Queues for delivery at exchange-registered commodity warehouses, allegations of slow loading-out rates and high movement-out charges are symptoms of the existence of conflicts of interest between warehousekeepers, their customers, supervisors and the interests of futures exchanges offering deliverable futures contracts. These conflicts pose a threat to the integrity of the relevant contracts.
CME Europe aims to address such issues in a market-led way to ensure the integrity of the contract by making the basis of its new deliverable cocoa futures contract:
Like the issues, the solution is three-fold. The first involves the basis of the contract; CME Europe cocoa futures contract terms require the owner delivering the cocoa against an exchange position also pre-pays the delivery-out charge. This is because the party storing the cocoa in the first place is able to choose the warehousekeeper – the party taking up the cocoa does not have that choice so it is equitable that the party storing the cocoa pays for the goods to be removed from the warehouse. With this understanding, the ability of the warehousekeeper to charge the party taking up the cocoa to move the cocoa out is removed. It is what occurs in the physical market when a potential buyer wishes to purchase goods stored with a warehousekeeper unknown to him, the seller will arrange to pay for those charges. The CME Europe cocoa futures contract is reflecting common and natural practice in the underlying cash market.
This also has the benefit of market-control of warehouse rents as parties know that as the owner may remove his stock for no charge, the potential for the stock to be removed helps to keep the warehouse rents broadly in line and related to the costs of storage. CME Europe does not intend to publish maximum warehouse rent rates and, as they are zero, has no need to publish the movement out charges.
The second point is that since cocoa which passes grading is worth more to the owner and warehousekeeper, there is room for concern over the potential incentiveto draw biased samples, one which is more likely to pass grading. CME Europe, in its Procedures, stipulates ‘All sampling shall be supervised by a Licenced Supervisor or by the Registrar. The Licenced Supervisor is responsible for the sampling being conducted in accordance with these Cocoa Procedures.’
The presence of an independent Licenced Supervisor appointed by the exchange minimises the scope to draw an unrepresentative sample, the consequences of which are not only may the warehousekeeper benefit from a potential increase in rental and movement out charges, but also of subsequent owners taking delivery of stock which is not correctly valued.
The third point is that there are three roles of activity in a warehoused deliverable futures contract which are best separated, namely:
The pressures of conflict of interest are increased when a warehousekeeper has a close relationship with the owner of the goods. This may be divided into two:
a. when there is a commercial contract between the warehousekeeper and owner; and
b. when the warehousekeeper is owned by, or there is a formal corporate relationship with a company with a trading arm of the potential owner.
Under a. above, providing the terms of the relationship reflect commercial practice there is less concern, even if these relationships are deep and longstanding, as ensuring that the delivery out charge is pre-paid and that the sampling is conducted under independent supervision ensures objectivity in the storage and delivery process.
The second b., poses an unfair situation as the warehousekeeping/trading entity may know the intentions of a competitor with stock stored with his subsidiary or corporate sister company. At delivery, stock is distributed at random to buyers by the allocation algorithm of the Exchange delivery system, so a receiver may be allocated stock lying with any Registered Warehousekeeper. Being allocated stock effectively stored with a warehousekeeping/trading competitor provides a source of potential private information to the competitor and needs to be addressed. As these companies are not subject to regulated market conditions and pose an unfair advantage that cannot be resolved by commercial means it therefore means it should not be allowed. The CME Procedures will not allow warehousekeepers to become approved if they have a corporate relationship with a potential owner.
As mention earlier, there is a potential conflict of interest between warehousing the goods and the assessment of their quality. As sampling the goods is inextricably linked to the results from subsequent analysis of its quality, prudent independent assessment should ensure that no warehousekeeper may be allied or affiliated with the supervision of the drawing of the sample, nor to an entity analysing its quality.
Under the CME Europe Cocoa futures contract Procedures, Registered Warehousekeepers cannot act as approved Supervisors, nor may they grade the cocoa samples. All sampling in the Warehouse is supervised (the Supervisors appointed by the Exchange) and by the nature of the process for bulk cocoa, also includes the supervision of the weighing. Once drawn, the Warehousekeeper will not have access to the grading sample as it remains in the hands of the Supervisor. Again, contract integrity is the basis of this separation of roles.
In similar spirit, while the approved Supervisor may be involved in both the sampling and grading process, no individual as an employee of the approved Supervisor, i.e. Licensed Individual, may undertake both the sampling and grading of any individual sample. An individual may do one but not the other. In addition, note that any grading may only occur in the presence of a CME appointed representative.
By addressing directly the issues facing the delivery of cocoa, CME Europe consider that changing the basis of the contract to ‘delivered out’; mandatory supervision of sampling and the separation of the roles of those involved in the delivery process are essential in maintaining the integrity of the contract.
The next article will deal with the innovation of the CME Europe warrant handling and Depository.
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