Commodity Exchanges: Setting the Rules of the Game

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Ethiopian Development Research Institute(EDRI) and IFPRI Ethiopia Strategy Support Program 2 (IFPRI-ESSP2) Seminar Series …

Ethiopian Development Research Institute(EDRI) and IFPRI Ethiopia Strategy Support Program 2 (IFPRI-ESSP2) Seminar Series
April 30, 2009

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  • 1. Commodity Exchanges: Setting the Rules of the Game Eleni Gabre-Madhin April 30, 2009 1
  • 2. 2
  • 3. 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 3
  • 5. 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? 5
  • 6. 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 6
  • 7. 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) 7
  • 8. 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) 8
  • 9. 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 9
  • 10. Institutions as Links in the Market Chain Transaction costs PRODUCER CONSUMER FIRM Norms Trust Rules STATE Laws Codes of conduct 10
  • 11. 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 11
  • 12. 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 12
  • 13. Enforcement along Market Continuum LOCAL EXCHANGE DISTANT EXCHANGE BAZAAR MARKET SPOT MARKET trust; networks, 3rd party laws morality repeated norms clientelism culture 13 Enforcement costs, Complexity, Specialization
  • 14. 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) 14
  • 15. Market organization and transaction costs SPOT HYBRID INTEGRATED MARKET (vertical or horizontal FIRM coordination, or both in supply chains) Asset specificity, Uncertainty, Complexity, Frequency 15
  • 16. 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 16
  • 17. 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 17
  • 18. 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 18
  • 19. 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 19
  • 20. 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 20
  • 21. 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 21
  • 22. 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) 22
  • 23. 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. 23
  • 24. 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 24
  • 25. 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 25
  • 26. Commodity exchanges in emerging markets Catching up fast Explosive growth and reach to the poor in India 26
  • 27. 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 27
  • 28. 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 28
  • 29. 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 dissemination 29
  • 30. The ECX Edge… Integration Laws and Regulationsb COMMODITY EXCHANGE AUTHORITY National Arbitration Tribunal Exchange Actors Association Market Information System EXCHANGE Trading System MEMBERS Trader Remote Access Centers Clients Data center Clearing and Settlement Exchange Warehouses Exchange Settlement Banks Grade Warehouse 30 certification receipt
  • 32. 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 diversity 32
  • 33. 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, participation 33
  • 34. Aweke Teshome Farmer, 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.” 34