The Dalian Commodity Exchange saw the first delivery of its iron ore contract this month – does the success of the onshore China contract threaten Singapore Exchange’s pre-eminent position in the iron ore swaps market, and how will both be impacted by the Shanghai free trade zone?

March 19 saw the delivery of 20,000 tonnes of iron ore in a deal between two Chinese trading companies. Although those figures are small beer for the sector – mining major Glencore Xstrata alone sold 33.2 million tonnes of iron ore in 2013 – it marked the first physical delivery for the iron ore swaps market on the Dalian Commodity Exchange (DCE).

Dalian launched the contract on October 18 last year, enjoying initial success, with total first-day trading volumes roughly equalling Glencore Xstrata's annual output. Although these figures quickly fell, it still trades roughly 20 to 30 times the average daily volumes of the Singapore Exchange (SGX).

Given SGX had painstakingly built the iron ore swaps business since it launched the product in 2009, accumulating such a deep pool of liquidity in the city-state that clears 95% of the world's iron ore swaps – the remainder accounted for by trades on the Chicago Mercantile Exchange and Ice – the DCE move appeared to pose a serious threat to SGX's business.

But, according to one Singapore-based iron ore swaps trader, this hasn't proved the case. Instead, SGX continues to build its iron ore swaps business.

"In line with a number of Chinese commodity contracts there are only three liquid months on DCE, for contracts that settle in January, May and September. With liquidity along larger parts of the curve in Singapore, this leaves traders with China operations able to conduct spread trades based on the arbitrage between DCE and SGX," he says.

According to Lily Chia, head of product management, commodities at SGX, the exchange expected this to happen and volumes continued to grow as a result of Dalian coming online last year (see chart).

"DCE's product has been a good complement to our offerings. Last year we saw a slight dip in volumes, soon after the launch of the DCE product, primarily due to a drop in volatility. There was unconfirmed speculation that the lower volume was brought by Dalian's launch. However, this trend completely reversed at the start of this year. When volatility rose, SGX volumes increased sharply. We had record months in January and we are set to break that record in March as well, in terms of volume."

Dual dynamics

The reason SGX volumes grew after the DCE launch is the significant difference between the two products: currency (RMB versus USD) and physical settlement in Dalian versus financial settlement on the SGX. This has led to the creation of different, and complementary, dynamics between the exchanges.

"The Dalian contract and the Singapore swap are fundamentally different contracts," says Leong Chean Wai, Singapore-based head of commodity derivatives at DBS Bank. "Dalian is a closed market – it isn't accessible to international players, unlike Singapore. It has, however, introduced the spread trade, which is a new element to the iron ore market, even though it is something that is commonly executed in other base metal markets. This encourages more players to enter the market and means the DCE contract has led to an increase in Singapore liquidity, rather than a fall."

This view was backed by a Singapore-based metals trader who says the impact of Dalian is to boost liquidity on the SGX at longer durations and increase the potential hedging options available. Previously, the Singapore contract was mainly useful to hedge out physical exposures – with limited liquidity over the past three months it was difficult to hedge out a long-term off-take agreement on the SGX.

"Dalian has changed that," says the metals trader. "People are looking more at Dalian as an entry point in order to get liquidity further down the curve – SGX was struggling at first to find liquidity beyond three months, whereas there are huge amounts of liquidity out to six months on Dalian.

"Effectively, it has allowed for larger positions further down the curve, which are then spread out and allows those who are looking at longer-term off-take and physical deals to be able to hedge part of that price risk. As a result, it has added to the overall volumes of iron ore that people are trading as a whole and, implicitly, SGX swaps as well."

According to Wang Shumei, senior manager in the industrial product department at DCE, the two most liquid contracts were issued last October and will fall due on the coming May and September. She concedes that a number of other contracts are currently not that active.

"This is largely attributable to the structure of market players in China. A lot of iron ore traders in DCE trade coke, coking coal and steel. They frequently adjust their positions among different contracts for arbitrage. This means it is difficult to predict which contract will be the most active one."

An absence of market-makers is an issue throughout China's derivatives industry and Wang cites this as a key reason for the patchy liquidity on the DCE iron ore contract.

"China's futures market is still taking baby steps. A well-developed futures market usually has market-makers who can guarantee that every listed contract has enough liquidity. But there are no market-makers in China's futures market. That's part of the reason why some contracts have great liquidity, but some do not."

But it's not so much a lack of market-makers that is holding back liquidity along large parts of the DCE curve; the seasonal nature of demand for commodities is also significant, according to Lin Ling, Shanghai-based analyst at Citic Futures.

"May and September are peak seasons for consuming iron ore. The consumption in January is quite low, but it's immediately before Chinese New Year and steel mills need to have some winter storage for the next year. This rule is applicable to both coke and coking coal as well."

China's commodity derivatives contracts are usually physically settled, part of an intention from the authorities to keep paper prices linked to economic fundamentals. But if the intention behind this is to dampen down speculation the result is a failure, according to a Singapore-based metals broker.

"No-one in their right mind believes Dalian is reflective of the underlying physical price, because very little of the huge volumes that are traded on Dalian are going to be delivered. Dalian is effectively a retail market for the domestic Chinese punter – one week they are betting on iron ore, the next week they are in Macau," says the Singapore-based metals broker.

However Wang, who set up the DCE's iron ore contract, rejects suggestions the Chinese exchange is driven by speculative impulses, in contrast with SGX trades being tied to economic fundamentals.

"I disagree with this statement. A lot of Chinese industry players trade in DCE. Miners, steel mills and merchants account for 13% of the overall trading volume and 31% of the positions," she says.

This view is supported by Jeremy East, Hong Kong-based global head of metals trading for Standard Chartered, who says there look to be more physical players tied to the DCE than in Singapore. "Our analysis is there are a lot of physical players that are intending to use the exchange to take delivery – depending, of course, on the price of the physical at the time." East describes the 20,000 tonne delivery as a "trial run".

The real test comes when the May contract – the first liquid month on DCE – becomes due. "It's not possible to predict how that will turn out until the actual day. A lot will depend on where the physical is trading compared with the exchange. China has a large active physical market and traders will wait – if the physical is cheaper, they will buy that, and sell out their futures positions and if the price is lower on the DCE than the physical delivery, they will do that."

There is, essentially, a three-way arbitrage on the China iron ore swaps market: the DCE futures price versus the physical onshore versus the international swap market. While the former is a straightforward arbitrage of the futures price versus physical, the onshore/offshore arbitrage is a function of the different curves in SGX and DCE.

Backward look

Chinese commodities markets are typically characterised by contango – where the forward price is higher than the spot – due to factors such as tax, storage costs and the limited access to onshore markets from international players, and iron ore was initially no exception. However, it has now moved into backwardation (where the futures price is below the expected future spot price for a particular commodity).

East says: "What we saw when the DCE launched its iron ore futures contract was that it was in contango, whereas the SGX market was in backwardation. What happened was that all the traders came in and bought SGX backwardation and sold DCE contango." Arbitrage is inherently risky and East points to the dangers posed by a steepening of either the backwardation or contango, which can lead to mark-to-market losses – and of course, having access to the China physical market is critical to arbitraging the DCE and SGX markets.

According to Gunnar Hoest, Singapore-based head of commodity derivatives, Asia-Pacific, at BNP Paribas, this is a relatively painless process. BNP Paribas has a wholly foreign-owned enterprise (WFOE) in the Shanghai free trade zone, which opened is currently trading base metals. Hoest says he is "looking into" opportunities in iron ore, particularly in the area of trading the onshore-offshore spread.

Hoest says the process of setting up a WFOE in the Shanghai free trade zone is relatively straightforward and not too different from setting up an entity in other more mature economies, except for a few more hurdles relating to capital injection and conversion of currency.

Even so, if a firm sets up a WFOE and trades successfully, it is still exposed to onerous levels of taxation that cut into the bottom line, according to one Singapore-based broker.

"If you are a very big international firm you can go onshore in China and set up a company, but the taxes on trading profits are very high – in the region of 30% or 40%. So, if you make $1 million profit, you will only get $600,000 and, even then, you probably won't be able to take the money out for a couple of years," says the broker.

While unexpected price moves are clearly the most obvious risk attached to arbitraging the two markets, even a successful trader could find themselves exposed to margin issues, according to Standard Chartered's East.

"These markets move – there is an arbitrage between the two, but also it causes problems with regard to margining. If the price goes up, the trader will be making a profit in one and a loss in the other but because these positions are in different exchanges he can't offset the margin," he says.

Tiecheng Lee, Beijing-based foreign legal consultant at law firm Clifford Chance, says RMB settlement and a more relaxed foreign exchange regime are the main concrete proposals in place for the Shanghai free trade zone. In addition, setting up commodities trading platforms is an option that may allow domestic enterprises to trade with foreign counterparts on a real-time basis.

One Asia-based commodity expert, however, urges patience when it comes to the pace and direction of change with regard to the Shanghai free trade zone, and says the authorities are taking their time to enact reforms in the zone due to the potential impact on the rest of China's economy.

"If you make even a small hole in a balloon, all the air goes out very quickly – so when you make that first hole you need to consider the consequences very carefully," the expert says.�