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  Freight Derivatives Exchange  

A - The Clearinghouses era

The FFA Market

FFAs are derived from the chartering rates set by ship owners and their customers. These rates apply to ocean-going vessels that move commodities from production to market zones. Crude oil, coal, grain, iron ore are all examples of commodities shipped by ocean-going vessels. The shipping business is generally divided into “wet” and “dry” categories. Wet covers crude and refined petroleum products, while dry covers everything else. The wet market is further broken down between “dirty” or crude oil markets and “clean” or refined product markets.

Dry accounted for the majority of this market, but  wet is growing far more rapidly, from 5% of the market in 2003 to 50% in 2007. In addition, clearing has made much greater inroads into the wet market, with 60% of the trading being cleared in 2004, versus just 5% of the dry market. For that reason, this article will focus primarily on the wet market.

The physical shipping market trades spot “fixings” or in longer term “time charter” contracts. These typically trade in 12 to 36-month time horizons but can go out as long as ten years. Many physical brokers service the daily spot and time charter markets, such as Clarkson, Simpson Spence & Young, Mcquilling Brokerage Partners, Poten & Partners, and Mallory Jones Lynch Flynn. These brokers contribute to the establishment of a daily index known as the Baltic Index of Tanker Rates or BITR. The index is compiled by the Baltic Exchange, a 250 year-old exchange based in London that has been the focal point for the world shipping community for many years.

In the FFA wet market, contracts are settled primarily on the basis of the BITR, and secondarily on similar broker survey indices produced by Platts. The indices are broken down by trade routes, such as Arabian Gulf to Japan, West Africa to the U.S. Atlantic coast, and so on, then further divided by class of vessel. Not all routes trade in the derivative market. TD3, the route between the Middle East and Japan, is by far the most actively traded route, followed by TD5 (West Africa to U.S. Atlantic Coast), TC2 (Europe to the U.S. Atlantic Coast), and TC4 (Singapore to Japan). Contracts are traded in thousands of metric tons and on any given day volume could be between 2,500 and 3,500 contracts. A small number of brokers quote option prices as well as forwards.

With volatility over 100% in the front month, why not! Quotes regularly come across the Yahoo messenger, the unofficial communication network of the industry, for outright calls and puts or quite often call and put spreads. The quotes start rather wide but when two serious players look to execute, the bid/offer spreads narrow down to two or three points and trades go through.

While 10 and 20 thousand metric tons (kmt) is the norm, 50 and 100 kmt can get done only a few points away from the quoted market. Another sign that this market has potential to take off is the way liquidity begets liquidity. When an otherwise sleepy trade route gets some price activity, it often seems that everyone who has been sitting on the sidelines jumps in. For the next week prices are posted on that route rather consistently.

Freight Fundamentals

From a seasonal perspective the market is similar to oil—strong leading up to the winter and softer in the early spring and summer. Of course, what happens in any given year depends on many other factors. On the demand side, inventory builds, heating demand, power consumption, and overall economic growth all influence the price a vessel will lease for in the spot fixing market. On the supply side, weather is the great unpredictable, with extreme events such as hurricanes and typhoons having very disruptive effects on the availability of shipping in a particular region. These effects can ripple out to other regions as ships are redeployed to meet the resulting shortage. All of these factors contribute to what has made for a rather volatile market the last few years. While the full impact of Hurricane Katrina is not clear yet, one only has to look back to Hurricane Ivan to get a sense of the potential effects. In the fall of 2004, Ivan suddenly created a huge demand for oil to be shipped to the U.S. from other  parts of the world to replace the disrupted supply from the Gulf of Mexico. Tanker rates soared and the benchmark TD3 rate for VLCCs (very large crude carriers) jumped from roughly 90 WS ($49,000/day) to over 300 WS points ($210,000/day) in November. The damage caused by the hurricane was soon cleared up, and by January prices had fallen all the way below 100 WS. Ivan was an anomaly, but prices continued to bounce around this spring and summer. Over the whole period, the implied volatilities traded in the market have ranged from roughly 45% to over 110%.

Who Are the Market Participants?

Like the energy sector, wet FFA trading is conducted out of Singapore, London and New York, with an influx of traders anticipated out of Houston in the near future. Many of the traditional energy derivative brokers such as GFI, Prebon and TFS have teamed up with physical tanker brokers to provide a combined expertise in execution and market insights. Traditionally trading was done over the telephone, but more and more trades are conducted on electronic trading platforms operating over the Internet. These screens let users view prices and in some cases offer full execution capabilities. The leading platform, at least in terms of the quality of pricing and range of coverage, is Imarex, a company based in Oslo that was started as a joint venture by several shipping industry companies and NOS, the Norwegian futures and options clearinghouse.

Imarex officially opened its market for freight derivatives in November 2001. At last count its screens covered 12 clean and dirty routes. Prices are listed monthly for the first six months then quarterly for six more quarters and calendar quotes are posted for two years out. Imarex also provides a direct link to NOS, and traders can request NOS clearing at the time of execution. Not surprisingly, the investment banks and oil companies have jumped in. Naturally Goldman Sachs and Morgan Stanley withtheir large energy departments are involved,and Barclays Bank, Deutsche Bank and Dresdner Bank offer both trading and clearing. Among the oil companies, BP, ConocoPhillips, Shell and Total have been active participants along with Hess Energy Trading, a proprietary trading company partially owned by Amerada Hess. Other players include Duke, Koch

Industries, Glencore, Mitsui, RWE and Trafigura. And of course the shipowners both large and small have been taking advantage of the market. Among the names active in trading FFAs are A.P. Møller, Frontline, General Maritime and Overseas Shipholding Group. A quick look at the Imarex website will show about 100 members.

The Arrival of the Clearinghouses

One new development that could increase the liquidity of the market is the listing of FFA contracts on several major clearing platforms. Nymex started this spring on its Clearport platform and now offers clearing for nine contracts, all in the wet FFA market. LCH.Clearnet is scheduled to launch its clearing service in September, and is promising to clear both wet and dry FFAs. These will complement NOS, which is currently the leader but lacks the financial resources of the other two. Last year NOS ran into a problem last year with one of its members. Navitrans Marine, a privately owned Greek shipping company, was unable to pay margin according to NOS, resulting in an $8.5 million default. Although NOS had enough capital to cover that loss, it has since taken several actions to beef up its credit position, including selling its stake in Imarex, cutting its dividend, and issuing new shares to Imarex and the Norwegian central securities depository. NOS also has improved its clearing offering in other ways. Thanks to increased liquidity and better data on correlations, the clearinghouse now provides more netting on cleared contracts, leading to reduced margins. In January it began accepting contracts negotiated via the voice brokers in addition to contracts traded on Imarex.

In April 2004 it began netting inter-commodity spreads for the first time, starting with the most liquid routes like TD3/TD5, and in June it began clearing freight options. NOS received permission from the Commodity Futures Trading Commission in January 2002 to clear and settle trades by U.S. persons, but there are some important limitations. All trades cleared by NOS are principal-to-principal transactions among commercial entities and investment firms. U.S. persons interested in this marketplace therefore should be aware that U.S. law limits participation to “eligible commercial entities.” Nymex has made little headway so far. Although it lists nine FFA contracts on Clearport, only four have been active so far, and just a handful of counterparties have taken advantage of the new clearing services. It appears that FFA clearing in the U.S. faces some of the same obstacles that OTC energy clearing faced a few years ago. Many counter parties have credit lines between themselves and view Clearport’s margin requirements as an expensive alternative. But as the futures market has learned, it doesn’t take many defaults or near defaults to see that credit support is critical. Both Nymex and LCH.Clearnet have well-established relationships with a wide range of clearing firms active in the energy and financial arenas, and hope to benefit from the increased participation in the freight derivatives market by financial brokers, hedge funds and investment banks. Clearing should make it easier for these companies to cross over from the futures market to the FFA market. In many cases they already have relationships with the clearing firms. They just add a new commodity to the list and off they go. And when a trade is posted on a clearinghouse, the contractual arrangement is simplified. There isn’t a need for a lengthy ISDA documentation process. Ultimately the success of clearing will depend on the success of the underlying market. The freight derivatives market has been extremely active over the last 12 months, but it is still a very young market. The question on everyone’s mind is how volatile will rates get this season and whether liquidity will continue to grow.

By Neil Levy - Is a consultant specializing in starting up trading and risk management operations in the energy field. This past year he helped develop a FFA department for a major shipping company.

B - The major Clearinghouses

1 - The IMREX Group

NOS ASA (NOS) was founded in 1987 to become the clearing house for the domestic financial derivatives market. From 1990, NOS has delivered clearing and settlement services to the derivatives markets within the financial, energy and freight sectors.

The International Maritime Exchange (Imarex) was established in 2000 and commenced trading in tanker futures in 2001. Today, Imarex is the leading marketplace for freight derivatives.

On September 1st 2006, NOS and Imarex merged and created the company IMAREX ASA (OSE:IMAREX) which owns NOS Clearing ASA, the marketplace Imarex, the leading power broker M3 and NENA, the leading supplier of energy analysis.
The Imarex group is organised in a holding company structure. Common functions including accounting, finance, legal and administrative services, are provided by the parent company.

NOS Clearing ASA is a clearing house for derivative instruments operating under licence from the Ministry of Finance. The company is also approved by the American Commodity Futures Trading Commission (CFTC) to carry out clearing of trades on Imarex.

NOS offers multi-product clearing services and its strategic objective is to develop, market and provide services to end clients and their intermediaries, so that these can reduce their risks and exposure and thereby improve profitability when conducting financial transactions.

Based on the continuing development of new technology, NOS intends to be a leading participant within clearing in the international commodities markets.

On Imarex, Principals (those trading directly for their own account) trade freight derivatives electronically on screen in real time, or via an Imarex Exchange Broker in Oslo or Singapore. All principals trade anonymously, and with the security of "Straight through Clearing".

www.imarex.com

The Norwegian Futures and Options Clearinghouse for the international commodities markets (NOS).

www.nos.no

2 – The Baltic Exchange

The Baltic is the world's premier and oldest shipping market. It traces its name to the Virginia and Baltick Coffee House, established in 1744. It was then used mainly by merchants who had a major trade in tallow from the Baltic seaboard. From those informal meetings the Baltic has developed into the world's most prestigious and only truly international, self-regulated market for matching ships and cargoes and buying or selling ships. Commodity dealing, formerly a major element in the Exchange's business, is now limited to a small number of members. "The Baltic", "the Baltic Exchange" and "the Exchange" are also used to describe the unincorporated association whose members participate in this market.

A large part of the world's maritime cargo chartering and sale and purchase business is negotiated at some stage by members of the Baltic. The Baltic publishes several daily indices which indicate the state of the markets. As well as providing vital guidance to brokers these form the price mechanisms in the freight futures market which is used for risk management.

Membership of the Exchange is available in one of three broad groups:

- Principals who trade on their own account. They either own or control ships or have cargoes to move;
- Brokers, who act as intermediaries between shipowners and cargo interests, and do not trade on their own behalf;
- Other members who, whilst not trading in the Exchange market, wish to be associated with this hub of international shipping. They include maritime lawyers, arbitrators, ship financiers and other maritime institutions.

You can download the Baltic code by opening the link below:

http://www.balticexchange.com/default.asp?action=article&ID=4

Maritime Glossary

http://www.balticexchange.com/default.asp?action=article&ID=11

The Baltic Exchange guide to market practice for members of the Forward Freight Agreement Brokers Association (FFABA)

http://www.balticexchange.com/default.asp?action=article&ID=18

The Baltic Exchange Website

http://www.balticexchange.com/

3 – LCH CLEARNET

LCH.Clearnet is Europe’s premier central counterparty, serving major international exchanges and platforms, equity markets, exchange-traded derivatives markets, energy markets, the interbank interest rate swaps market and the majority of the Euro-denominated and sterling bond and repo markets.

In September 2005 LCH.Clearnet Ltd with the support of the Freight Broking community launched a clearing service for the registration of OTC Freight Forward Agreements (FFA’s).

The service currently covers the most actively traded routes- nine dry and six wet routes. LCH.Clearnet is in close touch with developments in the market, ready to adapt existing contracts or add further contracts as necessary, in order to remain the Clearing House of choice for this growing market.

There are currently fifteen Clearing Members signed up to the OTC Freight clearing service, offering third party clearing services to the growing marketplace, which includes globally based chartering companies, ship owners and trading companies.

A number of Freight Brokers, all members of the FFABA (Forward Freight Agreement Brokers Association) are also active on the service. All these Brokers have open and equal access to the service, registering their OTC brokered trades with LCH.Clearnet for clearing.

Cleared FFA volumes saw steady growth in 2006, with a notional value of $1.5 billion. Volumes continue to flourish in 2007, with open interest growing month by month.

www.lchclearnet.com

4 - The New York Mercantile Exchange (NYMEX)

The New York Mercantile Exchange ClearPort technology network is a flexible, internet-based system that provides a market gateway to trading and clearing services.

The system lets market participants take advantage of the financial depth and security of the Exchange clearinghouse along with round-the-clock access to more than 260 energy futures contracts including natural gas location differentials; electricity, crude oil spreads and outright transactions; refined product crack and location spreads and outright transactions; and coal.

NYMEX ClearPort gives market participants unparalleled flexibility to either trade this extensive slate of derivatives through the NYMEX ClearPort trading system or, to conduct their own transactions off-exchange, negotiate their own prices, and still take advantage of the financial depth and integrity of the Exchange clearinghouse by submitting the transactions through NYMEX ClearPort clearing.

NYMEX ClearPort is an open system, which allows trading firms to customize their front-end software to meet their particular trading requirements. The system lets commercial traders quote transactions in standard commercial units, such as barrels or British thermal units, while converting them to cleared contract equivalents. It uses enterprise-wide credit limits across both traded and cleared-only transactions to allow for prudent risk management. It also supports negatively priced contracts allowing the trading of location, quality, and product differentials.

All market participants desiring to execute transactions on NYMEX ClearPort must first establish an account with an Exchange clearing member firm. Getting started to trade or submit transactions for clearing via NYMEX ClearPort is easy. Once an account has been established with a clearing member, complete the on-line registration form. Once approved, you'll be able to begin trading immediately.

www.nymex.com

Freight Futures market (select freight on the top)

http://www.nymex.com/cp_produc.aspx#ft

NYMEX documentation availalble to download

http://www.nymex.com/broch_main.aspx


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