Most major commodity futures markets in the US have physical delivery built into the contract terms. Even though very few trades ever result in the actual delivery of the underlying gold, corn, soybeans or heating oil, the mechanism helps keep prices in the futures markets in line with trends in the spot markets, and a small number of market participants use it on a regular basis to move large amounts of the underlying commodity.
The catch is that physical delivery is far more than a financial transaction. For the futures brokers involved with these trades, the logistics can be quite complicated, and it is essential to ensure that clients are ready and able to make or take delivery when their positions expire. This puts a heavy burden on the small number of operations staffers with expertise in this obscure but vitally important part of the futures business.
In a recent webinar sponsored by the FIA Operations Americas Division, experts discussed the various processing and settlement issues that exist in physical commodities markets and how industry bodies such as FIA might play a key role in leading the way on standardization.
Complexities of physical delivery
Eunice Pareja, vice president of strategic products and services in the Chicago offices of ABN AMRO, noted that the number of futures contracts that ultimately wind up being physically delivered is a "very, very small percentage" as positions are often rolled forward or delivered in cash. But when a contract does go to delivery, the resulting process for transferring ownership and moving the commodity from one location to another is extremely complicated. That is not only because of the differences in how each commodity is moved and stored, but also because of the lack of common deadlines and the variations in how settlement instructions are communicated. Getting any of the details wrong could saddle unwary traders with several tons of a physical commodity they never expected .
Although most market participants are content to stay out of the physical delivery process because they are more interested in managing risk than owning the underlying commodity, there are times when interest picks up and FCMs find themselves diving into the weeds with their clients. The panelists explained that when the basis widens, when spot prices of a commodity are relatively far from its futures price, that opens up the potential for arbitrage, and traders less familiar with the specifics of physical deliveries may get involved because they see an opportunity for profits. But that interest may come without a complete understanding of how to make or take physical delivery or what the potential risks could be.
Joseph Sagil, associate director and branch manager at Macquarie Futures USA, noted that a wide variety of timelines and deadlines exist even within the same product type or asset class. While other futures products have moved towards greater standardization, he notes that it is nearly impossible to standardize dates based on the nature of the physical goods themselves and the time it takes to move them.
"Oil moves thousands and thousands of barrels out of New York harbor and that's happening every day regardless of the futures contracts," he said. "But the grain elevators are doing their deliveries on a different cycle. The whole world moves dynamically and everything doesn't move the same. Grain doesn't go through a pipe like oil does."
Doug Robinson, vice president and North America deliveries manager for JP Morgan, noted these factors give traders and brokers less room for error during the post-trade process. When there are mistakes in the post-trade allocation process, for example, brokers work with their clients to make sure that positions settle into the right accounts. With physically delivered contracts, there is less time to "wiggle out" of a position than with cash-settled contracts, he explained.
"In an allocation of a futures trade or an option, as long as it doesn't expire you have some time to get that trade back and reallocate it to the proper place," Robinson said. "With delivery though, you don't have that. Depending on the product you have a very small window where you can try to find a partner that can maybe take that position off your hands because a client failed to trade out or inadvertently traded in to a position."
He added that this makes it crucial for futures commission merchants to know their client and stay in constant communication, and to also know other market participants that are active in physical commodities. There is also an important relationship between the FCMs and the exchanges, when there's a customer with big positions going into the close and proactive communication can help avoid issues with unwanted deliveries.
The importance of standardization
While panelists noted that the learning curve can be steep for participants in physically delivered commodity markets given these unique factors, steps have been made in recent years towards greater transparency and efficiency -- including more robust exchange rulebooks and operations manuals to provide clarity on various deadlines, as well as steps towards automation and electronification of the documentation associated with these transactions.
Eunice Pareja of ABN Amro noted that a few decades ago, FCMs would have to pay a courier to physically move paper certificates from one FCM to another. A move into electronic certificates was "a game changer for what was once a manual and costly activity," she said.
Pareja added that there is still a lot of manual work around organizing the settlement process and the specifics of delivery instructions that could benefit from similar digitalization in the future.
