Recently, CME Group and Flack Global Metals (FGM) collaborated to discuss the importance of hedging and why FGM uses CME Group's listed Steel futures specifically to mitigate price risk more effectively.
Introducing CME Group and Flack Global Metals
The pace of momentum in CME Group Steel futures and options continues to accelerate. U.S. Hot-Rolled-Coil (HRC) Steel futures and options average daily volume has increased 14% year-on-year to 1K contracts year to date, with average open interest at 37K contracts as of June 2022, an increase of 7% year-on-year.
Flack Global Metals (FGM) is an innovative domestic flat-rolled metals distributor and supply chain manager, international commodities trader, and financial services provider – purpose-built to deliver certainty. FGM designs and fulfills supply chains for OEMs using flat-rolled steel, aluminium, and stainless. Each metal is prepared to all value levels required, including, but not limited to, coating, painting, blanking, slitting, and sheeting.
This interview features:
Bernie Muich (BJM), Senior Director Client Development & Sales at CME Group.
Jeremy Flack (JF), Founder and CEO of Flack Global Metals.
BJM: FGM has long been a proponent of risk management and hedging. What made you an early believer?
JF: I came to the steel business from banking – starting out my career working for PNC Bank in Pittsburgh in the real estate group. For one project, we called on Chicago developers who were working on the new trading floor at the Chicago Board of Trade (CBOT). They were seeking a $150 million construction loan, and as the underwriter of the loan, PNC needed to understand more about the CBOT and how futures trading works. I was further ingrained in the steel industry via lending to its participants through additional projects. Ultimately, I moved on to work in the manufacturing and distribution sectors and was amazed to see the breadth of this industry.
Through these experiences, I realized that this commodity space has absolutely no ability to control its price risk. I thought, “That's ridiculous. There must be a better way.”
That's where the interest started for me. Walking into a market and being aware of how the rest of the commodity space dealt with risk led me to understand there were ways to control pricing volatility. When the CME Group introduced the Hot Rolled Coil contract, an obvious opportunity presented itself in our market – I leapt at that opportunity.
That was one of the inspirations to start FGM – combining a hedge for the futures contract in everything we do. We hoped that eventually, the world would embrace risk management for steel products.
BJM: Why do you think others in steel have been reluctant to embrace hedging as a means of managing their exposure to price risk?
There are a lot of factors. You have relatively new abilities to use Steel futures, only recent and decent liquidity, and behaviours that grew out of the long-term structuring of the steel industry.
We often work with OEMs that are 100 percent steel consumers (or at least predominately steel consumers) for the production of their products. They don't have the apparatus to deal with hedge accounting; they often don’t have an understanding of how these derivatives work. Equally often, there is a bit of fear based on what they've heard about hedging.
However, the industry has now reached the point where it's no longer a question of will hedging take hold – it has taken hold. So, now we must address the education, cultural, and history issues.
BJM: Yes, I agree, and changing incumbent behaviour with any new market that we develop is one of the biggest challenges we face. Those comments lead well into this next question.
As one of the first market participants trading Hot Rolled Coil (HRC) futures at CME Group, from your perspective, how has the market evolved?
JF: First, institutional participation is higher and awareness is better. We have all those components that we look for in a nascent market beginning to grow. It's no longer seen as an outlier or a curiosity. It has become a concept that even if companies are not ready to engage today, they know that they must start educating themselves. And that includes the mills, the service centers, and the OEMs – our entire community.
We also have the data to show how trading Steel futures has evolved. We conducted a backtest study to illustrate how you would have fared had you passively hedged HRC from 2013 to 2021. It shows how you would have performed versus the index or the spot market. The results are staggering. Even if you had only passively hedged during that time, you would have saved nearly $100 per ton on every ton you purchased.
We also see participation levels rising, which is undoubtedly a good thing as it shows an increase in acceptance and adds liquidity to the market. There are more brokers and more sophisticated players; even the traditional hedge funds are getting involved. We're seeing more parties interested in direct trading as well, so there’s a lot of activity.
BJM: Yes, as you mentioned, there is more market data available, and price transparency – now, participants can all view what others are looking at, and that increased market visibility has been helping as well.
JF: The industry is looking at the forward curve, finally acknowledging it. But one of the problems is that very few understand what it really is, and too many in our industry believe it's a predictive tool.
We're committed to educating the C-suite at steel-consuming OEMs to change the perceptions. Too often, we are witnessing steel buyers not getting the support they need from their executive leadership simply because hedging is still an unknown. We need to create a better method in our community for education and knowledge. That's something we're actively working on here at FGM that will help the community move forward.
BJM: We look forward to that, and education is definitely a part of our role at the exchange to help participants get over some of those hurdles that you mentioned.
This leads me onto my next question. What are some of the benefits of hedging, using HRC futures for your clients specifically?
JF: Because we are an intermediary, FGM can assist a company in realizing the benefits of hedging without having to endure the pain points of entering the marketplace themselves.
In addition to taking advantage of the curve and reducing the volatility of their pricing, our customers have access to the market using our balance sheet, which means they do not have to set up their own hedge accounting. They also access our brokers and our clearinghouses. It minimizes the impact on their accounting function and operations while allowing them to tap into the benefits.
They also benefit from our portfolio management approach to hedging. Instead of a “set-it-and-forget-it” mentality, we actively manage our customer portfolios hedges. We advise them where to pick their spots, if you will, finding the opportunities to increase their effectiveness in managing volatility and achieving the best effective price for them.
BJM: That sounds like a great service that you will be offering to the market. As you know, the pool of participants in our markets is growing. As more firms consider moving forward, how can an OEM interested in hedging get started?
JF: At FGM, it starts with educating and strategizing precisely what the customer needs. We’ve created different products for different opportunities. Some come into play when we supply the physical; others were designed specifically for when we don't supply the physical inventory. It’s always a series of conversations based on a methodology. It's a series of steps for entering the market conservatively and in a disciplined fashion. We always suggest that new entrants start small and build a position over time.
It’s critical to understand that hedging isn't something you do once and forget about it. It's something that you're doing all the time. We start customers with a strategy, then begin to allow that customer access through our intermediary tools. Again, the benefit is that it keeps them from having to do the back-office paperwork and hedge accounting.
For us, you’ll start small, then build into a position that matches your business and how you go to market.
BJM: That's great insight. What's next for CME Group is to continue working on building our liquidity, not only in HRC, but also across our other steel products such as Busheling Scrap, and Galvanized contracts, as well as our Steel options. We continue to work with the industry, across its supply chain, educating them on the benefits of hedging, and getting more participants comfortable with our markets. So, what's next for FGM?
JF: For us, there are two significant initiatives. The first is to develop a market-making operation. That's going to provide more liquidity for the CME Group hot roll-coil product.
The second is continuing to build Flack Metal Bank (FMB), which we launched in 2021. FMB is what allows us to serve customers when FGM does not provide the physical supply via a product called a Directed Buy Structured Transactions or DBST. This product enables an OEM, a steel mill, or a service center to keep their supply chain intact while FMB helps them effectuate a price swap. That swap can happen in either direction, either of their floating contract into a fixed price one or of their fixed price into a floating one.
Similar products are available in most other commodity markets, including energy, agriculture, and base metals. However, our DBSTs were designed to provide easy access to risk management, specifically within the steel market. Here's how it works. The OEM negotiates directly with the mill or service center, then assigns that contract to FMB. Through a hedging process, FMB can swap the pricing, such as the OEM now pays fixed while the mill receives floating as originally agreed. Keep in mind FGM doesn’t have to touch the supply chain. All an OEM does is write us an order through their ordinary course of business.
We have been doing this for years at FGM through what we call our Core Structured Transactions, when we also manage the supply chains. That part of our business has also seen steady growth. But the explosive growth for participating companies and market liquidity is in the ability to use the curve to manage price risk separately from their supply chain. Educating the industry about that opportunity is a big initiative for us in 2022.
BJM: That's great, it sounds like an exciting venture, and we look forward to your support as we collectively strive to grow liquidity in our markets. Thank you, and we appreciate your time today, Jeremy.
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All examples in this report are hypothetical interpretations of situations and are used for explanation purposes only. The views in this report reflect solely those of the author and not necessarily those of CME Group or its affiliated institutions. This report and the information herein should not be considered investment advice or the results of actual market experience.