The one thing all commodity exchanges promise is anonymity
You don't know who you are trading with and trading against, who is delivering goods to exchange warehouses and who picks them up. For an FMCG company it is the nightmare from hell.
Consumer product companies spend enormous time and effort identifying the right suppliers. They drill it down to the smallest detail. By the end of it, they know exactly from which factory, and often even the exact mandi, from which their raw material comes. They work on the principle of identity preservation.
Such diametrically opposite business philosophies – anonymity versus identity preservation - make FMCG companies natural outsiders to the world of commodity exchanges. And both lose out.
The companies don't hedge their raw material price risks. Since the annual volatility in commodities can be anything between 8 per cent and 25 per cent, left unmanaged, it can easily wipe out profits. Commodity exchanges lose out on the stability such value chain participants automatically bring to the market. Without commodity processors present on one side to underpin prices, there is always a danger of cowboy punters having a field day.
But now there is a key to unlock the door. FMCG companies can buy raw material from their preferred suppliers and simultaneously hedge their price risk on a commodity exchange.
It is called Exchange of Futures for Physicals (EFP) - jargon for “keep your supplier close and your peace of mind closer”.
Though the mechanics vary with exchange, here is how it works. A soft drink company wants to buy special high-quality sugar from a factory in Maharashtra in December. The two companies decide the quantity, quality and date of delivery as usual. What is left is price.
Both companies believe prices could go up due to the festival season. But the increase will affect them differently. If they fix a price today, the sugar company will lose potential profit while the beverage company will lose in margins. They need a way to make sure both don't lose out if prices rise. They also need a way to ensure that the other party doesn’t renege on the deal due to adverse price movement.
This is where the EFP comes handy. It allows physical sugar to be transferred from the mill to the beverage company, and at the same time allows them both to accept opposite futures positions from the other. That way no one makes extra profit. In short, the mechanism separates the pricing from the physical supply.
To price it, both companies can agree on a differential between the futures market and their own high-quality sugar. Then they call their brokers to register an EFP with the exchange. The exchange makes sure that the deal is genuine.
The beverage company buys a corresponding amount of long futures contracts, while the sugar company buys corresponding short position. On the day of the delivery, the sugar company sends its trucks to the beverage company. The exchange transfers the corresponding futures position to the other company’s account and closes them out simultaneously. Both gain and both sleep easy.
There are other advantages. The companies don’t have to worry about being trapped with a futures position in case there isn’t sufficient liquidity in the contract. The exchange will close out their positions on the date they say so.
Neither company has to worry about reversing their futures position by offset. Otherwise, they would have had to bear a price risk in the period between date of sugar delivery and offsetting of respective futures positions. Moreover, when EFPs are registered with the exchange, the volume is added to that trading day but the price is not declared to the market. So they are assured complete privacy. With so many advantages, no wonder then that the mechanism is popular overseas, especially in the pricing of crude oil.
Contract default arising from price volatility has always been a bugbear of the Indian commodity market. Even large companies with their supposedly iron-clad contracts with known suppliers have been left high and dry.
The best way to eliminate this risk and the accompanying mental tension is to make sure both companies use ways that keep them safe from price volatility. Now this is possible in India too.
It is true all lasting business is built on friendship. You believe your word is your bond, and a handshake is as good as a contract in business. But does the other guy swear by it too? It is good to be doubly sure.
