One of the final questions a small farmer from the Mwihoko group asked us was, “Would Lesiolo be willing to give me a guaranteed contract at harvest (September) to buy my grain in March at a pre-negotiated price?” This savvy farmer was technically referring to a forward contract (with the approaching creation of a Kenyan futures exchange system , the contract he referred to would be classified as a futures contract). By entering into a futures contract, the farmer makes an assumption: that the price he negotiates today will be better than the price he would sell for in the spot market in March (the spot market price is the price of grain settled on by seller and buyer for immediate transfer of ownership).
This farmer was using a financial instrument called a hedge. Hedging is a strategy that has been around for hundreds of years and is employed by producers and users of grain (millers, animal feed companies, edible oil producers) as a way to protect their harvest or inputs against future price volatility. It was quite interesting for a small farmer in rural Nakuru to be asking about a derivatives product that would allow him to hedge his interests while allowing speculators (people on the other side of a futures contract who assume the price will go the other way) to enter the Kenyan grain market. It was also intriguing because a futures exchange in Kenya does not exist – yet.
As part of our deliverable, we took it upon ourselves to research the advent of a Kenyan futures market. We discovered a very interesting fact about developing a futures exchange market in an emerging economy – a Warehouse Receipt System is the cornerstone of successful exchange markets in these environments.
For those of you following our previous blog posts, you know that another significant part of our project is the enhancement ofLesiolo’s WRS. This revelation raised the stakes on our deliverable: not only did Lesiolo need a successful WRS to increase its’ bottom line and further support the small farmer, but Kenya needed a WRS to support the implementation of a futures exchange. It’s important to clarify the correlation between a WRS and a successful futures market. Exchange markets fail in emerging economies for several reasons, and a functioning WRS can counteract these risk factors:
Commodities Exchange Risk Factor #1: Small Markets
According to USAID, a commodities exchange fails when there is a small market. A small market is one that lacks enough counterparties to take the opposite side of a contract. In this scenario, a single bet could sink the clearinghouse responsible for covering losses or gains on unpaid contracts. A small market can also refer to the number of commodities being traded. Although white maize is a food staple of East Africa, and an important commodity in the market, a strong exchange requires a variety of commodities. This variety stabilizes the exchange even if the government intervenes and participants renege on contracts.
WRS Opportunity 1):
A Warehouse Receipt System encourages larger market participation in several ways:
a) More Market Entrants: A functioning WRS attracts new farmers into the system, and more market entrants stabilize price volatility in a commodities exchange.
b) Stability: A WRS stabilizes markets by allowing traders to sell commodities at different points during the year, not just at harvest. This added stability to the agricultural value chain encourages participation.
c) Insurers will only participate in an exchange if there is a sound WRS. Without insurance, there is no exchange: buyers and sellers need guarantees that if a party defaults on their obligation, someone will assume responsibility for debt.
Commodities Exchange Risk Factor #2: Lack of Proper Infrastructure
Infrastructure refers to storage facilities, roads, railways, and communications platforms, but it also refers to buyers, sellers, and lenders.
WRS Opportunity 2):
A commodities exchange is based upon the ability to buy and sell goods. In order for this to occur, institutional voids need to be addressed. Private entities such as Lesiolo have gone to great expenses to install modern storage silos and grain laboratories, establish lending practices, procure trucks for transport of goods, build weigh stations to inventory grain storage, and build communication platforms to communicate with stakeholders. Through the development of their WRS, Lesiolo has become a key provider of much of the infrastructure needed to ensure efficient and fair trading practices and encourage participation by the parties necessary to construct a commodities exchange.
Furthermore, private entity participation encourages public policy action, the final component needed to truly modernize grain trade and establish an exchange. Governments need to step in and build roads, maintain reasonable interest rates, apply taxes in a sensible manner, and ensure a lawful society.
Commodities Exchange Risk Factor #3: Lack of Legal Frameworks
If a country lacks proper legal frameworks, contracts cannot be enforced. This dissuades lenders, insurers, clearinghouses and other vital participants from committing to a commodities exchange.
WRS Opportunity 3):
The key to a legal framework is a commodity that is uniform in grade (quality) and quantity. The secure grain laboratory at Lesiolo records these control metrics: the quantity of commodities entering and exiting the facility, moisture content, protein amounts, foreign matter, broken, rotten, discolored, immature or diseased grains, insect damage and live infestation. Once these factors have been established, contracts can be written to include buyer and seller responsibility, deadline for delivery, and size of tradable lots – all with the assurance that a buyer or trader is getting the product they agreed to, without having to actually see it.
Financial backers (clearinghouses) and insurers are also integral players in a legal framework, and enforceable contracts assure their involvement in the system. A WRS provides these players with affirmation that the grain products traded in the market actually exist, which means that contracts can be executed and enforced.
Commodities Exchange Risk Factor #4: Consistent Contract Abandonment
When Governments intervene with excessive price controls, it’s easier for parties with commodity-backed contracts to renege on obligations. Consistent reneging on the terms and conditions for standing agreements will collapse an exchange.
WRS Opportunity 4):
A WRS is used to confirm the physical presence of a commodity. The accurate reporting and inventory management provided at secure grain handling facilities assures that the government cannot speculate on reserves of grain. It also increases the likelihood that the government intervenes only when necessary, and not for political or personal gain.
Commodities Exchange Risk Factor #5: Lack of Consistent Information
If the market lacks consistent information, it becomes non-transparent. This can result in collusion. To avoid collusion, an exchange must have accurate current and historical data. This data must be free flowing.
WRS Opportunity 5):
New entrants and returned participants in a stable WRS provide consistent transparency into the: quantity, quality and spot price of grains. When grain is stored it enforces immediate data capture.
During a trip to Nairobi, I met with the Head of Research and Development of the Security and Exchange Commission for Kenya. My time with this gentleman revealed that the SEC is one of five consortiums invited to bid on a proposal to develop a Futures Exchange in Kenya. The process was suspended, and the Kenyan Commodities Market Authority hired a consultant group to determine the rules and regulations of an exchange. Once those rules are established, and a reasonable amount to finance the exchange has been determined (the original amount was quoted at US20M) the bidding process to build and operate an exchange will resume. I asked this gentleman to name the advantages of an exchange for the SEC. His response was; “boost liquidity, manage risk, and push return on equity”. These are fairly obvious responses to interested parties. Less obvious is the aforementioned correlation between a functioning WRS and a futures exchange.
As we began our project, Lesiolo immediately earned our respect by demonstrating its commitment to the promotion and well being of Kenya’s small farmer. As our project concludes, we realize that Lesiolo is a key player in the development of an extremely valuable financial market. Our team has worked to connect Lesiolo with the parties responsible for developing Kenya’s Futures Exchange. We’re anticipating additional discussion within the industry regarding the correlation between a WRS and a successful exchange market. Lesiolo’s commitment, and an ongoing dialogue among industry players, will ensure the company’s inclusion in important conversations with national and international stakeholders. Our hope is that increased involvement leads to an immediate increase in the utilization of their WRS.