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Grain Swaps Offer Hedgers Brave New World

Ready or not, here they come.

After years of planning, the Chicago Board of Trade has introduced a new hedging tool for the world grain industry that differs significantly from its century-old futures markets, but promises to take the risk management game to a new level – once everyone gets on board.

“So far my clients are lukewarm to the idea,” said one longtime CBOT floor broker who has been promoting the tool, swap contracts, to his hedging and fund investment clients.

Swaps are a complicated but proven way for grain users to fund operations. But they offer the traditional insurance service that has made futures integral to the world of finance. The big difference: They are private, tailored agreements.

What CBOT, a unit of CME Group, plans to do is to bring these currently over-the-counter transactions out of the shadows and into the bright light of centralized trade clearing, making visible an opaque but growing market.

“There is an OTC market in grains that is available to anyone who is an eligible swap participant. However, what’s new April 6 is that you’ll be able to clear these OTC transactions that conform with our standardized specs,” said David Lehman, CME Group director of commodity research.

CME-cleared ag swaps will still be privately negotiated. But once the trade is registered on CME’s Clearport system it will be subject to the same mark-to-market rules for margins and reporting as CBOT’s world benchmark grain futures and options, a plan backed by both lenders and the government.

Central clearing will thus effectively remove the main current risk in OTC grain swaps – counter-party default – by having the CME monitor and enforce execution of all contracts.

Swaps – one-to-one agreements between two parties to exchange money flows – are already multibillion-dollar markets in world debt, currency and energy commodities.

OTC grain swaps already use CBOT’s futures and futures options as risk-offset tools. But swaps are complicated and will likely remain a tool for industry rather than farmers.

Grain traders note swap participants need brokerage accounts for CME clearing. Individuals who are principals in the deals must have minimum $10 million net worth and companies that qualify as hedgers a $1 million minimum net worth.


But many traders are intrigued to see how cleared swaps develop, especially if central clearing frees up more money for lending to participants and thus boosts trading volumes.

“There is big interest in over-the-counter markets – it’s not as big as it once was, but there is still a lot of grain traded OTC,” said one futures trader who spoke anonymously as he uses CBOT futures to hedge OTC trades for customers.

“Virtually anyone who is trading OTC is a potential user of these contracts, it’s really a matter of how much someone wants to show the government what they’re doing.”

CME will clear two types of OTC swaps, each based on CBOT futures contract sizes of 5,000 bushels.

Registered “calendar” swaps for corn, soy and wheat will be settled based on an average futures price during the expiration month. They will work much like traditional futures hedging.

The other type, corn “basis” swaps, are an interesting experiment to help merchandisers manage the biggest U. S. crop of 10 billion bushels or more each season.

“Basis” measures the difference between local cash prices at each location and the CBOT futures price. But basis itself represents variable risk for freight and other costs.

“In this day and age when people are frankly scared to death to sell to anybody, using basis swaps could be a way to avoid that and still get some protection,” said Diana Klemme, vice-president of Grain Service Crop in Atlanta.

Futures positions related to swaps will be marked-to-market daily and margins shared by the swap participants. Basis swaps to start with will be cash-index settlements for six Midwest regions: northeastern Iowa, northwestern Iowa, southern Iowa, eastern Nebraska, eastern South Dakota and southern Minnesota.

“I think there may be more interest in some of the basis swaps in the beginning – because there is so much counterparty risk right now,” Klemme said.

Basis swaps could work for “both parties as long as the real world basis tracks pretty closely with whatever the index does,” she added. “Otherwise you might end up introducing more risk than what you got rid of.”

Still, CBOT brokers expect that many players are expected to initially remain wary, hold back and study the market.

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