts.
I do not know if there are issues with the investment climate that need to be discussed with the investment agency, but with the aggressive GTP targets the potential for investment is high.
We pay two Birr every time a sack is uploaded and off-loaded. These high handling costs make us uncompetitive. We need to change the inefficiencies in our system. If we change one part of the chain, the whole thing will change and that would be good for the economy.
Q: Critics claim that the establishment of the exchange did not create sufficient backward linkage in the value chain of traded commodities, including production methodology, input utilisation, and postharvest technologies. Some even claim that the exchange failed to create sufficient inspiration for agricultural transformation. What is your stand on these issues?
I do not know whether I agree or disagree. We have not seen any systematic analysis of that. To make any conclusive statement, we need to study it in depth. However, ECX has definitely impacted on backward linkages. A simple visit to the field would show the fact.
If you look at our grading system, which gives the price per grade, the farmer now knows all the different quality differentials that the market can reward. That is a very powerful market signal.
Farmers are doing more to achieve higher quality and are getting more money back in their pockets. Farmers are also obtaining a higher share of the final price due to improved accessibility of market information.
Farmers are investing more on the production side because they know from calling up our market, finding out the price, and listening to the radio that they can reliably determine what the output price is. Through the warehouse receipt financing system, farmers can obtain a loan for the amount they put in our warehouses and use it to pay for next year’s fertiliser input.
Q: The potential contribution of ECX to enhance market performance inspired you even before its establishment. Are you still optimist after all these years of trying to convince traders, farmers, politicians, and the international community of its benefits?
I am optimistic about this country. The past seven years in Ethiopia have been very exciting, with the exchange occupying the last four.
What we are building is not just a modern market, but hope and a sense of power. It is just a scratch of what we could do. This is the start of a long and meaningful journey.
We dream, but we do not dream blindly. There are bumps in the road, but nothing worth having comes easy. Things will never be perfect.
I have more energy than when I started, because I have seen that if you try hard enough and believe, things happen. I am even more excited than before about what we could do.