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Commodity Exchanges:

Setting the Rules of the Game

Eleni Gabre-Madhin

April 30, 2009

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One form of exchange, market exchange, has been

allowed to encircle the globe and penetrate deeply into

societies. It is therefore a matter of no mean irony that so

little is known about how markets work in developing

countries.

Barbara Harris-White, 1999

It is part of an institutional ritual in development

economics, as in much of economic theory, to relegate all

institutional matters into a „black box.‟ The box is

supposed to contain something vaguely important, but it

does not usually receive more than a nodding, if

somewhat intriguing, recognition in passing.

Pranab Bardhan, 1989

INFRASTRUCTURE INSTITUTIONSSECTOR

FARMERS

TRADING FIRMS

PROCESSORS

TRANSPORTERS

STORERS

PUBLIC SECTOR

INCENTIVES

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Why do Institutions Matter for Markets?

Three I‟s of Market Development:

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What are Institutions?

Can they be identified with formal laws,

informal norms, established organizations,

contracts, people‟s mindsets, culture, or

some combination of some or all of these?

How do institutions emerge and evolve?

Are they endogenous (internally-derived)

or exogenous (externally-driven) or both?

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What are Institutions?

Different definitions using game analogy:

Institutions are the “players of the game”

– organizations, agencies, church, school,

etc

Institutions are the “rules of the game” -

the humanly devised constraints that

shape human interaction (Douglass North)

informal: sanctions, taboos, customs,

traditions, and codes of conduct

formal: laws, contracts, constitutions

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What do Institutions Do?

Institutions are efficient solutions to

minimize transaction costs of economic

organization in a competitive framework

(Williamson) (INTERNALLY DRIVEN - NO STATE ROLE)

Institutions, as the rules of the game, are

devised to create order, reduce uncertainty,

and shape the incentives of players (North) (EXTERNALLY DRIVEN - ACTIVE STATE ROLE)

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Historical record

“The inability of societies to develop

effective, low-cost enforcement of

contracts is the most important source of

both historical stagnation and

contemporary underdevelopment in the

third world.”

North (1990)

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A Unified Definition of Market

Institutions

Institutions for markets can be defined as the set of constraints – formal or informal, exogenous or endogenous – that govern relations in the exchange process

This includes: contracts, trading practices, community norms, commercial laws and regulations, supply chains, etc.

Focus on relations between actors, rather than actors, and behavior of actors rather than outcomes

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Institutions as Links in the Market Chain

PRODUCER

FIRM

STATE

CONSUMER

Norms

Trust

Rules

Laws

Codes of conduct

Transaction costs

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Approach to Institutional Design

Synchronic Problem – understanding the role and complexity of institutional arrangements in the market:Enforcement: How are market interactions enforced?

What are formal and informal rules that define interaction? What and where are the constraints and costs of enforcement?

Coordination: What are costs of coordination? What are sources of costs? How do these costs determine the economic organization of the market?

Diachronic Problem – understanding the process of institutional change:Where do the rules of the game come from? Who should

alter them: internally versus externally? How context dependent are the rules? What would be impact of change on the existing institutional arrangements

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Enforcement

Enforcement mechanisms depend on

market complexity and type: local, distant,

complex, …

Complexity linked to technical

characteristics of product and production

process

As markets scale up, move from internal to

external role of either private or public 3rd

party

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Enforcement along Market Continuum

LOCAL

EXCHANGE

trust;

repeated

DISTANT

EXCHANGE

networks,

norms

BAZAAR

MARKET

clientelism

SPOT MARKET

3rd party laws moralityculture

Enforcement costs, Complexity, Specialization

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Coordination

Changing the extent or nature of underlying transaction

costs will achieve a different configuration of market

coordination outcomes: this is the policy challenge of

external intervention

Appropriate market coordination emerges, depending on

market type, that is, type of transactional attributes

(local, distant, spot,..): this is the internal part

Commodity type is less relevant than market type and

nature and extent of transaction costs: eg. export vs.

staple is not meaningful - staples can be tradable in

anonymous domestic or world market)

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Market organization and transaction

costs

SPOT

MARKET

INTEGRATED

FIRM

Asset specificity, Uncertainty, Complexity, Frequency

HYBRID

(vertical or horizontal

coordination, or both

in supply chains)

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The Problem of Economic Order

The peculiar character of the problem of a rational economic order

is determined precisely by the fact that the knowledge of the

circumstances of which we must make use never exists in

concentrated or integrated form but solely as the dispersed bits of

incomplete and frequently contradictory knowledge which all the

separate individuals possess. The economic problem of society is

thus not merely a problem of how to allocate "given" resources.

It is rather a problem of how to secure the best use of resources

known to any of the members of society, for ends whose relative

importance only these individuals know. Or, to put it briefly, it is a

problem of the utilization of knowledge which is not given to

anyone in its totality.

Friedrich Hayek, 1945

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Information is at the heart of the

institutional problem of order

Information transmission on prices, quantities supplied, quantities demanded, actors, product quality and attributes, and processes is the key to market coordination

Information incompleteness or asymmetry leads to different concerns and debates (echoes still at present): Central Planning Debate: Hayek versus Mises

Bounded rationality: Herbert Simon

Missing markets and risk: Joe Stiglitz

Transaction cost economics: Williamson

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Enforcement and coordination

through a commodity exchange

When information is missing or incomplete, coordination is weak, and contracts are unreliable

markets don‟t clear, risk is high, search costs are high, enforcement costs are high

A commodity exchange is a particular institution that has emerged (for certain commodities) to overcome this problem

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Why is an exchange needed?

By setting the “rules of the game,” an exchange reduces transaction costs Coordination:

Facilitating contact between buyers and sellers

Standard product grades

Standard contract terms

Price discovery mechanism

Information:

Broad dissemination to all actors

Enforcement: Contract enforcement through payment and delivery

systems

Rules based and compliance monitoring

Risk transfer : forwards, futures

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Price Discovery

Price discovery is the most important function of

an exchange. The most reliable prices in any

market are derived from those where the greatest

concentration of trading takes place.

Price discovery methods include: open outcry,

ring trading, auction bidding, electronic bidding

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Price information transmission

Open dissemination of market data is the

second most important function of an

exchange, that is integrally linked to

fostering a price discovery process that

reflect true underlying supply and demand

Contract enforcement

Ensuring that the contract is enforceable

and reliable is another key function of an

exchange.

Integrity of the product (grades)

Integrity of the actors (membership)

Integrity of the transaction (order

matching, payment and delivery)

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Risk transfer

In addition to the transfer of goods across space, market actors may seek to transact over time, that is, enter into contracts for future delivery, as opposed to “spot” transactions.

This is particularly appropriate for agriculture, where there is a time lag between the decision to produce and harvest, which incurs risk

By selling their production forward, producers can reduce price risk (or “hedge”) by locking in a price for future delivery

Forward contracts are individually negotiated contracts between buyers and sellers for future delivery. Futures contracts are standardized contracts with pre-specified delivery dates and other terms offered on exchanges.

As markets evolve, “speculators” engage in buying and selling futures contracts independent of physical delivery, based on their evaluation of risk and price trends.

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A Note on Speculation and Volatility

Much conceptual confusion: speculation, arbitrage, and

volatility are considered bad

To the contrary: modern financial economics suggests

that

Speculation is a socially beneficial activity

speculation is at the heart of price discovery

An efficient market must exhibit volatility

new information is rapidly captured into prices

Arbitrage where “buy low and sell high” enables the

“law of one price” or market efficiency

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Exchanges emerging around the

world

Country has active

futures exchange(s)

Country has active

exchange(s) trading

in contracts for spot

or forward delivery

Plans for the creation

of a commodity

exchange

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Commodity exchanges in emerging markets

Catching up fast

Explosive growth

and reach to the

poor in India

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When not to “exchange”?

When goods are not easily standardized

(highly differentiated)

When goods are not storable (perishables)

When trade is highly decentralized with no

central hub of market flows

When there is weak volume and few

buyers and sellers

The Ethiopian experience

Need to address rampant market failures

in the commodity market: exchange

considered an appropriate approach given

structure of market (many buyers and

sellers, high search costs, high risks)

Powerful combination of political will

coupled with market need

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The ECX model

Membership based

Demutualized commercial entity: PPP

Spot-and-futures

Open outcry and electronic bidding

Rules-based (surveillance and

compliance enforcement)

In house physical management and

delivery

In house payment clearing and settlement

Aggressive data dissemination29

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COMMODITY EXCHANGE AUTHORITY

Laws and Regulationsb

Market Information

System

Trader Remote Access

Centers

Arbitration Tribunal

Trading System

Data center

Exchange Warehouses

Grade

certificationWarehouse

receipt

Exchange Settlement Banks

Clearing and

Settlement

National

Exchange Actors

Association

EXCHANGE

MEMBERS

Clients

The ECX Edge… Integration

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WAREHOUSE GOODS

RECEIVING (QUALITY AND

QUANTITY

CERTIFICATION)

MARKET DATA

PROCESSING

DATA

CENTER

MARKET

SURVEILLANCE

CENTRAL

DEPOSITORY OF

WAREHOUSE

RECEIPTS

CLEARING AND

SETTLEMENT

TRADE ORDER

MATCHING AND

RECONCILIATION

ME

MB

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C

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SW

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EH

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SR

EG

UL

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PR

ICE

TIC

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WE

BS

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DA

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FE

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BA

NK

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MEMBERSHIP

MANAGEMENT

Integrated ECX Technology Solution

Powerful Market Platform

Zero contract default

Zero payment default

Zero delivery default

Real time information transmission

Flexible contract design to accommodate

product heterogeneity

Flexible membership system to

accommodate actor diversity32

Impacts: early assessment avenues

Price information “ripple” effect

Impact on trade flows

Impact on arbitrage behavior

Impact on quality improvement

Contract enforcement effect

Impact on market risk

Impact on transaction costs

Market coordination effect

Impact on volumes, participation33

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Aweke TeshomeFarmer, member of Wedera Union (Farmers Union)

“Now we are members of the ECX and are happy that big volume

sales can take place in a risk free environment. Additionally, as a

result of our involvement with the ECX our knowledge regarding the

concept of grading has increased and our resolve to produce quality

products has strengthened.

We are so happy to have a market which is

transparent and risk free.”