This is a special guest post by Mr. John Mckinstry. John’s bio follows at the end of the analysis.
The container swap market is a relatively new derivatives market designed to reduce risk associated with volatility in the container freight market. In theory it is designed to allow shipping lines and operators to hedge the risks of freight rates falling and conversely allows shippers and consignees to hedge the risk of freight rates rising over a given period. A simple enough concept and one familiar to many managers in companies trading internationally that regularly hedge against the risk of currency fluctuations. In essence this is a new tool to manage business risk in the container shipping market.
The first of these container swaps took place in January of 2010 between Morgan Stanley and Delphis, a regional European container ship operator. This new risk management tool appears to be gaining traction with CSAV, a South American container carrier that nearly failed in the depths of the 2009 recession, executing a swap in August with Morgan Stanley as the counter party. The stated aim of these swaps is to begin to develop a fully functioning liquid container derivatives market. The new derivatives are an over the counter (OTC) cash-settled swap that are settled against the newly created weekly Shanghai Composite Freight Index (SCFI). This index is comprised of weekly freight rates assessed on an “all-in” spot basis on various major global trade lanes. The rates are assessed by 30 panelists comprising shipping lines, NVOCCs and freight forwarders.
This move towards the further commoditization of container freight rates mirrors the establishment and growth of other derivatives markets from the 1990s onwards. The largest derivatives market by far is that for Interest rates with other major derivatives markets being those for foreign exchange, equity, various commodities and credit. The rampant and largely unregulated expansion of the last of these being one of the underlying causes of the recent financial melt-down.
The container swap market is the newest addition to the overall global freight derivatives market. These global freight derivatives are financial instruments derived on the future value of freight rates such as dry bulk and oil tanker rates and currently tend to be used most often by end users such as ship owners and commodity traders as well as by suppliers such as integrated oil companies. The purpose of these well established derivatives markets is to mitigate risks against price spikes in the supply chain. These derivatives now include Exchange Traded Funds (ETFs), swaps and futures as well as the older “Freight Forward Agreements” (FFAs) which were sold over the counter and based on a model popularized in the agriculture and commodities industries. They are still relatively new products in the global marketplace and the advent of clearing services has brought increased safety and with it liquidity into the business.
Putting this market into the context of the overall derivatives market, the Q1 2010 OCC report, a department of the US Treasury, indicates the total notional value of all derivatives in the United States at US$216.5 trillion, of which 84% is made up of interest rate products with the balance being currency, commodity and equity based products. The Financial Times, in a recent article in July, states that the global market in freight derivatives was US$155 billion in 2008 although this may have dropped by half in 2009 due to the downturn. This indicates that the global freight derivatives market represents only around 0.03%-0.07% of the total US derivatives market. Tiny by all accounts.
In the past the liner conference system was the main mechanism regulating the price of container freight rates. This system functioned as a kind of clearing house whereby liner operators looked at overall supply and demand and offered pricing to the shipping community based on their forward assumptions. These conference operators never controlled freight rates on trade-lanes in their entirety and new entrants to the shipping market often tended to be outside the conference system, at least initially. However they often represented the lion’s share of capacity on individual trade-lanes. The purpose of this system was to regulate supply and to mitigate the risk of rate volatility, although this was done internally within the industry and came to be seen by shippers as a cartel.
However shippers failed to take into account the fact that overall demand in the short run at industry level is in fact quite inelastic. In effect X number of shippers need to ship their cargos to their customers and this amount was growing annually at an average of 10% p.a. Conversely demand at the firm level was elastic due to the fact that the services of each carrier were relatively homogeneous and switching costs of shippers changing carriers were very low. This resulted in a prisoner’s dilemma situation for carriers, similar to the oil industry, whereby it is in the interests of individual carriers to cut prices, regardless of the conference system, as this will result in increased revenues for the carrier due to the flat slope of the demand curve. Conversely, if all carriers follow suit this will result in a fall in total revenues at the industry level due to the steep (inelastic) industry demand curve.
The reasoning behind the conference system was that freight rates, like many commodities, had a high correlation to the business cycle. Given the high level of capital investment needed to maintain adequate services to accommodate a 10% p.a. growth in international container trade, carriers looked to this system to maintain stable cash flows despite the industry’s cyclicity. This system was largely dismantled throughout the last decade and the advent of the financial crisis in 2008 clearly demonstrated that the container freight market was as volatile as the business cycle itself – the conference system was dead. However the huge swings in 2008/2009 in demand and the consequent mothballing of ships to reduce supply has inevitably led to extreme price volatility and thus higher risk to both carriers and shippers over this period. Lines bore huge losses on the down turn and shippers faced huge hikes in rates in the recent recovery. This also had the knock on effect of dramatically reducing the planning and budget horizons of all parties concerned.
Therefore it is inevitable that the financial services industry sees an opportunity to add container freight rates to its lists of derivatives products to assist in managing these risks. The question is whether this will actually deliver benefits in terms of cost and efficiency to the industry as a whole. In addition to this, will these benefits outweigh the costs incurred by the industry in the form of profit and commissions levied by the clearing houses and financial institutions for providing this service? Put differently, will this simply add additional cost to the global supply chain and if so is it offset by increased efficiency and reduced cost in the global supply chain?
It seems that there may well be a battle developing here as to which way freight rate risk is seen and managed in the global supply chain. The clearing houses, London Metals Exchange (LME) and financial institutions appear to be moving in the direction of a commodity style market in freight rates while many major shipping lines and the Baltic Exchange remain opposed. Eivind Kolding, the CEO of MaerskLine recently described the fledgling container swap market as “a freight rates casino” and “the wrong avenue” for the industry. In addition, the Baltic exchange is involved in countering an attempt by the LME to have its trading platform used for the current FFA market as well as the fledgling market in container swaps. Jeremy Penn the chief executive of the Baltic Exchange was also recently quoted as saying “We will not offer our support for changes in the marketplace which potentially threaten the existing and sometimes fragile FFA liquidity”. In effect the major carriers and Baltic exchange are adopting a “business as usual” or “wait and see” approach rather than countering with any proposals of their own to mitigate risk in the newly volatile container freight markets.
Going forward, it will be interesting to see if these new derivatives become common practice amongst carriers, shippers and also speculators or whether they will remain simply another exotic financial tool on the eriphery of the industry. In fact the introduction of speculators to the container freight market may well result in more rather than less volatility in the market by decoupling pricing from the supply and demand for capacity. Pricing could in fact become more a function of supply and demand of swaps, and therefore the future expectation of prices rather that the underlying supply and demand within the industry itself. How this develops at a macro level will likely be determined by the structure and characteristics of the industry itself. While the container shipping market has some characteristics in common with other commodity markets it also has a number of similarities to other markets within the global supply chain. There does not yet appear to be any sign of a derivatives market in airfares or trucking rates for example.
Carriers usually hold one of several relationships with shippers. In increasing levels of depth these are – basic, which are largely transactional; co-operative; interdependent and integrated. The largest shippers tend to hold interdependent or integrated relationships. Container swap derivatives may well remain an attractive option where the relationship is basic or cooperative but carriers may well be able to agree a joint response to manage volatility where they hold interdependent or integrated relationships with shippers. This could potentially counter the need for the use of container swap derivatives for the bulk of container volumes.
In conclusion, the financial services industry clearly sees an opportunity to profit from risk management in the container freight market but it remains to be seen if their products will increase the efficiency of the overall global supply chain. This may in fact simply be an additional cost in the total supply chain. On the other hand there is clearly a demand for risk management in the newly volatile container freight markets, so it may be useful for the parties involved in the container market to look at alternative models for managing price volatility rather than simply continue business as usual. In short a structural change in the container market pricing mechanism occurred with the demise of the conference system, and the financial services industry is responding to it. It will be interesting to see how the response of carriers and large shippers develops in the near term.
For more information on Mr. John McKinstry click here