Commodity Exchange – Functions, Advantages And More

A Commodity Exchange or Comex is a regulated market allowing the purchase and sale of contracts backed by commodities such as gold, silver, crude oil and so on. Such an exchange serves as the central location for trading the commodities. Some of the major commodity exchanges in the world are Chicago Mercantile Exchange (CME), Chicago Board of Trade (CBOT), Carbon Trade Exchange (CTX), New York Mercantile Exchange (NYMEX), London Metals Exchange (LME), Tokyo Commodity Exchange (TOCOM) and more.

Brief History

Most historians are of the opinion that the use of gold coins as a medium of exchange in medieval Europe played a crucial role in the development of markets for trading commodities. Initially, these coins were traded with the merchants from the East Indies and Asia. Later, the need was felt for centralized exchanges.

Main Participants

There are four main participants in a commodity exchange;

Producers

These supply the commodities for trade. Without them, there will be no commodity to trade, and thus, no need for an exchange. Producers are usually oil and gas companies, farmers, mining companies and cattle ranchers.

End-users

These could be individuals and companies and help to build a demand for a commodity. For instance, the end-users could be companies using the commodities in their production processes, such as cloth makers, food manufacturers and more.

Speculators

These are the traders that bet on the movement of the commodities prices. They often serve as a liquidity source for producers and the end-users as well.

Traders

They serve as an intermediary between the producers and the end-users. At times of market imbalances, they help to provide liquidity. For example, if a producer has an excess inventory and there are no end-users to buy it. Then, traders may buy this inventory to restore the prices.

Commodity Contract Features

Each contract has the following standard feature:

Quantity

Generally refers to the quantity of the commodity stated in the contract. It can be either in the metric unit or traditional units such as a bag or barrel or the imperial unit.

Price

The price of the contract is determined through fair price discovery between the buyer and the seller. Exchanges, usually, do not play any role in the price determination unless there is some dispute.

Quality

It is not that relevant usually. Quality refers to the specifications of the commodity such as the commodity might be from a specific region and so on.

Delivery

Exchange decides the delivery date of each contract along with the method and place. There would be some contracts that are settled through financial payments rather than physical delivery.

What Commodities Are Traded?

Initially, in the 19th century, the exchanges were in use for trading agricultural products such as wheat, corn, cattle. Today, commodity markets have evolved and offered a wider range of products.

Generally traded commodities on the exchange are:

  • Natural soil produces such as cotton, jute, tea, etc.
  • Manufactured products such as artificial jams, hides, gunny bags and so on.
  • Mineral products such as lead, crude, mica, gold, silver, and others.

Commodity Qualification for Trading on Exchange

Not all the commodities are fit for trading on the commodity exchange. There are a few characteristics that a commodity should possess to qualify for trade on the exchange. These characteristics are;

  • Durability – since the expiry of the contracts can be extended up to one year, the commodities should have a longer shelf life. Goods that can perish quickly can’t have long term contracts, and therefore, traders can’t trade them on the commodity exchange.
  • Homogeneity – all units of a commodity must be the same. This ensures that the dealers meant the same commodity when they talk about it in their dealings.
  • Price Fluctuation – the price of the product should have frequent fluctuations in order to be fit for trading. If the price remains steady for most of the time, the speculators would have only little to gain from trading it on the exchange.
  • Gradability – if it becomes difficult to categorize the product into well-defined grades, then trading it on the exchange becomes challenging. If there is no grading before, then the quality of the commodity will have to be ascertained each time before trading.
  • Open Supply – there should not be a monopolized market for the commodity, either Government or any private party. If it is so, it will only make trading impossible on the exchange.

Commodity Exchange

Forward and Futures Markets

Like with the stock markets, the commodity markets also have Forward and Futures contracts. In fact, the need for such contracts is more in commodity markets.

During the 1800s, the phenomenal growth in the grain trade in the US-led to the development of commodities forward contract. Farmers from other parts of the globe will bring their crops to Chicago to store them before shipping them. However, it was possible that the prices of these crops might change during the time it actually reaches the buyer. Also, the quality of the crop could deteriorate during the process.

To overcome such challenges and many more, the buyer and sellers were allowed to lock prices even before the delivery. This led to the formation of the forward contracts. It ensures that the seller delivers an agreed amount of grain for an agreed price at an agreed date.

Functions of a Commodity Exchange

  • To serve as a platform for a different type of investors for buying and selling the commodities through fair price discovery.
  • To acquire and disseminate the commodity news, in order, to help traders in making decisions.
  • Exchanges also help in settling the disputes between the traders.
  • Exchanges are also responsible for grading the commodities available for trade. This allows dealers and other parties to enter into an agreement quickly.

Advantage of Commodity exchange

  • It gives an option to the investors and traders to transfer their risk to professional risk bearers.
  • Exchanges offer a continuous and fair market for the price discovery wherein the producer of the commodity is free from middlemen.
  • Since the commodity exchanges ensure the continuity of trade, financiers and bankers have no issues to extend a loan against the commodities.
  • Commodity exchanges offer hedging opportunities. This helps to reduce the effect of fluctuation in the price.

Disadvantages

Leverage – margin requisites by the exchanges are kept low, thereby, causing poor money management. This sometimes leads to unnecessary risk-taking.

Physical Delivery – traders don’t prefer the physical delivery of the commodities because they cannot afford to take deliveries of huge quantities of commodities.

A Risky Business – matching the speed of the bots and Algo trading is always a risky business with many traders burning their hands due to either greed or fear.

Final Words

Many criticize speculators and traders in the commodities exchanges for driving up the prices of the food, gasoline or other commodities. In reality, no speculator can affect the price of commodities. And, even if they do it somehow, the markets react very quickly to correct any imbalance.1–3

1.
Functions Advantages and Disadvantages of Commodity Exchange. Business Finance and Accounting Blog. September 2019. [Source]
2.
Commodity Exchanges: Definition, Objectives and Functions. Your Article Library. September 2019. [Source]
3.
Commodity Exchanges: The Definitive Guide at Commodity.com. Commodity.com. September 2019. [Source]
Last updated on : September 25th, 2019
What’s your view on this? Share it in comments below.

Leave a Reply