Edited by Sarah Owoeye and Elizabeth Aloho Esiekpe
Table of Contents
Types of Commodity Exchange Market Economy
1. Spot Market
The spot market is a segment of the exchange where contracts are executed for immediate payment (in cash or its equivalent) and commodity is delivered to the buyer. Due to the prompt delivery, these contracts are often called ready delivery contracts. However, in practice, payment and delivery may be delayed for a few days to address technical or logistical issues. Despite these minor delays, the core principle of immediate payment and delivery remains unchanged.
2. Forward Market Economy
The forward market is a segment of the exchange where contracts are made at a predetermined price, with payment and delivery scheduled for a future date. This predetermined price is known as the forward price. The forward price may differ from the spot price at the time the contract is created and may also differ from the spot price on the actual payment and delivery date. Both the buyer and seller are bound by the agreed forward price, ensuring certainty about the price at which payment and delivery will occur when the contract matures.
Methods of Commodity Exchange
1. Open Outcry Mechanism
The open outcry mechanism is a traditional method of trading that involves face-to-face verbal bids (intentions to buy) and offers (intentions to sell) in designated trading pits. These pits, located on the trading floor, are specially designed for open outcry trading, with separate pits for each commodity or group of commodities. The term “open outcry” originates from the practice of brokers and traders shouting, yelling, and using distinctive hand signals to communicate. Many floor brokers wear brightly colored jackets, and their hand signals—well understood by all traders—help facilitate communication and transactions amidst the lively activity in the pits. To trade under this system, an individual intending to buy or sell must contact their broker with the appropriate instructions. The commodity broker then relays these instructions to floor brokers, who are authorized to execute trades in the trading pit. Floor brokers can trade either for their own accounts or on behalf of commodity brokerage firms. Unlike floor brokers, commodity brokerage firms are not authorised to take orders directly from public customers or participate in trading within the pit.
2. Call Over System
The call over system is a variation of the open outcry method, adapted for use in emerging commodity exchanges. In this system, a chairperson oversees the trading process, manages the transactions, and allocates commodities to buyers. Despite this added structure, it retains the core features of the open outcry method, particularly its manual, face-to-face approach, making it somewhat old-fashioned compared to modern trading systems.
3. Electronic Trading Mechanism
The electronic trading mechanism involves executing trades through computer terminals. A commodity broker enters a customer’s buy or sell order into an online trading platform. The system then automatically searches for a matching opposite order—a buy order seeks a sell order and vice versa. If a match is not found immediately, the order remains stored in the system until it finds a match or expires if it has a set time limit. The trade is executed as soon as a matching order is located.
Benefits of a Commodity Exchange
A commodity exchange offers several advantages to both traders and the broader economy. These benefits include the following:
1. Benefits to Producers
Producers of traded commodities, such as farmers, miners of solid minerals, and explorers or exploiters of crude petroleum oil and gas, gain significant value from participating in commodity exchanges. The key benefits include:
i) Opportunity to Manage Price Risk:
Commodity producers can hedge against the risk of future price declines by using the exchange’s hedging facilities. This allows them to lock in prices and protect their revenue, enabling them to focus on production without the constant worry of price volatility. Managing price risks is left to professional speculators, while producers concentrate on what they do best—producing commodities. Hedging also promotes efficient production planning since it provides price certainty, which can lead to increased production volumes.
ii) Price Discovery:
Price discovery means gaining access to transparent and reliable price information. The commodity exchange provides centralized market information, allowing producers to determine fair market prices. This reduces their vulnerability to exploitation by middlemen and buyers, ensuring they receive fair value for their goods. It also eliminates the need for prolonged price negotiations, saving time and resources.
iii) Assurance of Regular and Reliable Demand:
Producers benefit from the security provided by irrevocable contracts with buyers. The exchange’s enforcement mechanisms ensure that buyers honor their contracts, offering producers confidence in continuous and uninterrupted demand for their commodities. This stability helps producers plan better and maintain consistent production levels.
iv) Easier Access to Finance:
Forward selling of farm produce and other commodities allows producers to use these contracts as collateral for bank loans. For example, warehouse receipts, which serve as proof of ownership of goods stored in certified warehouses, can be pledged as collateral. This enables producers to access needed funds while waiting for the contract delivery date, improving their cash flow and financial flexibility.
v) Improved Storage Facilities and Practices:
Commodity trading promotes the development and expansion of better warehousing facilities. With enhanced storage systems, producers can preserve their goods more effectively, reducing spoilage and maintaining quality until sale. This results in increased product value and better market opportunities for producers.
2. Benefits to Users (Buyers of Commodities)
Buyers of commodities, such as food processing industrialists, crude petroleum and gas refiners, and manufacturers of solid mineral products, gain several specific advantages from participating in a commodity exchange:
i) Opportunity to Manage Price Risk:
Commodity processors can hedge against the risk of future price increases by locking in prices through the exchange’s hedging facilities. This allows them to focus on their core activities—processing raw materials—without worrying about price fluctuations. Managing price risk is left to professional speculators. Hedging also improves production planning by providing price certainty for raw materials, ultimately encouraging increased processing volumes.
ii) Price Discovery:
The commodity exchange provides centralized and transparent market information, enabling processors to access real-time pricing data. This helps them determine fair market prices and reduces their risk of over-invoicing or unfair pricing. Time and resources previously spent on prolonged negotiations are also saved.
iii) Assurance of Reliable Raw Material Supply:
Irrevocable contracts with suppliers, backed by the exchange’s enforcement mechanisms, guarantee a steady and uninterrupted supply of raw materials. Buyers can stagger the expiry dates of multiple contracts to align deliveries with their production needs, ensuring consistent raw material availability.
iv) Quality Product Assurance:
The commodity exchange enforces strict measurement and grading standards for raw materials, ensuring product quality and consistency. This helps buyers secure high-quality inputs for their industrial processes, improving their overall production efficiency.
3. Benefits to the Whole Economy
i) Expansion of the Formal Economy:
By substituting traditional market trading with transactions conducted through commodity exchanges, the informal or traditional economy shrinks while the formal, modern economy grows. As the formal sector expands, the government’s tax base increases, providing more resources for public services and development initiatives.
ii) Creation of Employment and Income:
Commodity exchanges generate numerous employment opportunities across various sectors, including brokers, warehouse operators, assayers, speculators, and market regulators. The growth in employment leads to higher income levels, contributing to greater economic stability and prosperity.
iii) Access to International Markets:
The modernisation of commodity trading results in improved product quality that meets world-class standards. This enhances the ability of local commodities to access and compete in international markets, boosting exports and attracting foreign investment.
iv) Overall Growth of the Economy:
The combined benefits to buyers and sellers within the exchange contribute to the overall growth of the country’s Economy. Increased productivity, enhanced market access, and a larger formal economy lead to higher national income, fostering a more prosperous economy.
Constraints to Commodity Trading
Despite the numerous benefits of commodity trading to producers, buyers, and the overall economy as outlined above, its growth has been slower than expected in many developing countries, including Nigeria. Someof the reasons for these are:
1. Inadequate Trading Volumes
The low participation in commodity markets, leads to insufficient trading activity and a lack of liquidity. Many commodities listed on the exchange are not traded at all. As a result, sellers are uncertain about finding buyers for their products, and buyers are unsure if they will find the right commodities. This creates a cycle where traders become increasingly discouraged from engaging in the market.
2. Inadequate Infrastructure and Trading Facilities, Including Warehouses
New or emerging exchanges lack sufficient trading facilities, including computer networks that can connect multiple locations. Additionally, the available warehouses are often inadequate to meet the needs of the market.
3. Low Awareness of the Benefits of Commodity Trading
Due to the generally high illiteracy levels in countries like Nigeria, many potential traders, particularly farmers, are unaware of the benefits they can gain from commodity trading. As a result, there is little incentive for them to participate in the market.
4. Inadequate Knowledge of How Commodity Trading Works
In countries like Nigeria, there is a general lack of understanding about the workings of a commodity exchange, especially when compared to the more widespread knowledge of how a stock exchange operates.
5. Unfavorable Ethics, Values, and Beliefs
Speculation in commodity markets is often compared to gambling or betting, leading many individuals with ethical values and beliefs that oppose gambling to view speculation—and even commodity trading in general—as immoral, thereby discouraging participation.
6. Unfavorable Legal Environment
Commodity trading flourishes when the legal environment supports effective contract enforcement through the judicial system. Since the foundation of commodity trading relies on contracts and their enforcement, a lack of a conducive legal framework can hinder its growth.
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