Final settlement for CME Group’s agricultural contracts occurs in one of two ways – either physical delivery, or cash settlement.
In contracts with physical delivery, the underlying physical market is inherently tied to the futures contract through the delivery mechanism. During the delivery period and/or at contract expiration, any entity with open positions will be matched with an entity or entities with opposite positions, and the process of physical delivery begins. Eventually, the commodity or a certificate legally representing the commodity will change hands between the maker of delivery and the taker of delivery. Any entity holding a long position after the close on 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.
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.
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 marked 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.
For the South American Soybean (FOB Santos Soybeans) futures contract, daily settlement in each expiry is derived from a volume weighted average of trades on Globex during a given window of time before the daily market close. The specified window of time in which the daily settlement is derived will be each trading day between 1:10 p.m. and 1:15 p.m. Central Time. In the absence of any trades during the settlement window, then the last trade is used to determine the settlement price validated against the bid/ask. In the absence of any trade in an expiry, the daily settlement price will be determined by applying the net change from the preceding contract month to the given contract month’s prior daily settlement price validated against the bid/ask and adjusted to the bid or ask if necessary.
It is critical to note that, while the daily settlement for South American Soybean futures will be calculated based on screen trades, one key component in any new cash-settled contract is finding and working with participants who are embedded in the cash market. Oftentimes, these market participants might be brokers who facilitate bilateral negotiation and trade between counterparties and submit those trades to the exchange for clearing. The role and participation of the brokers is generally key to a well-functioning cash settled futures contract.
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 change hands. In cash-settlement, it is the price to which all financial obligations will be marked.
In most physically delivered agricultural contracts, the final settlement price that will be used to determine the price at which the commodity will change hands 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. In cash-settled agricultural contracts, a price reporting agency (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. The exchange then employs calculations, which differ by commodity, to turn these assessments into final settlement prices.
For the South American Soybean futures contracts, the final settlement will be a monthlong average of the Platts SOYBEX FOB Santos assessment (code: SYBBB00). The averaging period will begin the 16 of the month prior to expiry and end on the last trading day, the 15 of the month of expiry. For example, a May FOB Santos Soybeans futures contract will cease trading on April 15. The final settlement price will reflect the average of the daily Platts SOYBEX FOB Santos assessment that are published from March 16 to April 15. This is true only for final settlement, as each day during the assessment window, the exchange’s daily settlement price will continue to be established by screen trades.
Price reporting agencies play a vital role in derivatives markets. Any PRA chosen to supply assessments that underlie a final settlement price must be thoroughly trusted by the industry. Final settlement prices determined by the exchange using PRA data represent the final valuation of a commodity for the entire marketplace. The exchange puts serious consideration into the PRAs that it works with. Customer validations are continually conducted to assure PRAs retain the highest confidence within the industry, and all PRAs that partner with the exchange are expected to operate in line with the principles of the International Organization of Securities Commissions (IOSCO).
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.
Cash-settled contracts are typically less complicated to design and can work for a broader array of market participants. Setting up a physical delivery mechanism requires significant time and investment by the exchange. Often, that effort is the best fit for an industry and physical delivery makes sense. However, some markets already have active over-the-counter (OTC) trades being valued to reliable PRA assessments. This existing infrastructure, already accepted by market participants, can make a cash-settled contract more straightforward and timely to launch.
Additionally, 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 CME Group agricultural product suite contains several successful cash settled products, including the Lean Hog, Feeder Cattle, Dairy, Fertilizer, Black Sea Wheat, and Black Sea Corn futures contracts.