Freight derivatives market shifts further towards clearing

Fears of counterparty credit risk have led to a sharp migration towards clearing in the freight derivatives market over the past four months. The ratio of cleared forward freight agreement (FFA) trades to non-cleared over-the-counter trades in the last quarter of 2008 was 4.3 to 1.

The Baltic Dry Index (BDI) - which measures the cost of shipping 'dry' commodities (such as iron ore, coal, grain) across the globe - plunged 94% from 11,793 on May 20 to 663 on December 5 last year as global trade slowed sharply. Average weekly volumes of dry bulk FFAs - the standard derivative contract for dry commodities - fell by 38% in the final quarter of 2008 compared with the first three quarters, from 46,053 trades to 28,349. FFAs on capesize vessels - 100,000 dead weight tons or over in size - from Brazil to China plummeted from $108.13 a ton on May 20 to $6.82 a ton on December 1.

A growing string of defaults began to spread through the shipping industry towards the end of the third quarter. In particular, Armada Singapore's default demonstrated how devastating counterparty credit risk could be. When it filed for bankruptcy in December, the company owed $1.08 billion to 64 creditors.

Armada lost $375 million on FFAs linked to chartering vessels. However, the company was also hit by exposure to other bankrupt counterparties such as Atlas, the Copenhagen-based shipping company, and Britannia Bulk, the UK shipper, which defaulted on FFAs worth $10 million and $6 million respectively. Pioneer Freight Futures, a subsidiary of Hong Kong-based Pioneer Metals, defaulted on $45 million in FFAs with Armada.

"Once you start to see failures and selective lack of willingness to pay, some segments of the OTC market can grind to a halt. Once counterparties begin to default, it has the potential to cause a chain reaction," said Richard Bowler, London-based head of freight origination at Citi.

Historically, cleared and non-cleared OTC trades have sustained similar volume levels. In fact, before the BDI plummeted, there were often instances of traders substantially opting against the clearing route; the week of April 28 saw 58,250 uncleared OTC trades, almost double the 24,753 cleared trades.

As the year went on, the move towards clearing became more pronounced: in the week of September 29, there were 64,874 cleared trades, compared with 21,089 non-cleared trades. The trend has continued into the new year, with an average in 2009 of 13,678 cleared trades a week compared with 3,234 non-cleared trades.

"People are prepared to pay the premium for clearing; it's a cheap insurance relative to the exposure you get," said Bjørn Strømsnes, global head of dry freight derivatives at Imarex, the Norwegian shipping derivatives house.

Bankers and brokers agree that purely bilateral OTC trades are unlikely to regain their former prominence. Philippe van den Abeele, London-based managing director at Castalia Fund Management UK, a hedge fund specialising in freight derivatives, told Risk News that his fund had not done a single OTC trade since September.

Some observers, however, maintain there will always be some companies favouring the bilateral route. "There are still market participants who are willing to give and take each other's credit risk because they are doing it in the physical market as well," explained Jeremy Penn, chief executive of the Baltic Exchange in London.

Meanwhile, the spate of bankruptcies has had severe knock-on effects on the freight derivatives market. "It is obviously not good news for the market. Some of these participants that are no longer around had been quite active traders, so it's a pity to lose the liquidity that they were providing," said Jeremy Penn.

"I would say liquidity has dropped 30-40%, if not more," added van den Abeele.

See also: Credit dries up in shipping industry ;
The state of freight