Commodity Exchanges: The Ultimate Guide To How They Work & Why You Should Care


The Essential Guide
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What Are Commodity Exchanges?

A commodity exchange is an organized, regulated market that facilitates the purchase and sale of contracts whose values are tied to the price of commodities (eg, corn, crude oil, or gold).

Typically, the buyers of these contracts agree to accept delivery of a commodity, and the sellers agree to deliver the commodity.

Exchanges stipulate the following standardized features of each contract:

  1. Quantity
  2. Quality
  3. Price
  4. Delivery

Quantity

Quantity is the amount of the commodity represented in the contract. This can be expressed in a metric unit, an Imperial unit, or a traditional measurement unit such as a barrel or bag.

Quality

Quality dictates the features of the commodity being traded in the contract. For example, the commodity may have to come from a particular region or have certain physical characteristics.

Price

Exchanges can stipulate the minimum price increments at which a commodity can trade. For example, an exchange can require that a barrel of crude oil trade in $0.01 increments. However, exchanges do not determine the prices for commodities. Traders and member firms determine those prices through the mechanism of price discovery.

Price discovery is the process whereby buyers and sellers determine the price at which supply meets demand.

Delivery

Exchanges stipulate the delivery date for each contract and the method and place of delivery. Some commodity contracts are settled through cash settlements rather than physical delivery.

In addition to physical commodities, some commodities exchanges trade other products such as Eurodollars or US treasury bills. Some also trade options contracts or indices such as the S&P 500.

The members and management of commodities exchanges are responsible for establishing and enforcing rules and regulations that govern the trading of these standardized commodities contracts.

Gold Coins - France 1793 24 Livres via the National Numismatic Collection on Wikimedia
Image of Gold Coins-France 1793 24 Livres by the Paris Mint via Wikimedia.

Who are the Main Participants on Commodities Exchanges?

Commodity exchanges depend on a diverse group of participants, each of whom plays an important role in maintaining a fully functioning marketplace.

The role of exchanges is to ensure that the rules are fair to all of these market participants:

  1. Producers
  2. Industrial End-Users
  3. Traders
  4. Speculators

Producers

These are the individuals and companies that supply the commodity being traded. Without producers, there would be no commodities to trade and, therefore, no need for commodity exchanges.

Mining companies, farmers, cattle ranchers, and oil and gas companies are all examples of producers.

Producers often sell commodities futures contracts prior to producing the commodity. For example, a corn farmer worried about the volatility of corn prices can sell futures contracts three months prior to harvest. By utilizing a commodities exchange, producers can lock in a price for future production.

Specs for a corn futures contract
Corn Futures Contract Specs via CMEgroup

Industrial End-Users

Companies and individuals that use commodities in their production process are called end-users. They provide the demand for the commodity being traded.

Examples of end-users:

  • Food manufacturers
  • Factories
  • Clothing manufacturers
  • Construction companies.

Commodity exchanges allow end-users to purchase products in advance. For example, a commercial builder concerned that steel prices might rise can purchase steel futures contracts prior to beginning a new project. The contract protects the builder against price hikes and allows the builder to better forecast the costs of completing the project.

Traders

Professional independent traders and trading firms play an essential role as intermediaries between producers and industrial end-users. Traders provide liquidity when there are imbalances in the markets.

Examples:

  • If a producer has excess inventory to sell and there are no industrial end-users to purchase, traders step into the market and buy. Similarly, traders often maintain an inventory of commodities to provide to buyers.
  • If an industrial-end user needs to purchase a commodity and a producer doesn’t have a supply of it, a professional trader will provide inventory for sale.

Essentially, professional traders negotiate prices with both sellers and buyers. To compensate for the risks of providing liquidity to both buyers and sellers, traders usually earn a spread or an additional profit tacked on to the price of the commodity futures contract.

Speculators

These are traders that speculate or bet on the direction of commodities prices. Speculators play a crucial role in commodities markets since they are often another source of liquidity for both producers and industrial end-users.

How Do Commodities Exchanges Work?

Commodities exchanges conduct business via two methods: pit trading and electronic trading.

Pit Trading

Not long ago, most commodity exchanges conducted trading via a means called open outcry in locations called trading pits.

This process works as follows:

  1. The buyer or seller of a futures contract(s) calls a commodities broker and places an order.
  2. The commodities broker relays the order to a desk clerk on the floor of a commodities exchange.
  3. The desk clerk relays the order to a floor broker standing in the pit where the particular commodity trades.
  4. The floor broker executes the trade on behalf of the customer with another floor broker or with a market maker (a trader that provides liquidity for brokers).
  5. The floor broker informs the desk clerk when the trade is executed.
  6. The desk clerk informs the commodities broker.
  7. The commodities broker informs the customer.

The process might take as long as a few minutes from start to finish. Although some trading still takes place in trading pits, the overwhelming majority of commodity trading now takes place electronically.

Electronic Trading

With electronic trading, traders simply enter their orders onto an electronic trading platform where exchanges match buyers and sellers.

Electronic trading has several advantages over pit trading:

  • Simplicity – Electronic trades take seconds to execute and involve far fewer people and steps.
  • Cost – Electronic trades cost far less to execute.
  • Transparency – With electronic trading, the trader can see the market quote, size, and last trades on a screen.

Although pit trading is increasingly being replaced with electronic trading in most commodities exchanges across the globe, there are still some places such as the London Metals Exchange (LME)’s “Ring” where pit trading remains.

Advocates for pit trading note may its advantages over electronic trading in certain cases:

  1. Information Flow – Floor brokers standing in a pit and watching non-stop trading in a commodity may have a better feel for the action than a broker trading on an electronic platform. The floor broker can relay these insights to the customer via the upstairs commodities broker.
  2. Large or Complex Orders – Futures orders with many “legs” (parts of a trade) may lend themselves better to pit trading.

Example:

A trader may want to execute the following four-legged trade: buy a front month future in corn, sell a back month future in corn, sell a front month future in soybeans and buy a back month future in soybeans. A broker standing in a pit may be able to produce better execution for this type of complex order than a trading platform would.

  1. Fast Markets – When markets are very volatile, electronic markets may not be as reliable as pits. However, better technology and more stringent requirements for electronic market makers should improve the reliability of electronic markets in the future.

Why Are Commodities Exchanges Important?

Some critics say that speculators drive up the cost of food and gasoline or that commodities exchanges turn the markets for essential daily goods into a casino.

However, these arguments stem from a lack of understanding of how commodities exchanges work.

In reality, no individual speculator can move the price of commodities. Markets work to correct imbalances and often do so very quickly.

If the price of oil, for example, rises to an unjustifiably high level, then producers will simply ramp up production and sell more oil in the marketplace. This, in turn, will drive prices lower.

In fact, speculators could still operate without the presence of commodities exchanges.

Exchanges simply create a formalized process for the buying and selling of commodities and provide the following advantages:

  1. Transparency and Efficiency – The process of price discovery allows market participants to see and trade off of prices instantly, creating more efficient markets.
  2. Standardization – Since commodities exchanges standardize the features of futures contracts, market participants can compare prices on an equal basis.
  3. Liquidity – Without commodities exchanges, producers and suppliers would lack the liquidity to buy and sell raw goods. This would increase the volatility of commodities and create unnecessary price swings for everyday items.

Leading Global Commodities Exchanges

ExchangeFoundedOverviewInteresting Fact
Carbon Trade Exchange (CTX)
CTX Logo
2009This is the world’s first and largest electronic exchange for trading voluntary carbon offsets.CTX collaborates with the United Nations on an initiative aimed at reducing carbon emissions.
Chicago Board of Trade (CBOT)
CBOT Logo
1848A subsidiary of the CME Group since 2007, the CBOT offers more than 50 different futures and options across several asset classes.Oldest futures and options trading exchange in the world.
New York Mercantile Exchange (NYMEX)

NYMEX Logo
1882The world’s largest physical commodity exchange, the NYMEX was acquired by CME Group in 2008. Operates Commodity Exchange, Inc., (COMEX), a leading metals exchange.
Shanghai Futures Exchange (SHFE)

SHFE Logo
1999SHFE offers trading in a variety of metals and energy commodities.SHFE is a non-profit regulated by the China Securities Regulatory Commission.
Australian Securities Exchange (ASX)

ASX Logo
1987Australia’s primary securities exchange, ASX offers futures and options markets on agricultural, energy, and electricity commodities.   ASX merged with the Sydney Futures Exchange in 2006.
B3 – Brasil Bolsa Balcao SA

B3 Logo
1890Offers trading on a menu of broad indices and sector indices.Exchange was formerly known as BM&FBOVESPA.
Chicago Mercantile Exchange (CME)
cme Logo
1898This American financial and commodity derivatives exchange offers one of the largest menus of futures and options contracts of any exchange in the world.Began as the Chicago Butter and Egg Board, a dairy exchange.
Ethiopia Commodity Exchange (ECX)

ECX Logo
2008ECX is an agricultural marketplace that trades five commodities: coffee, sesame, haricot beans, maize (corn) and wheat.ECX is the first commodity exchange in Africa.
Euronext NVG

Euronext Logo
2000Offers liquid contracts on a variety of agricultural commodities.Euronext was spun off from ICE and became an independent company again in 2014.
European Energy Exchange (EEX)
European Energy Exchange Logo
2002EEX is the leading energy exchange in central Europe and offers futures on energy, agriculture, metals, biomass, and environmental commodities.The EEX offers markets on emissions auctions and emissions secondary markets.
Deutsche Borse AG
Deutsche Borse Logo
1992Offers contracts on a variety of energy, metals, and agricultural products.One of the largest exchange organizations in the world.
Integrated Nano-Science and Commodity Exchange (INSCX)

inscx Logo
2009Electronic trading exchange for nanomaterials and nano-enabled commodities.INSCX is based in the United Kingdom and offers live markets during UK and North American business hours.
Intercontinental Exchange (ICE)

Ice Logo
2000US-based electronic exchange that focuses on global commodities futures markets and cleared OTC products.Began as an exchange focused on energy markets.
London Metals Exchange (LME)

LME Logo
1877UK-based exchange that offers futures and options trading primarily on base metals.Although formally founded in 1877, the exchange traces its origins back to the reign of Queen Elizabeth I in 1571.
Multi Commodity Exchange of India Ltd. (MCX)

MCX Logo
2003Offers trading in metals, energy and agricultural commodities.MCX is India’s largest commodities derivative exchange.
Tokyo Commodity Exchange (TOCOM)

TOCOM Logo
1984The largest futures exchange in Japan, TOCOM trades precious metals, energy, and agricultural products including rubber.Formed from merger of the Tokyo Textile Exchange, Tokyo Gold Exchange, and Tokyo Rubber Exchange.
Zhengzhou Commodities Exchange (ZCE)

ZCE Logo
1990Offers trading on agricultural commodities, glass, methanol, ferroalloy, and thermal coal.Launched as a forward trading exchange.
South African Futures Exchange (SAFEX)

JSE Logo
1990Offers trading in agricultural, metals, and energy derivatives.The exchange is a subsidiary of the Johannesburg Stock Exchange (JSE).
Nadex Exchange

Nadex Logo
2004NADEX stands for North American Derivatives Exchange and offers spreads & US-regulated binary options.IG Group, which is a leading UK-based financial derivatives firm, owns NADEX.

FAQs

Here we answer some interesting questions about commodity exchanges.

Where are commodities exchanges located?

Commodity exchanges can be found worldwide. Major exchanges are located in Africa, Asia, the Americas, Europe, and Australia. They are typically found in cities that were located on major trading crossroads like Chicago, New York, London, Shanghai, São Paulo, and Sydney. Some commodities exchanges were created more recently, like those in Tokyo, Addis Ababa, Johannesburg, and Leipzig.

What is an exchange-traded commodity?

Exchange-traded commodities (ETC) allow traders to gain exposure to commodity prices (like oil or gold) without actually owning the commodities. ETCs can be based on a single commodity like wheat or a “basket” or “bundle” of several commodities. With ETCs, traders can make a bet on whether the spot price or future price for a commodity will rise or fall. 

What is a liquid contract?

Liquid contracts involve high-demand, easily-sold commodities that are traded globally in large volumes without much loss in value. Liquid contracts are typically favored by traders and speculators. Energy commodities are most liquid, but agricultural commodities and precious metals are liquid too. Crude oilgold bullion, and corn are examples of liquid commodities.

How did commodity exchanges form?

Most historians agree that the adoption of gold coins as a medium of exchange in medieval Europe played a key role in the development of formal markets for trading commodities. Regions throughout Europe began making their own specialized gold coins and trading with merchants returning from the East Indies and Asia.

These developments led to the need for centralized exchanges.

The Exchange (beurs) of Antwerp via Wikimedia
Public domain image of The Exchange (Beurs) of Antwerp via Wikimedia

The first stock exchange formed in the early 1600s when the Dutch East India Company began offering transferable shares allowing people to invest in voyages to the East Indies and Asia. Soon, more Dutch companies and then the British and French governments joined in.

West India House in Amsterdam 1655 via Wikimedia
Public domain (US) image of West India House in Amsterdam 1655 via Wikimedia.

The goal of these trips was to bring back spices, silk, and other treasures. However, the sailors faced risks including Barbary pirates, bad weather, and poor navigation. To diversify their risks, traders would bet on several voyages at the same time. A separate limited liability company financed each voyage, and together they formed the first commodity company investments.

What are forward contracts and futures markets?

In 1851, the burgeoning grain trade led the Chicago Board of Trade (CBOT) to offer the earliest forward contracts ever recorded. Farmers in the Midwest would bring their crops to Chicago for storage prior to shipment to the East Coast.

However, during storage, the prices for these grains might change for a variety of reasons. The quality of the stored item could deteriorate, for example, or demand for the item could increase or decrease.

Forward Contracts

To allow buyers and sellers to lock in transaction prices prior to delivery, the parties created forward contracts. These contracts bound the seller to deliver an agreed-upon amount of grain for an agreed-upon price at an agreed-upon date.

In exchange for this obligation, the seller would receive payment upfront for the grains. They trade in the over-the-counter market, which means the contracts are privately negotiated between two parties. The buyer faces the risk that the seller might default on the contract and fail to deliver the asset.

Futures Markets

As more farmers began delivering their grains to the warehouses in Chicago, buyers and sellers realized that customized forward contracts were cumbersome and inefficient. Furthermore, they subjected the buyer to the risk of default by the seller.

A group of brokers streamlined the process by creating standardized contracts that were identical in terms of:

  1. Quantity and quality of the asset being delivered
  2. Delivery time
  3. Terms of delivery.

They also created a centralized clearinghouse to act as the counterparty to both parties in the transaction, eliminating the risk of default with forward contracts. In 1848, they established the Chicago Board of Trade (CBOT) to trade these contracts, which became known as futures contracts.

How many commodities exchanges are located in India?

There are four major commodities exchanges in India, located in Mumbai, which trade base metals, precious metals, agricultural commodities, and energy commodities: 

Further Reading

Learn more about the world’s largest commodity exchanges.


Credits: Original article written by Lawrence Pines. Major updates and additions in August 2020 by Natalie Mootz with contributions from the Commodity.com editorial team.

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