China's planned iron ore futures a threat to dominant swaps market

Reuters

* Dalian exchange may launch iron ore futures beforeyear-end

* Latest China effort to influence iron ore pricing

* Yuan-denominated contract seen key to liquidity

By Manolo Serapio Jr and Ruby Lian

SINGAPORE/SHANGHAI, Oct 8 (Reuters) - China's imminentlaunch of its first iron ore futures contract could pose athreat to the $28 billion swaps market in the commodity byexploiting massive untapped hedging potential at home.

The contract to be offered by the Dalian Commodity Exchangelikely before year-end will be China's latest stab at boostingits power to price the world's second-largest traded commodityafter oil as a more volatile iron ore market exposes its legionof steel mills to more risks.

By being the first yuan-denominated iron ore futurescontract, the Dalian exchange can easily draw on the growinghedging appetite in China, a market that bourses in Singapore,the United States and Europe have been trying to tap for years.

Beijing has kept a tight rein on overseas derivativestrading by state-owned firms after many lost billions of dollarsin offshore futures during the global financial crisis.

The lack of a domestic hedging tool has led Chinese companies to increase their use of the U.S. dollar-denominatedcash-settled swaps offered by the Singapore Exchange (SGX) and CME Group.

"The market is in China, so Dalian's futures will attract abig number of domestic companies because this can help themavoid currency volatilities and restrictions which is a bigchallenge to Singapore's swaps," said Zhao Qian, a senior brokerwith CITIC Securities Futures in Shanghai.

"In the longer term, Beijing hopes to gain more pricingpower via its own futures and it is hoping it can become amarket benchmark."

China buys at least 60 percent of the world's seaborne ironore and last year that reached a record 744 million tonnes,almost seven times the size of swaps cleared by the SingaporeExchange, pointing to the huge hedging opportunity in China.

"There's no doubt the Dalian exchange will do a lot becausethere is a hell of a lot of untapped liquidity in China that isnot trading iron ore swaps," said a Singapore-based broker.

With more than 127 million tonnes traded last year, theswaps market accounts for just over a tenth of the 1.1 billiontonnes of seaborne iron ore sold annually.

But the volume is rapidly increasing. In January toSeptember this year, nearly 210 million tonnes of swaps havebeen traded, valued at $28.3 billion based on the average priceof about $135 a tonne. SGX clears over 90 percent of global ironore swaps.

A launch of the futures contract may happen before the yearends after the Dalian Commodity Exchange secured regulatoryapproval in mid-September. It will be the first iron ore futurescontract that is backed by physical delivery.

If the strong debut of China's thermal coal futures on the Dalian bourse is any indication, the iron orecontract should see brisk demand.

China is also the world's top consumer of coal.

COMPLEMENTARY PRODUCT?

The iron ore futures contract adds to China's suite ofhedging tools for steelmaking raw materials that includes cokingcoal and coke. Its Shanghai Futures Exchange has rebar, theworld's most liquid steel futures, that iron ore swaps tradersclosely track for trading cues.

SGX, on its part, is not worried about the Dalian contractlaunch, saying it is a complementary product to its swaps andthat there is a market for swaps outside of China.

"If liquidity grows onshore in China, liquidity offshore isable to grow because you're leaning on another layer," MichaelSyn, head of derivatives at SGX, told Reuters.

"And the Chinese aren't the only ones playing on iron ore.There's still as many people outside of China who need to hedgeas there are in China," Syn said.

SGX began offering cash-settled iron ore futures in April inresponse to regulatory changes in the United States where someof its clients are. But bulk of its business remained in swaps.

Some market participants say the size of each lot - 100tonnes based on Dalian's plan - may be too small for big Chinesemills to hedge and may only draw retail investors looking tomake quick cash. In comparison, each lot of SGX's swaps is 500tonnes.

Providing adequate liquidity may be a tough task for afledgling futures market. Previous attempts to launch iron orefutures have suffered from low liquidity, including contractsfrom the Singapore Mercantile Exchange, India's Multi CommodityExchange and Indian Commodity Exchange and CME.

Nonetheless, the market looks headed towards futures,traders say.

"Swaps brokers are very well aware that this will eventuallyhappen, futures is the way to go. These brokers should startlooking for jobs," said a Singapore trader who handles physicaltrades.

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