Cash settlement vs. physical delivery
| Standard Size (Physical Delivery) | Mini-Sized (Physical Delivery) | Micro-Sized (Cash Settled) | |
|---|---|---|---|
| Corn |
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| Soybeans |
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| Wheat |
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| KC HRW Wheat |
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| Soybean Oil |
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| Soybean Meal |
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| Fertilizer |
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In a contract that is physically delivered, the underlying physical market is inherently tied to the futures contract through the delivery mechanism. At contract expiration, any entity with remaining positions will be matched against an entity with an opposite position, and the process of physical delivery will begin. Eventually, the commodity will change hands between the maker of delivery and the taker of delivery – any entity still holding a position after the close on the first position day is eligible to be matched for delivery, and every entity with a position after expiration will need to deal with the delivery process. The standard-sized and mini-sized Grain and Oilseed contracts are physically delivered.
On the other hand, cash-settled contracts are not physically tied to the underlying commodity. At expiry, a final settlement price is determined, and each entity is either owed money or pays money to settle their position. No one involved in the futures market is at risk of being compelled to make or take delivery of a physical product. The Micro Grain and Oilseed contracts are cash settled.
Benefits of cash settlement
There are strengths and weaknesses with both physical delivery and cash settlement. Each commodity market is unique, and contracts should be developed to suit the specific needs of that given market. That said, there are several benefits afforded by cash settlement.
Traders can participate in the expiration of a contract without the consideration of any aspects of physical delivery. It facilitates speculation near contract expiration since liquidity providers need not be concerned with notice days and delivery timing. Additionally, any market participant within a commodity’s value chain can hedge their risk without concern over physical delivery. Cash settlement allows a greater number of entities to participate late into a contract’s life because the end result is purely a financial exchange rather than optionality on a physical commodity.
The Micro Grain and Oilseed contracts are still pricing the same products in the same geographic delivery area as their corresponding larger physically delivered contracts and are inherently tied to the underlying cash market. Participants can liquidate their position via taking an offsetting position, trade the implied Standard-Sized: Micro spread, execute an exchange for physical (EFP*) if they desire to buy or sell the physical commodity or take their position to expiration without the threat of engaging in the delivery market.
Daily settlements
There are two types of settlement events for all futures contracts – the daily settlement and the final settlement. The daily settlement is used internally to facilitate the mark to market transfers of funds, calculate margins and establish daily price limits. It is used externally as a signal for the current price of a given commodity.
In most liquid, screen-traded, physically settled Agricultural futures products, daily settlement is derived from a volume-weighted average of trades on Globex during a given window of time before or at the daily market close.
Our standard-sized Grain and Oilseed contracts derive their daily settlements from a volume-weighted average of trades at the end of each trading day. The corresponding mini- and micro-sized contracts use the daily settlement price of the standard-sized contracts as opposed to deriving their own prices.
Final settlement
The other important settlement price that should be noted is final settlement. Final settlement is the price used by both the buyer (long) and the seller (short) to ultimately terminate a contract. In physical delivery, it represents the invoice price at which the commodity will be sold and changed hands. In cash settlement, it is the price to which all financial obligations will be marked.
In most traditional Agricultural contracts, the final settlement price is derived in nearly the same way as daily settlement – a volume-weighted average price calculated during a short settlement period on the day of expiry. This is how the final settlement price in the standard-sized Grain and Oilseed contracts is calculated. In most cash-settled Agricultural contracts, a PRA or some other price reporting entity is necessary to determine final settlement. The role of the PRA is to combine data on underlying cash transactions, bids and offers along with their knowledge of the market to come up with a price assessment – either daily or weekly – for a given commodity. However, because the mini- and micro-sized Grain and Oilseed contracts reflect the same underlying market as the deeply liquid standard-sized contracts, the final price for the standard-sized contracts is used to settle both smaller contracts. In Mini Grain and Oilseed products, that final price is used for physical delivery. In Micro Grain and Oilseed products, that final price is used to determine financial pays and collects between counterparties.
*EFPs are subject to rule 538.
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.
