How CME Europe’s Unique In-house Depository Can Save You Money and Time - Article 4

With the launch of new physically delivered, euro-denominated cocoa futures on 30 March, CME Europe will introduce a first-of-its kind, in-house depository for material warehouse warrants that uses electronic lodging.

This unique system significantly reduces the cost and time previously required to lodge warrants for deliverable commodities on an exchange-held position, whilst ensuring the legal integrity of the contract.

What is a warehouse warrant?

Traditionally, a material (i.e., physical) document called the warehouse warrant has been used as proof of ownership of goods in a warehouse. Warehouse warrants (or warehouse receipts) are bearer documents that provide the owner title to the goods they represent (as in the form required by CME Europe)

With warehouse warrants, ownership of cocoa lying in a warehouse can by transferred by the seller providing the applicable warrants to the buyer in exchange for payment (instead of physically transferring the goods). As negotiable financial instruments, warrants also are commonly used as collateral for loans and, in soft commodity trading, for the financing of cocoa. 

These documents are essential in the sale of goods lying in a warehouse. It’s also important to note that warehouse warrants are subject to aspects of the legal jurisdiction in which the goods are stored, not only to the law governing the sale contract itself.

Why not have electronic warrants?

In the past, delivery of cocoa against a futures contract was made by the physical delivery of material warrants from seller to buyer. With increased volumes of business, this step has become an administrative nightmare for all parties involved, requiring both seller and buyer to physically check the details on each document at the time of contract performance. 

In today’s electronic age, the opportunity arose to automate the administration of these documents by making them electronic and removing the need for material warrants.  Upon further scrutiny, however, CME Europe recognised that we’re not yet at the administrative nirvana where material warrants are not required at all, as not all legal jurisdictions recognise warrants in an electronic form, which would have two key consequences for a the futures contract:

  1. Transfer of title of the goods from seller to buyer at time of delivery.  If this transfer of ownership is not considered legally binding it questions the basis of the contract itself, an untenable situation.
  2. Should a warehousekeeper go into liquidation, the administrator should have no doubt about ownership of the goods lying in the warehouses. As legal recognition of electronic warrants has yet to be accepted in some legal jurisdictions, this situation is too untenable for prudent parties. 

It is therefore essential that the transfer of title is considered legally binding, and that any potential administrator recognises the owner of the goods through the warrants.

Exchanges have worked round the issues by having the transfer of ownership effectively conducted under the terms of the law of England and Wales.  This means that electronic transfer of ownership is considered legal when the material warrant (still required) is located in England or Wales.

Until now, exchange systems have required the material warrant to be:

a)    printed at the port or location where the goods are stored;

b)    physically sent by secure courier to the appointed broker (FCM);

c)     lodged in the appointed Depository (in England or Wales) by the appointed broker for safekeeping and to enable the transfer of ownership under English law.

Such a process is not only expensive, requiring:

a)    courier costs from the port to London;

b)    courier costs from the broker to the Depository; and

c)     costs to lodge the warrants in the Depository;

… it also requires considerable administration and coordination by the warehousekeeper, broker and Depository.

Can we have the benefit of electronic warrants and the safety of material ones?

The short answer is yes.  CME Europe has developed a method of warrant-handling whereby the security and integrity of the process is maintained and the benefits of an electronic system are added.

Through the CME electronic administration system, Deliveries Plus, the warehousekeeper creates the warrant as usual, but instead of being printed locally, it is printed directly at the CME Europe Depository in London.  Each warrant is printed on secure paper in the Depository, each sheet of which has a unique number pre-printed on it. 

The warehousekeeper alone is advised of that number by the Depository staff in order to maintain the integrity of the warrant, i.e., a CME Europe warrant presented to a warehousekeeper must have the correct security number in order for the warehousekeeper to recognise it as valid.  The only way a warrant may be generated at the Depository is through the Deliveries Plus system.

Such a system provides:

a)    the quick lodgement of warrants;

b)    a reduced cost to the participants; and

c)     reduced administration by the parties involved.

The process of printing the “warehouse warrant” directly at the secure Depository in London is unique to CME Europe.

By ensuring that CME Europe warrants are generated only through Deliveries Plus, not only do the documents generated have conformity, but the security of the system is reinforced.

When the cocoa is needed for use and taken off-warrant, the warrant will be sent to the warehousekeeper or his agent by CME Europe, with instructions that the goods be held to the order of the owner, as evidenced by Deliveries Plus, providing secure handling over the whole process.

Alternatively, Members holding a net short position on expiry must make cocoa, via warrants, available to the exchange via Deliveries Plus.  Members with a net long position will receive the notification of the warrants held to their order via Deliveries Plus.

Advantages of a CME cocoa futures warrant

The advantages of owning cocoa under a CME Europe warrant include:

  1. a seller will require a CME Europe warrant in the Depository to deliver against a short position on the exchange (note that for delivery this has to be accompanied by a valid grading result for the cocoa);
  2. security of warrants in the Depository;
  3. ability to obtain finance of deliverable warrants;
  4. reduced administration, time and cost in the lodgement of a CME Europe warrant;
  5. reassurance that cocoa stored under CME Europe warrants lodged in the Depository is:
    • freely available (subject to the CME Europe Procedures) within 21 business days and delivery can be taken without charge;
    • subject to CME Europe storage conditions, including, at the discretion of the Registrar, disinfestation at the expense of the warehousekeeper.

As a result, the security of the material warrant is maintained with the added benefits of an electronic system, all without compromising the legal status of the process.  And it’s more economical, too.

Our next two articles in our cocoa trading series will concentrate on how CME Europe deals with the sampling and grading procedures to ensure its new physically delivered cocoa futures contract better reflects the practices of the physical market.

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