2013 BD SpecialReport AfDBGuidebookonAfricanCommoditiesandDerivativesExchanges 28NOVEMBER 2013

8/11/2019 2013 BD SpecialReport AfDBGuidebookonAfricanCommoditiesandDerivativesExchanges 28NOVEMBER 2013

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AFRICAN DEVELOPMENT BANK GROUP

Cedric Achille MBENG MEZUILamon RUTTEN

Sofiane SEKIOUAJian ZHANG

Max Magor NDIAYENontle KABANYANE

Yannis ARVANITISUche DURU

Bleming NEKATI

Guidebook on African Commodity

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Cedric Achille MBENG MEZUILamon RUTTEN

Sofiane SEKIOUAJian ZHANGMax MAGOR NDIAYE

Nontle KABANYANEYannis ARVANITIS

Uche DURUBleming NEKATI

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Rights and Permissions

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Directors, or the countries they represent.

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AFRICAN DEVELOPMENT BANK GROUP | iii

African policymakers have increasingly realized thatefficient financial and commodity exchange markets are

important for growth as well as for equitable, inclusive andsustainable development. Derivatives and commoditiesexchange markets can help deliver an improved markettransparency, financing of commodity chain and financialmarket participants, hedging and risk management, andprovide the financial resources for privates sector partic-ipation in Africas infrastructure development. As a sec-ondary effect, derivatives and exchanges can result in jobcreation and enhanced cross-border economic integrationby offering venues for the mitigation of key financial andtrade risks. It is in the financial sector where inclusion andinnovation has taken place and can unlock Africas financial

potential.

Commodity exchange and derivative market developmenthas therefore become an important aspect of developmentinitiatives and aspirations in many African countries. Yet,some notable exceptions notwithstanding (e.g., Ethiopia,South Africa), the past three decades of African exchangemarket development have not yielded much to show forthe effort. The results of various initiatives are being calledinto question for inappropriate approaches, poor resultsin take-off, unsustainable impact, and inadequate use ofappropriate technologies. And factors - such as globali-

zation, the information revolution, the tremendous growthin international markets -- and the development paradigmshifts with the prominent role of the private sector in cre-ating and sustaining markets are causing national authori-ties and their development partners to reassess their rolesin commodity market development.

Africa is latecomer to commodity and derivative markets.However with the recent growth dynamism on the con-tinent, African countries are tapping into new and inno-vative sources of financing, including exploiting the fullpotential of the commodity exchange and derivatives

markets to facilitate the development of local capitalmarkets. Ethiopia is a good example in this regard.

A fully functioning derivatives and commodity exchangemarket will be pivotal in improving competitiveness, facil-

itating both domestic and international trade and integra-tion of the continent to the global economy. And morecan be done by developing further Africas leadership inm-banking, m-agriculture and related areas.

At the same time comprehensive evaluations of derivativeand commodity market development reveal the severe limitsof narrow approaches that are divorced from the broaderenabling environment within which these markets and theirrelated economic institutions must operate. African govern-ments can play a facilitating role by developing institutionalframework and improving the regulatory environment that

will encourage institutional investors to make use of thesefinancial instruments.

The African Development Bank, in line with its role as acatalytic agent at the heart of Africas capital and financialmarkets development, disseminating best practices andinnovative ideas across the continent, took a lead in draftingthis Guide Book which aims to promote innovative ideasand discourse on best practices on derivatives and com-modity markets development. It draws on three decadesof Africas development efforts in this area, complementedwith lessons and best practices from across the globe.

The Guide Book also illustrates how these lessons can beapplied going forward.

The Guide Book was written in the context of the firstPan-African Workshop for Regulators of Derivatives andCommodity Exchanges that the Bank, in cooperation withBourse Africa Limited and with the support of BotswanaInvestment and Trade Centre (BITC), organized in Gaborone,Botswana in July 2012.

We hope that this volume will help African countries, theprivate sector investors and other development actors

deepen their understanding on the benefits that arisefrom exchanges and the development of paradigm-shifting structures and practices that can revolutionizeAfrican capital and commodity markets.

Foreword

Professor Mthuli NCUBE

Chief Economist and

Vice-President of the African Development Bank


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Acknowledgements

This is a product of the Regional Integration and Trade Department (ONRI) led by Mr. Alex Rugamba, Director of ONRI.It was produced under the strategic guidance of Ms. Moono Mupotola, Manager of the Regional Integration and Trade

Division (ONRI.2).

The coordinator and team leader was Cedric Achille Mbeng Mezui, Senior Financial Economist (ONRI.2), and is the resultof collaborative efforts between the African Development Bank and African commodity exchanges. Within the Bankthe team comprised Lamon Rutten (Consultant ONRI.2), Kamgnia Bernadette (Division Manager, EADI.2), Jian Zhang(ONRI.2), Sofiane Sekioua (OPSM.4), Yannis Arvantis (EDRE.1), Nontle Kabanyane (AFMI), Max Magor Ndiaye (FTRY.4),Uche Duru (ONEC.3), Bleming Nekati (ONRI.2), Hugues Kamewe (MFW4A), Olumide Abimbola (ONRI.2), MichaelMahmoud (Consultant, ONRI.2) and Alassane Diabat (ORNB). Externally, the Bank collaborated with Adam Gross (BourseAfrica), Chris Sturgess (SAFEX), Chris Goromonzi (Bourse Africa), Eleni Gabre-Madhin (Founder and fmr CEO, ECX),Brian Tembo (ZAMACE), Charles Furaha (CMA Rwanda), Phemo Marumoagae (Botswana NBFIRA), Tirivafi Nhundu(Securities Commission of Zimbabwe), Ombara (Kenya CMA), and Endris Negus (Ethiopia Commodity Exchange Authority).


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Contents

Foreword

Acknowledgements

Abbreviations

Executive simmary

Introduction

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1 | A brief history of commodityexchange developmentin Africa

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2 | Perspectives on the economic

benefits of commodityexchanges for Africa

2.1 Spot, futures and other commodity exchanges

2.2 Making the market complete: the basic functions

of a commodity exchange2.3 Boosting trade opportunities

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3 | Conditions and constraintsfor African commodityexchange development

3.1 Physical market structure

3.2 Product quality, standardization and grading issues

3.3 Traceability and exchange trading

3.4 Price transparency and price volatility

3.5 The potential for speculative involvement

3.6 Banks involvement in the commodity sector

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4 | The current situationwith respect to Africancommodity exchanges, and themoves ahead

4.1 Aspiring for a pan-African exchange

4.2 Sub-regional initiatives4.3 National developments

4.4 Common challenges

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5 | The regulatory response how to develop an appropriatelegal and regulatory environment

5.1 The principles of regulating spot and futurescommodity exchanges

5.2 Regulating futures markets: a division of responsibilities

5.3 Laws and regulations specifically pertaining tocommodity exchanges, and the securities law

5.4 Regulating the different market users

5.5 Customer protection: defending consumers againstunscrupulous brokers

5.6 Regulations affecting clearing operations

5.7 Regulatory aspects of the exchange delivery process

5.8 Insider trading

5.9 Laws and regulations affecting physical trade

5.10 Relevant aspects of warehousing laws

5.11 Taxation and accountancy rules

5.12 Summary overview of regulatory responsibilitiesof exchanges and regulatory agencies

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ACE Agricultural Commodity Exchange for Africa,

Malawi

ACEF African Commodity Exchange Forum

AHCX AHL Commodity Exchange, Malawi

AfDB African Development Bank

ASCE Abuja Securities and Commodities Exchange,

Nigeria

AU African Union

BAL Bourse Africa, Botswana

BCEAO Banque Centrale des Etats de lAfrique

de lOuest

BoT Bank of Tanzania

BRPB Bourse Rgionale des Produits de Base,

Senegal

CAADP Comprehensive Africa Agriculture

Development Plan

CCH Commodity Clearinghouse, Ghana

CCP Central Counterparty Clearinghouse

CEO Chief Executive Officer

CME Chicago Mercantile ExchangeCOMESA Common Market for Eastern and Southern

Africa

Comez Commodity Exchange of Zimbabwe

CTA Technical Centre for Agricultural and Rural

Cooperation

EAC East African Community

EAGC Eastern African Grains Council

EAX East Africa Commodity Exchange, Rwanda

ECOWAS Economic Community of WestAfrican States

ECX Ethiopia Commodity Exchange

EFP Exchange of Futures for Physicals

EU European Union

FACOMEX First African Commodities Exchange, Nigeria

GBOT Global Board of Trade, Mauritius

ICT Information and communications technology

ICX Integrated Commodity Exchange of Africa

IFC International Finance Corporation

IFPRI International Food Policy Research Institute

IOSCO International Organization of Securities

Commissions

JSE Johannesburg Stock Exchange

MCX Multi Commodity Exchange of India

MoU Memorandum of Understanding

NASFAM National Smallholder Farmers Association

of Malawi

NGO Non Governmental Organization

OTC Over-the-counter

P4P Purchase for Progress

SADC Southern African Development Community

SAFEX South African Futures Exchange (part of the

Johannesburg Stock Exchange)

SRO Self Regulatory Organization

UCE Uganda Commodity Exchange

UEMOA Union conomique et montaire ouest-

africaine (West African Economic and

Monetary Union)

UNCTAD United Nations Conference on Trade and

Development

USAID United States Agency for International

Development

VSAT Very Small Aperture Terminal

WFP World Food Programme

ZACA Zambian Agricultural Commodities Agency

ZAMACE Zambia Agricultural Commodity Exchange

ZIMACE Zimbabwe Agricultural Commodity

Exchange

Abbreviations


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AFRICAN DEVELOPMENT BANK GROUP | xi

Executive summary

Commodity exchanges are highly efficient platforms forbuyers and sellers to meet; primarily to manage their price

risks better, but also to improve the marketing of theirphysical products. They have significant, well-documenteddevelopment benefits, making economies more inclu-sive, boosting the links between agriculture and finance,and making the commodity sector more efficient andcompetitive.

Africa was home to one of the worlds first commodityexchanges in Alexandria, Egypt over 150 years ago. Theimportance of bringing commodity exchanges to the regionwas recognized by policy makers in the Abuja Treaty of1991. Further endorsements came in resolutions adopted

by African Ministers and Heads of State. These resolutionswere clear in their intent: governments should, in partner-ship with the African business sector, develop and supportcommodity exchange initiatives; identify and remove bar-riers to the establishment and operations of commodityexchanges; and procure government requirements acrossthe trading floors.

The first modern commodity exchanges created in thecontinent were in Zimbabwe and Zambia in 1994 and inSouth Africa in 1995. The second, wave started in Ethiopiain 2008. The Ethiopian Commodity Exchange (ECX) which

was mainly driven by government and donor support hasbuilt a reasonable volume, and has shown that a com-modity exchange can be successful in spite of infrastruc-ture and commodity sector development challenges.

Many of the economic conditions in the continent are ripefor a continent-wide commodity exchange which also hasthe potential to boost the continents pursuit of green andinclusive growth through introducing sustainability bench-marks in commodity sector value chains.

We are now in the third wave of African exchange develop-

ment, with numerous national initiatives alongside a numberof ambitious and well-funded sub-regional and regional ini-tiatives. Some of the worlds largest exchange groups areinterested in the continent. In this respect, African govern-ments face an important policy choice. As noted by FestusMogae, former President of Botswana and Chairman of theBourse Africa Advisory Board, the opportunity for Africato achieve its development potential is unprecedented,and the international environment has changed, and con-tinues to change, in ways that open up new possibilities,new potential and new paths to progress for our Continent.

The big question is whether Africa is to do this as 54 sep-arate countries or as Africa.1 Available technology now

presents a veritable opportunity for the benefits of a pan-Af-rican exchange platform in lieu of singular exchanges in dif-ferent countries.

In view of the challenges that may face the inception ofcommodity exchanges, a more effective public-privatepartnership approach is needed to promote the emer-gence of viable commodity exchanges. The private sectorhas significant expertise on issues of decisions on owner-ship pattern, financial arrangements, technology choice orselection of the contracts to be traded. However, exchangeinitiatives still require appropriate government and devel-

opment partner support. The public sector in this respecthas the responsibility for providing the appropriate legal andregulatory frameworks.

Africa is the worlds current frontier for commodityexchange development, attracting the interest of domesticinvestors as well as some large international commodityexchange groups. With the competitive global businessenvironment, it is now time for African countries to put placeviable exchanges that offer the services demanded by thecontinents economies. This will enable the continent tointernalize the associated valuable revenue opportunities,

and to ensure that all African countries, no matter their size,are carried along in this stride for economic development.To realize these opportunities, African countries need tomake the right choices, and they have to do so in the nextfew years. This involves making a concerted effort in thefollowing areas:

nThe role of the government: While a stronghands-on approach that marginalizes the privatesector carries significant risk, there are howevergood arguments for government involvement. Itcould be a minority shareholder, should commit

to using the exchange for large-scale commodityprocurement, and has to make efforts to create afavourable policy, legal and regulatory regime.

nThe focus of the exchanges: While agriculturalcommodities may be the priority for governmentand development partners, the likelihood of anexchange becoming viable is much higher if theexchange itself can chose the products it wishesto introduce. An exchange initiative needs todemonstrate the prospect of reaching critical mass

1 Quoted in African Development Bank/Bourse Africa, 2012.


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| xii NEPAD, REGIONAL INTEGRATION AND TRADE DEPARTMENT

nThe choice of regulatory model:Elaborating thedetails of such a model should not delay the intro-

duction of an exchange. If the government wishesto give regulatory responsibility to the securitiesregulator, it should ensure that it is interested in andable to act as promoter of the commodity exchangemarket, and has sufficient understanding of theparticularities of commodity exchanges.

nThe inclusiveness of the exchange: While itis true that non-commercial participants (theso-called speculators) can have a short-term dis-ruptive impact, they are also critical to the successof an exchange initiative. Exchanges should be able

to attract such participants, including among theircountries main financial institutions (e.g., pensionfunds, insurance companies).

nThe positioning of the exchanges national,regional, pan-African or global: Nationalexchanges may find it difficult to reach criticalmass. But available technology makes it pos-sible for governments to combine their desirefor a national trading platform with a pan-Africanexchange network which provides, through theinternet cloud, the necessary electronic systems

and links the various national exchanges together.

nPublic and development partner support:Thereis a strong public good element to an exchange in particular through its price transparency andprice discovery functions which justifies publicsupport. This should be particularly focused onmaking the exchange more inclusive in terms ofconnecting to smallholder farmers. Developmentpartners can assist by playing a catalytic role inincubating new approaches, and disseminatingbest practices and innovative ideas related to com-

modity exchange development; and by supportingthe development of an appropriate policy, legal andregulatory framework.

(i.e., profitability) in order to attract investors and toconvince others (e.g., brokers, banks) to invest in

setting up the network that will link the exchangewith prospective users

nThe strength of the clearinghouse:A clearing-house can only be strong enough to attract inter-national participants if it is empowered to handleefficiently the payment flows that are associatedwith clearing operations, and if it is a qualifiedcentral counterparty under international bankingregulations (for which it is necessary that a govern-ment regulator qualifies it as such).

nThe choice of technology: Only with electronictrading systems can one meet global standards.Electronic systems also have significant benefits interms of transaction costs, audit trails (for regula-tory oversight) and reach.

nThe choice of contracts to be traded: While thebest programme of action is determined largely bynational conditions, it is worth noting that there isno necessity to introduce spot trading first, and onlylater futures trading; that even futures exchangeswill need to have a well-developed delivery system;

and that if one starts with spot exchanges, thereneeds to be a clear pathway to futures trading. Interms of types of contracts, in addition to traditionalspot and futures contracts, exchanges shouldalso consider innovative products such as ware-house-receipt-backed repo contracts.

nThe development of the warehouse receiptsystem: An exchange should ensure that sucha system is built alongside the trading platform.Governments should enable this, and not haltexchange development while elaborating ware-

house receipt laws and regulations.


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Introduction

Organized commodities exchanges have a long history.Grain traders in Japan began experimenting with the idea

in 1730, while the Chicago Board of Trade (CBOT) andthe London Metal Exchange (LME) successfully launchedtheir operations in 1864 and 1877, respectively. Hundredsof exchanges were created in the next few decades, incountries ranging from Argentina to China, Egypt to Russia,Hungary to Turkey, and India to the USA. However, mostexchanges outside of Europe and the USA fell prey to politicalupheavals, and at the start of the post-World War II period,most of the remaining exchanges were in the developedworld. Their role and influence grew, but until the late 1980s,they remained largely confined to industrialized nations.Only in the 1990s, with market liberalization and increas-

ingly affordable information technology, did commodityexchanges start mushrooming around the world. By 2005,non-OECD countries accounted for more than 50% of theagricultural futures and options traded in the world. Themajority of the worlds functional commodities exchangesare now located outside of North America and Europe.

Commodity exchanges offer significant developmentalbenefits. An UNCTAD study assessed a broad range ofpotential impacts of new exchanges in Brazil, China, India,Malaysia and South Africa, in the areas of price discovery,price risk management, commodity sector investments,

facilitation of physical trading, facilitation of commodityfinance, and broader industry development (includingcapacity-building, market internationalization and use ofICT)2. It found,inter alia, evidence to support 66 of 76 pos-itive impact hypotheses as occurring in one or more of thefeatured markets -- 30 of these were farmer-related, and 36related to the wider sector or economy. Moreover, impactswere generated across all six broad functions.

The desirability of creating an African commodity exchangewas first mentioned in the Abuja Treaty of 1991 (article 46(d)),establishing the African Economic Community (the pre-

decessor of the African Union). There was no commodityexchange in Africa at that time the last one in existence onthe continent, a cotton exchange in Alexandria, Egypt, hadgone out of business in the 1960s. Since, one highly suc-cessful African commodity exchange has been created, theSouth African Futures Exchange, with the countrys mainstaple, white maize, as its flagship contract. There havebeen a number of other commodity exchange initiatives,but further success has been sparse.

Africa has a sufficiently large agricultural base to allow thesuccessful operation of a regional commodity exchange;

however, an exchange should not limit itself to agriculture.The continent has abundant exports of minerals and fuels,and is a large user of many commodities (e.g., fertilizers,oil products). Ideally, an exchange should trade multipleasset classes, from agricultural to energy and mineralcommodities, and including currency contracts and otherfinancial products. There is a multitude of currencies inthe region, and underdeveloped financial markets leave alarge room for new exchange contracts. Judging from thecurrent large number of commodity exchange initiatives inthe region, there is widespread interest in the creation of aviable exchange.

Many groups can benefit from such an exchange.Considering agricultural contracts, for example, farmers willhave greater flexibility and can better plan their operations,agro-processors can reduce the impact of price fluctua-tions on their processing margins, traders can enhancetheir procurement and better manage their risks, bankswill find lending to each of these groups much safer, gov-ernment entities can buy and sell more easily and moretransparently. A futures exchange would allow farmers andtheir service providers to operate in the typically risky envi-ronment of a free market place without having to rely on

government guarantees or subsidies. In all, having accessto a viable agricultural futures exchange, which offers theproducts that their economies most need, will help Africancountries to realize their potential as agricultural exporters,will help governments and development partners to avoidcostly market interventions, and in the process, will improvethe predictability of agricultural prices and enhance thecontinents food security.

Many of the economic conditions are propitious for a com-modity exchange to be successful. The underlying physicalmarket is large, prices are volatile, farmers access to finance

(now a large problem) can be unlocked through better riskmitigation tools, payment systems have improved to suchan extent that fast payments between countries are nowpossible, and market players are plentiful. These marketplayers have the capacity to learn how to use a futuresexchange properly, and thanks to the rapid penetration ofthe Internet and mobile phones throughout much of Africa,most could, in principle, access an exchange.

2UNCTAD, 2009a.


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1.

Africa was home to one of the worlds first commodityexchanges: Egypts cotton exchange, established in 1861in Alexandria. It did not just play a national role but wasalso of large importance for global trade, attracting usersfrom the rest of Africa and from the USA to India. However,as a result of the steady encroachment of the State incotton trading, the exchange was closed in the year it cele-brated its 100th anniversary.3The continent then remainedwithout commodity exchanges until the launch of theZimbabwe Agricultural Commodity Exchange (ZIMACE) inMarch 1994.

During the lost decades, commodity exchanges in Europeand the USA went through a massive transformation,adding financial contracts to the traditionally traded physicalcommodities, innovative instruments (options were addedto the traditional futures contracts followed by index con-tracts and other more exotic products), opening up to amuch larger audience, and revolutionizing their technology.These decades were very profitable for the exchanges,giving them the capital base to continue adapting to theeven greater and faster changes in capital markets duringthe 1990s and 2000s.

The withdrawal of government from commodity tradingin the 1980s had inspired discussions on commodityexchange development in many African countries, fromGhana and Nigeria to Uganda, Zambia and Zimbabwe. Atthe political level, the idea began to receive increasing andbroader support:

nThe desirability of creating an African commodityexchange was already mentioned in the Abuja Treatyof 1991 (article 46(1.d)), establishing the AfricanEconomic Community (the predecessor of the AfricanUnion).4

n The African Commodity Exchange became one ofthe instruments of integration of the African Union(AU), which was formally launched in July 2001.

nAt the regional level, UEMOA in West Africa includedthe plan to create a regional exchange for food prod-ucts in the UEMOA Agricultural Policy paper, adoptedby its heads of state in December 2001.

nSeveral AU meetings confirmed the interest in movingahead. In particular: the African Union Business Forum,

Building the African Common Market, 17-18 June 2003,

3 The Alexandria Cotton Exchange was reopened in 1994, but without offering a trading platform.4 Member States shall cooperate in the development of agricul ture () in order to: () protect the prices of export commodities on the

international market by means of establishing an African Commodity Exchange.

Box 1

Some of the relevant recommendations of the African Ministers of Trade

in the Arusha Plan of Action on African Commodities, November 2005

African Governments should:

nCreate a regulatory and institutional environment enabling national stakeholders to use market-based schemes for

managing risks;

nPlay a proactive role in developing local capital markets that would help in generating local funds for agricultural

development;

nCommit to the establishment of commodity exchanges, with the support of the African business sector;

nProvide a forum to highlight the problems met and identify remaining obstacles that governments are in a position

to remove; and work with the private sector to identify and remove such barriers to commodity exchange estab-

lishment and operations;

nAdopt a partnership model cooperating with a broad range of private sector interests (including banks, ware-

housing companies and collateral managers).

Source: African Union, 2005

A brief history of commodity exchangedevelopment in Africa


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|2 NEPAD, REGIONAL INTEGRATION AND TRADE DEPARTMENT

concluded that The envisaged African CommodityExchange should be subjected to a feasibility study.

Meanwhile a capacity building programme on risk-management skill development should be launchedto prepare African entrepreneurs, especially women,for efficient use of risk management instruments in theCommodity Exchange. (Final report, para. 5)

nThe African Unions First ordinary session of theMinisterial Sub-Committee on Trade, SpecialisedTechnical Committee on Trade, Customs andImmigration, 16-20 June 2003, extensively discussedcommodity exchange issues, and recommendedthat The Commission of the African Union should be

authorized to undertake detailed Feasibility Study andformulate a Business Plan, with Legal Instrumentsand Operating Systems Manual for the proposedAfrican Commodity Exchange (para. 16.b).

nThe report of the Ministers of Trade was endorsed byboth the Ministers of the Executive Council and then,in Maputo in July 2003, by the Summit of the Headsof State and Government of the African Union (whichthen appealed to UNCTAD and other internationalinstitutions to provide support to the establishment ofthe proposed African commodity exchange).

nAU Ministers of Trade once again declared an Africancommodity exchange a priority in the Arusha Plan ofAction on African Commodities of November 2005(see Box 1).

nThe Plan of Action was subsequently endorsedby African Heads of State at the 6th AU Summit inKhartoum in January 2006.

nA 2004 NEPAD study recommended that RegionalEconomic Communities should organize capacity-

building support for exiting exchanges and encouragenew exchanges in their communities.5 It enshrinedthe development of commodity exchanges in its2009 Comprehensive Africa Agriculture DevelopmentProgram, Pillar 2 (Framework for Improving RuralInfrastructure and Trade Related Capacities forMarket Access), which has as a general goalmodernize regional trading systems, including thedevelopment of regional and national commodityexchanges (Strategic area A, point b.iii), and also

refers to these exchanges as one of the two maincomponents of CAADPs promotion of regional

markets. It has among its proposed Early Actionsfor Pillar II creating trading platforms to better linkinternational supply and demand and reducing thecost of transactions in regional staples markets bybuilding on East African efforts to develop a regionalcommodity exchange and replicating these efforts inWest Africa.6

Nevertheless, until the mid-2000s, only in SouthernAfrica did these discussions lead to the creation of newexchanges, first when the then-vibrant farming sector setup the Zimbabwe Agricultural Exchange (ZIMACE) in 1994;

later in the same year in Zambia when grain traders andbrokers came together to create an exchange; and a yearlater in South Africa when the successful financial deriva-tives exchange added a commodity department.

While South Africas exchange flourished, the exchangesin Zambia and Zimbabwe rapidly went the way of theAlexandria Cotton Exchange, for similar reasons theprivate sectors role in agriculture was steadily eroded. Foranother decade there would be little more than further dis-cussions and studies, against a background of a withdrawalof the State from the commodity and financial sectors in

many countries.

However, the second half of the 2000s brought change.Accelerating economic growth, the perception of anAfrican renaissance, technological developments and, inmany countries, a more cordial relationship between thegovernment and the private sector all helped the spreadof commodity exchange initiatives in the continent.Development partners supported one of these initiatives(in Ethiopia) enthusiastically, with tens of millions of US$;but lesser amounts of development partner funding went toother countries. By 2010, there were licensed commodity

exchanges or noteworthy commodity exchange plans in11 countries, and in addition, two well-capitalized regional/pan-African initiatives. Two major international exchangesas well as a large international investment group had startedinvesting in new initiatives in the continent.

Since ZIMACEs start to the present period, three trendscan be discerned: ; a growing ambition of exchange ini-tiatives; and a shift from private sector initiatives togovernment initiatives.

5 NEPAD study to explore further options for food-security reserve systems in Africa, June 2004.6 Baba Dioum et al., Framework for Improving Rural Infrastructure and Trade Related Capacities For Market Access, CAADP-Pillar II, NEPAD,

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A growing reliance on warehousereceipt systems.

With the exception of South Africas SAFEX, most of theearly commodity exchanges as well as the unsuccessfulexchange initiatives in Africa were configured around tradingfloors where buyers would be able to meet sellers, and firststrike a deal in principle, and then negotiate delivery modal-ities. By the late 2000s, this had completely changed: allexchange initiatives had as delivery modalities either thedelivery from exchange-approved warehouses, or morecommonly, the delivery of warehouse receipts.

In a number of cases, governments and analysts have sug-

gested that there should be sequencing: first create a viablewarehouse receipt system, then start exchange trading.There are two fallacies here. First, while building a soundwarehouse receipt system as a first step may clear the pathfor a future commodity exchange, this is by no means acertain or efficient way to move towards such an exchange.Second, experience in 19th century USA and India over thepast decade indicates that its commodity exchanges thatcreate an efficient warehouse receipt system, not the otherway round.

On the first point, it may be useful to consider the some-

what sobering experience of Zambia. After the failureof the first Agricultural Commodity Exchange, devel-opment partners attention shifted to the developmentof a warehouse receipt system. In 2001, a number ofdevelopment partners started supporting the ZambianAgricultural Commodities Agency (ZACA), a privateinspection and certification agency for warehouses.It was supposed to set up the warehousing and gradinginfrastructure that would link smallholders to the commer-cial market. At the peak of its success, in 2004-2005, it hadcertified warehouses with a total capacity of 105,000 tons.Depositors in the warehouses used the receipts to get US$

2 million of warehouse receipt finance from banks.7A yearlater, ZACA ceased existing.

The reality was that ZACA did not function all that well.Apart from having serious managerial and reputationalissues, virtually all of the warehouse capacity that wascertified was used for the operators own deposits, not forthird party. The smallholder deposits were engineered toplease development partners.

Development partners then (in 2007) shifted to the supportof a new commodity exchange initiative, the Zambia

Agricultural Commodity Exchange (ZAMACE). One lessonwas that a warehouse receipt system doesnt create anorderly market. It is a product of one.8 ZAMACE was notunduly focused on smallholders, but rather recognizedthe importance of large farmers and trading companiesin driving the evolution of the market. A core function ofZAMACE was to provide a credible, certified warehousereceipt service. With this in mind, it set up a process tocertify warehouses, and regularly inspect them; it alsodeveloped a warehouse receipt registry. However, in 2011ZAMACE stopped operating (there are plans to revive it in2013). The private sector expressed loud support9, but con-

tinued executing most trade outside the exchange; and thegovernment said it supported the initiative and was workingon legislation to enable it to operate well, but undermined itthrough its grain marketing policies.

On the second point, in the United States the commoditywarehousing sector in the second half of the 19th centuryhad oligopolistic powers, and the commodity exchangesplayed a major role in making them more competitive andmore efficient in their service provision, thus laying the basisfor a modern warehouse receipts system. In India, the col-lateral management firms that made finance based on

warehouse receipt attractive for banks (leading to an explo-sion of agricultural lending) had their origins as deliverydepartments of the countrys leading (private sector) com-modity exchanges.

The advisable way forward may be, as Ethiopia and Indiahave done in recent years, to permit a dynamic com-modity exchange to emerge, and allow this exchange tohave as part of its strategy the development of a viablewarehouse receipt system. Governments should leavethe exact sequencing of actions as well as the choice ofcommodities to the exchange. When warranted, govern-

ments should adopt new, improved warehouse laws andregulations to support the financialization of the commoditywarehousing sector. On a temporary basis, they may alsogive an exchange regulatory authority over the warehousesthat it accepts as delivery points. Central Banks shouldpermit banks to finance goods in such warehouses, andrecognize this as a low-risk form of lending (with low pro-visioning requirements). Central Banks may also open dis-count windows for loans that use warehouse receipts as

7 Munro, 2009.

8 Munro, 2009.9 ZAMACE represents the future of commodity trade in Zambia. (Jacob Mwale, Executive Officer of the Grain Traders Association of Zambia,

at UNCTADs workshop on Improving the Functioning of Commodity Markets in Eastern and Southern Africa through Warehouse ReceiptSystems and Market-base Interventions, Lusaka, 30 September 2 October 2009)

CHAPTER 1: A BRIEF HISTORY OF COMMODITY EXCHANGE DEVELOPMENT IN AFRICA


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| 4 NEPAD, REGIONAL INTEGRATION AND TRADE DEPARTMENT

collateral. In other words, there is a whole range of sup-porting actions that governments can take (which is not

the subject of this paper); however, governments micro-management can affect the way that an emerging com-modity exchange interacts with the warehousing sector.

A growing ambition of exchange initiatives.

The exchange initiatives in the period up to the early 2000swere all small-scale, often with a focus on only a few crops,the involvement of only a small number of companies,low-end technology, and very small budgets (generally inthe tens of thousands of US$). Development partner funding

often sustained these initiatives for years, but such fundingthat was provided in small amounts, even though totalinghundreds of thousands of US$ over time, was insufficientto create a proper exchange. In the early 2000s, setting upa proper single-country commodity exchange, including itslinkages with warehouses and banks, would probably havecost over US$ 25 million.

South Africas commodity exchange platform was able touse the technology developed for currency futures trade.Until the Ethiopian initiative in 2006, there was no exchangeinitiative that had raised the millions of dollars needed to set

up a viable exchange.10

According to estimates, over US$ 50 million has nowbeen invested in the development of the Ethiopian com-modity exchange (some estimates mention US$ 100million). However, such an amount is no longer exceptional.COMESA in East Africa estimated a similar requirement forsetting up an exchange for the East African region. Bourse

Africa, with an ambitious pan-African outlook, is an initia-tive of over US$ 100 million. Other exchange initiatives in

East and West Africa envisage similar budgets. While somegovernments are still looking at development partners tocover these costs, the private sector is now ready to makethese investments. The experience in India, where condi-tions in the early 2000s (when the countrys now-leadingexchanges were set up) were similar to those of Africatoday (but with a commodity market that is smaller thanthat of Africa), probably inspires such willingness to invest:Indias largest exchange, the Multi Commodity Exchange ofIndia (MCX), was set up in 2002-2003 with a budget of lessthan US$ 25 million. When it did its Initial Public Offering inFebruary 2013, the exchange was valued at US$ 1.4 billion.

Exchange initiatives have also become more ambitiousin terms of geographical coverage looking for a sub-regional or pan-African role as well as in their targetaudience which now generally includes banks as opposedto only commodity sector participants.

A move from private sector initiatives togovernment initiatives.

The early exchanges, in Zimbabwe, Zambia and South

Africa, were all private sector initiatives. Several countriesin West Africa also saw private-sector-led exchange pro-jects. However, from the creation of ECX in 2006 onward,the establishment of commodity exchanges has becomestrongly government-driven. There is a risk that this willlead to a scattering of national exchange initiatives that areeconomically non-viable, and that threaten the scope formore viable private sector initiatives, particularly those witha regional perspective.

10There were earlier initiatives that aimed for this, in particular PACDEX, but these failed to raise the necessary investments.


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Perspectives on the economic benefitsof commodity exchanges for Africa

2.

Many African economies have been among the worldsfastest growing over the past decade, but for this growthto be sustained and, importantly, to benefit a greater part ofthe populace, structural changes are necessary. Economiclinks among African countries need to be strengthened;African farmers need to become better linked to Africasfast growing cities; African entrepreneurs need to capturea larger portion of the upstream part of Africas commodityproduction; investments risks in Africas commodity sector from production to processing and logistics need tobe reduced; financiers (including investment funds) need

to become more comfortable with lending to Africascommodity sector; the losses resulting from inefficientsupply chains need to be decreased. A sound commodityexchange can help achieve all these key imperatives, andmore.

2.1 Spot, futures and othercommodity exchanges

A commodity exchange is an organized marketplace wherebuyers and sellers come together to trade commodity-

related contracts following rules set by the exchange. Thereis a wide variety of ways in which the market can be organ-ized (table 1 below describes some of the possibilities), butexchanges tend to have the following elements in common:

nAn exchange provides a trading platform, eithera physical location (a trading floor) or an electronictrading system, in both cases with an intricate setof trading rules. In this report, a number of simplerforms, namely fair grounds where buyers and sellershave been brought together and prepared for trading(trading fairs in West Africa), and a radio-supported

bulletin board (KACE) are included in the discussion,largely because they are an indication that marketparticipants are likely to be interested in a properexchange platform.

nExcept in its simplest form (trading fairs, bulletinboards), an exchange provides standard contracts,rather than letting buyers and sellers determine allcontract provisions themselves. The extent to whichthe contracts are standardized in terms of quality,quantity, delivery location, delivery time, etc. can vary in their most evolved form, exchanges set all thecontract conditions except for the price.

nAgain except in its simplest form, an exchange willnot deal with most of its users directly, but throughbrokers. Brokers act as the agents for buyers andsellers, not just for placing transactions, but also formanaging the related payment and information flows,and for managing the delivery process. Exchangesdeal with the implicit agency risks in two ways. First,there are strong controls on the ways that brokersexecute their clients orders, to make sure that brokersdo not abuse their clients. Second, the exchange hasthe broker assume liability for his clients, in terms

of payment obligations, delivery processes etc.;this ensures that a broker will exercise due care inapproving clients for trading on the exchange.

nAn exchange provides security on the quality and thequantity of the commodity traded. It will normally setgrades and standards, and license those who arepermitted to issue grading certificates. It may usewarehouse receipts, which guarantee the physicalpresence of the goods. It may have a mechanism tosettle quality disputes. A fully-developed exchangeguarantees the delivery; if there is a problem, it will

either procure goods on the market for delivery to thebuyer, or compensate him financially.

nAn exchange may guarantee logistics. This is rare the prime examples are ACE in Malawi and Belarusscommodity exchange but it is well worth consid-ering. In the case of ACE, farmers can deposit goodsin certain upcountry warehouses, and if the grain is ofthe required standard, the warehousing company willswap this grain against equivalent grain stored in citywarehouses. In Belarus, the spot exchange enablesinternational buyers to buy for delivery from ware-

houses in nearby countries (e.g., Estonia, Ukraine),thus protecting them against transit risk (the exchangeprotects itself through a policy with the countrysexport credit agency).

nExchange trading is tightly regulated, with theexchange as frontline regulator. Regulations may besimple e.g., arbitrage procedures to deal with con-flicts between buyers and sellers but in an advancedstage of development, there are several layers ofregulation involving different regulatory agencies.


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Table 1The degree of sophistication of an exchange, as expressed in different characteristics

From simple ..................... to more advanced

Tradingplatform

Bringing peopletogether in onelocation

Bulletin Board Auction Open outcry ring Electronic platform,compatible with globalstandards

Speedof trading

Hours Minutes to days Minutes Seconds Milli- or micro-seconds

Tradedinstruments

No standardproducts, tradeon basis ofreputation

Trade on the basisof samples

Trade on the basisof description/grading certificates

Standardizedspot contracts,warehouse receipts

Futures, options, repos

Brokeragestructure

No brokers Clients leave theircommodities withbrokers for theirlater sale

Clients givebrokers instructionsby phone

Electronic orderflow from clients tobrokers

Brokers approve clients whothen trade directly

Clearing andsettlement

Pre-selection ofparticipants

Fixed guaranteedeposits

Payments handledby exchange

All tradesguaranteed by theexchange. Globalrisk managementstandards.

Clearing by unrelated thirdparty clearinghouse. Linkedto global clearing firms.

Use ofwarehousereceipts

None Warehousereceipts act as theinstrument for thebuyers sale

Active trade inwarehouse receipts,which changehands more than

once

Warehouse receiptsact as deliverymechanism for thefutures market

Trade of repos backed byreceipts

Standardsetting andgrading

None Exchange offerssimple gradingservices.

Exchange keepssamples ofcommoditiestraded, to helpsettle contractualconflicts

Exchange setsgrading criteria,licenses gradersand arbitratesquality conflicts.

Trade is in a narrow rangeof standard commodities.Exchange has strict gradesand standards.

Priceinformation

Prices sampledfrom marketparticipants

Systematiccollection of pricesfrom representativepool of marketparticipants

Contracted pricesare registered at theexchange premises

Contracted pricesare broadcast, witha delay (e.g., end-of-day)

Real-time price informationdistributed in many ways

Governanceof trade

Committeeof marketparticipantscontrol access

No governmentregulation. Arbitragerules, enforcedby exchangecommittee

Governmentregulator alongsideself-regulatoryexchange

Exchange orregulator also givenpowers to regulatewarehouse receipts

Four separate regulatorystructures for overallregulation, exchangeoperations, brokerage andwarehouse receipts

Examples The boursesin Burkina Faso,Mali, Niger

KACE, UCE ACE, ZAMACE ECX Bourse Africa, EAX, GBOT,SAFEX


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The worlds largest commodity exchanges are futuresmarkets, trading futures and option contracts that are

meant as risk management tools rather than tools to buyor sell the underlying commodities. In emerging markets,however, commodity exchanges can play a useful role forphysical trade, including in the financing of commodityinventories. By providing a transparent, disciplined market-place they can reduce the discovery costs of physical tradeand the counterparty risks in commodity transactions.

Commodity exchanges can trade a range of instruments. InAfrica, Egypts former cotton exchange traded the gamut ofinstruments from spot trading to forward trade and futurescontracts. South Africas exchange trades futures and

options, and recently also started offering trade in ware-house receipts. Zimbabwes ZIMACE was a spot market inwhich buyer and seller, once they were matched, negotiateddirectly on delivery specifics. Ethiopias exchange is a spotmarket which relies on standardized warehouse receipts.

Malawis ACE trades warehouse receipts, operates auctionsfor large buyers, and offers a spot trade matching facility.

Bourse Africa plans to operate a multi-asset platform, withboth spot and futures contracts, and associated to it, anelectronic warehouse receipt system. GBOT in Mauritius onlytrade futures.

All these different trading systems have different regulatoryimplications. Table 2 sets out the different forms of con-tracts that can be offered on an exchange, and regulatoryimplications. Regulatory implications should be seen in thelight of the need to regulate governments should refrainfrom unnecessary intervention. There are just three pos-sible reasons: to protect the integrity of the operation of the

exchange; to protect customers from abuse; and to protectthe wider financial sector from systemic risk. An exchangethat is primarily used by trade participants needs no gov-ernment regulation, while an exchange that is open to thepublic, whose prices are used widely, and which is used bymany of the countrys largest financial sector actors needsa well-developed regulatory framework.

Box 2

Electronic trading systems: from matching service to clearing

In several regions of Africa, mobile phone applications have been introduced for matching buyers and sellers of com-modities. The largest such effort was set up by Tradenet in Ghana (but with a regional focus), since renamed Esoko. In

Zambia, Sangonet has piloted a scheme of this nature to link farmers in the country to consumers in the Democratic

Republic of Congo, with the plan to expand it to the whole COMESA region if the pilot is successful. National projects

include Radio Marchin Mali, KACE in Kenya, and Kudu in Uganda. Typically, buyers or sellers can send a message to

a group of registered users (i.e.users who have indicated they are interested in buying or selling a specific commodity)

offering to buy or sell commodities of a certain quality perhaps indicating the price. In a somewhat more complex

form, sellers can register details on their products into a database, and buyers can register details of the deals they

are interested in (in terms of grade, location, quantity, price, delivery location). A matching engine identifies potential

matches and contacts the two parties. In either case, it is up to the two parties then to pursue negotiations, if they

wish, and conclude a deal, if they can.

In principle, this is a simple electronic commodity exchange, allowing sellers and buyers to find each other. In practice,

little trade actually results from this matching service. The main reason is risk. The system just matches potential coun-

terparties, but does not guarantee any resulting deals. Thus, both buyer and seller remain exposed to considerable

counterparty risk.

In contrast, in an organized commodity exchange, the exchanges clearinghouse interposes itself between

the buyer and the seller once a deal has been struck, guaranteeing to both the fulfillment of the transaction.

Normally, there will be a layer of risk transfers. If the buyer defaults on his obligations, his broker still has to make good

on them. If the broker is unable or unwilling to do so, the brokers clearing company will guarantee that the seller is

made good. If this is beyond the means of the clearing company, the clearinghouse will guarantee performance, if

necessary tapping into its settlement guarantee fund, capital reserves and insurance coverages.

When contracts are cleared, it is irrelevant for a buyer or a seller who the counterpart is. So there is no problem with

the typically anonymous character of futures trade: there is no reason to know or trust ones counterparty. This can be

particularly helpful for building new trade flows, e.g.between neighbouring countries.

CHAPTER 2: PERSPECTIVES ON THE ECONOMIC BENEFITS OF COMMODITY EXCHANGES FOR AFRICA


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2.2 Making the market complete:the basic functions of a commodityexchange

Commodity exchanges provide three basic functions: price

transparency (everyone has access to a neutral referenceprice); price discovery (demand and supply developmentsare readily reflected in price levels); and reduced trans-action costs (its easier to find buyers or supply througha centralized market place). Each of these functions canbe inconvenient for certain market participants. Withoutan exchange, large, well-organized trading houses have abetter overview of the market than smaller market partici-pants, and thus a better idea of what prices should be. Theymay not appreciate it when farmers become well-informed experience from India and elsewhere indicates that farmerslearn very fast how to use price information to improve theirbargaining position. The prices discovered on an exchange

may not be the prices that any particular stakeholder groupor politician would like to see emerge, and they may blamethe exchange for the bad news (see Box 3). Reduced trans-action costs imply greater possibility for competition, whichcan reduce the margins of intermediaries.

If the exchange offers forward or futures contracts, it alsoprovides a risk transfer function. Forward contracts tend tobe risky, as market participants will be tempted to defaulton their obligations if physical market prices move stronglyin their favour. If the exchange offers futures, it will generallyalso offer option contracts, which tend to be more attrac-tive to farmers. This is for different reasons: when bought,options act as insurance, protecting against negative pricemovements but still permitting to benefit of improving phys-ical market prices; options can be bought through a singlepremium payment, whereas futures require continuousfinancial management to maintain the exchange-set marginlevels; and options are better instruments when there is

Table 2Instruments and their uses, and regulatory implications

Contracts offered Use Regulatory implications

No standardized contracts all contracts agreed on bilaterally

The exchange provides a meeting placefor buyers and sellers

No need for government regulation.

Exchange may handle contract performanceguarantees and operate arbitration procedures.

Standardized spot contracts, withdelivery through warehouse receipts

The exchange offers a liquid, safeenvironment for spot trading.

No need for government regulation.

The warehouse system can be regulated by theexchange.

Standardized forward contracts The exchange permits buyers and sellersto make commitments for future delivery.

No government regulation needed as long as these aregenuine forward contracts.

The exchange has to actively manage the risk ofcounterparty default.

Warehouse receipt repos The exchange enables those with stocksof physical commodities to use them ascollateral for short-term loans.

Warehouse regulation required.

The sell-and-buy-back arrangement has tobe exempt from VAT. Capital market regulations have topermit an exchange to have this function.

Commodity futures and optioncontracts

Risk management tools. It is advisable that there is a government depar tmentwith the explicit responsibility of overseeing the market.

Separate regulator for warehouses desirable.

Currency and interest rate futuresand options

Risk management tools. Government regulation necessary, with goodcoordination with Central Bank.

Securities derivatives Offer leveraged alternative to cashsecurities, and can also be used tomanage the risk on a securities portfolio.

Securities derivatives need to be regulated by thesecurities regulator.


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a risk regarding the quantity of production. For example,in South Africa some 20 per cent of commercial farmers

use SAFEX, and most of them use options.11Most SouthAfrican farmers hedge their price risk indirectly, throughfixed price forward contracts with traders or processors;the latter often lay off the resultant price risk on SAFEX.

Even for a futures exchange, in its initial years it maywell be the reduction of transaction costs when tradingthrough the exchange rather than the management ofprice risks that will attract most physical market partici-pants. In emerging markets, in the initial months that anexchange operates, one can in effect often observe thatmany such participants use the exchange as a delivery

tool rather than for price risk management. New futuresexchanges should capitalize on this to build a strongconstituency in the physical market, rather than try tominimize their interface with the physical trading sector.South Africas SAFEX illustrates well how effective this canbe. By creating an extensive and reliable delivery network,which market participants could trust as a channel for pro-curement and delivery, the exchange overcame the initialskepticism of farmers.

Exchanges bring further benefits. They normally help todefine better quality standards, by creating incentives for

market participants to produce commodities that meetexchange specifications.12For example, when SAFEX intro-duced premiums that rewarded the delivery of higher qualitygrain, farmers reacted by applying extra fertilizers in order toimprove the quality of their production.13By defining qualitystandards, they speed up the process of product standard-ization. They also improve the discipline in the market place,by incentivizing market participants to behave according toexchange rules. Exchanges are dynamic tools to remedythe weaknesses of the market place, and exchange pro-moters should be open to provide any tool that may servethe goal (see box 4 below).

One function that could be particularly useful in the Africancontext is for the exchange to act as registration vehicle

for commodity-related transactions in particular, forwardcontracts, and the pledging of commodities (expected tobe produced, or growing in the field, or already depositedin a warehouse) to secure loans (e.g., from banks, or frominput suppliers). The exchange could provide standard con-tract templates and arbitration facilities; and could eventu-ally also act as escrow agent between buyer and seller.

The more sophisticated instruments that can be offered onan exchange (futures, options, repos) can be repackagedby traders and banks to offer tailored contracts to pro-ducers and processors, giving them much greater flexibility

in their marketing decisions. For example, the First NationalBank in South Africa offers a full range of products in itsGrain Hub product suite, including:14

- Spot contracts, supporting processors and tradersin buying SAFEX-delivered grains.

- Pre-plant contract: the bank provides grain inputfinance, with production risk covered by multi-perilinsurance and force majeure insurance (which coversagainst disaster risk: if there is natural disaster thatdestroys the crop, no debt repayment is necessary).

Price risk is hedged on SAFEX.

-Repo contract: the bank finances grain against silocertificate as collateral. To cover the related pricerisk, it purchases 25% out the money SAFEX putoptions15 for the financing period. The maximumsize of the repo is 75% of the daily market value. Theclient is responsible for storage and interest duringthe financing period.

11Rod Gravelet-Blondin and Chris Sturgess, South African farmers and the agricultural commodity derivatives market, UNCTAD/SFOA,The Worlds Commodity Exchanges: Past, Presence, Future, September 2006.

12 It should be noted that if a small part of production concerns premium products (the premiums could be linked to quality, fair trading criteria,environmental criteria etc.), then the tendency of the exchange to create standard products could actually threaten the prices received by theproducers of these premium products. Normally, these producers will then avoid use of the exchange. How exchanges can deal with premiumproducts is discussed in section 3.3.

13 UNCTAD, 2009a.14 Based on UNCTAD, 2009a.15 Put options provide protection against the risk of price falls. They are bought at a certain strike price, which is the price at which the buyer can

execute the option by converting it into a futures contract (in the case of a put option, he can deliver a futures contract at the strike price, andin the case of a call option, he can buy a futures contract at the strike price). The out of the money indicates that the strike price is at somelevel below current price levels (in the banks case, if the current price is 100, the put option has a strike price of 75); such options are rathercheap. To give an example, if the put option has a strike price of 75, it gives the buyer the right to deliver a futures contract and receive 75. Ifthe futures price falls below 75 (say it is 60), he can buy futures at 60, and deliver them for 75, realizing a profit of 15. As long as the futuresprice has moved in tandem with the physical market price, this will compensate the bank and its client for losses due to price falls below 75.

As the banks financ ing is at most 75 percent of the initia l value of the commodities (i.e., in this example, 75), the bank runs virtually no risk thatthe value of its collateral falls below the value of the loan.



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Box 3

Blaming the messenger

One of the functions of a commodity futures exchange is similar to that of barometer: it converts signals that

are more or less invisible to the common man into a simple metric that conveys useful information about the

future to everyone. The futures prices quoted on an exchange indicate where the market expects prices to be

in 3, 12, 48 months or beyond, as the case may be. However imperfect, studies have shown that commodity

futures market are better predictors than other sources such as expert panels. Futures prices only reflect the

information that is currently available to market participants, and when new information arrives, they can change

rapidly; but still, they provide a useful service to all market participants, who can more easily prepare for future

price developments and react better to new information.

Sometimes, a barometer indicates that bad weather will come. It cannot be blamed for this it merely processes

the available information. Banning the use of barometers will not affect future weather; it will just make it more

difficult for people to anticipate it. Yet, time and time again and in all regions of the world, there are politicians

who blame the barometer of the exchange for the direction of price movements. Exchanges cannot ignore this

political undertow, and should be ready to demonstrate with data that their prices reflect market realities.

Politicians and stakeholder groups may blame exchanges for both high and low prices. For example, in 2002,

South Africas maize prices rose precipitously, and the Governments Food Price Monitoring Committee

began an investigation into the role of SAFEX in particular, as to whether SAFEXs grain market was being

manipulated. As reported in Kirsten and Geyser, 2009, the investigation found that in the 2000-2004 period,

SAFEX prices were only marginally different from the prices calculated using a model that just reflected two

factors: hard red wheat prices in the USA, and the Rand/US$ exchange rate. Similarly, South Africas maize

price [in 2002] reacted in a predictable fashion to the change in the exchange rate and the international price of

maize, also to market perceptions of the relative scarcity of maize in Southern Africa.. There was no indication

of any manipulation. Lack of proper market information was the more important hindrance to the exchanges

price formation process.

In 2007, South African grain prices in particular, maize - fell to very low levels, and once again, SAFEX was

accused of manipulation. This time the producers complained. Once again, a statutory body (the National

Agricultural Marketing Council) was asked to investigate whether there was indeed price manipulation. The

results mirrored that of the earlier investigation the trend of prices was the same everywhere. However,

grain prices in South Africa were relatively more volatile than those on other markets, primarily due to rainfall

unpredictability and currency volatility. In its recommendations, the Council focussed on improving information

(both market information and information on positions on the exchange), and introducing position limits on large

speculative users of the market.

-Advanced price contract: supporting processorsin the spot purchase of grain at advance payment.

To manage price risk, the forward contract iscovered by a long futures and a put option.

- Fixed price forward purchase contract: to supportthe forward purchase of SAFEX grain commoditiesup to 65% of the total crop; with the financing per-centage determined by the borrowers financial andrisk record, as well as crop estimate reports.

-Average min/max forward purchase contract: thisguarantees a minimum and maximum price over

the contracted period (covered by the bank buyingand selling options); physical delivery of contractedgrain is compulsory.

- Weighted average forward purchase contract:guarantee a minimum price, but the client sharesin the gains if market prices, from his perspective,improve.


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- Minimum forward purchase contract: this guaran-tees a minimum price for the contracted period.Clients have a right, at any time, to fix the price of apart of their covered volume.

-Average call option contract:for processors, permit-ting them to lock in a maximum purchase price whilestill being able to benefit in part from price falls.

Finally, exchanges can make the commodity sector bank-able. In the first place, they do so indirectly, because theirreference prices allow banks to better value commoditiesgiven as collateral, and because banks can be confidentthat they can deliver commodities that they obtain after aclient default to the exchange. However, exchanges canalso directly improve commodity finance, by setting up a

warehouse receipt mechanism or even, by trading com-modity repo contracts. In South Africa, the warehousereceipt system developed by SAFEX has led to bank lendingof equivalent of close to a billion dollars annually. In India,the collateral management companies set up by the twoleading commodity exchanges have enabled equivalent ofbillions of dollarsof new agricultural finance, by banks whopreviously were wary of such lending.

In a liberalized environment, there are few other institu-tional mechanisms that can easily provide these functions.Specialized press agencies could collect price informa-tion and distribute this to subscribers, but this tends to be

expensive, and moreover, price collection is normally noton a continuous basis. Traders associations can providemarket discipline, but this normally only works within arelatively small group. In western countries as well as in

countries like China and India, commodity exchanges havegenerally sprung up because they were the most efficienttools for dealing with the exigencies of a liberalized marketplace.

While there is little exchange experience in Africa yet, ananalysis of ECX indicates that the expected reduction oftransaction costs indeed materialized: The comparison ofavailable data before and after the ECX indicates that trans-action costs have declined in terms of

(i) the average number of intermediaries each trader

used (buying agents, brokers, and selling agents)along with the role of ethnicity and religion,

(ii) average number of people consulted and involvedto make a transaction per market day,

(iii) methods/means of verification employed forsesame quality assurance, and

(iv) time required per transaction.16

Similarly, marketing costs have declined by about 57% ascompared to the situation before the start of the ECX.

Box 4

Exchanges should police commodity trade - an unconventional interpretationExchanges in emerging markets may look for inspiration at what the large exchanges in western countries are

doing. However, they may learn more from what these exchanges used to do when their countries commodity

sectors were less well organized than they are today. The key to success of a commodity exchange is that

it greatly reduces transaction costs for market participants as compared to other mechanisms. History from

western exchanges shows many ways to reach this goal, including unconventional ones.

An example is cotton trade in the USA in the 19th century.* Cotton traders used to face considerable problems

with theft and fraud. For example, cotton graders often took samples that were much larger than what was

required for the grading and sold the excess. Cotton was systematically pilfered from bales. The New Orleans

and New York cotton exchange decided to aggressively tackle these problems. They imposed new regulation

on sampling: samplers had to be exchange-licensed, and the exchange retained the samples; the result was a

90 percent decline in losses from sampling. The exchanges appointed guards, with the power to arrest, to patrolthe wharves and levees where the cotton was shipped; this resulted in a halving of the insurance costs for stored

cotton. The experiences were so successful that smaller exchanges decided to make similar arrangements.

* Based on Stephen Craig Pirrong, The Efficient Scope of Private Transactions-Cost-Reducing Institutions:

The Successes and Failures of Commodity Exchanges, The Journal of Legal Studies, Vol. 24, No. 1, January 1995).


16 Meijerink et al, 2010


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2.3 Boosting trade opportunities

There are large opportunities for agricultural commodi-ties trade in Africa, and most of these opportunities lie innational and regional trade. According to a 2005 estimate17,the value of the market for Africas traditional export com-modities, such as cocoa, coffee and cotton, is projectedto increase from US$8 billion in 2000 to US$10.5 billionin 2030 (in constant dollars). The markets for high-valueexports (e.g., flowers, fruits, vegetables) would increasefrom US$3 billion to US$10 billion. However, the Africanurban market for food was expected to grow from US$50to 150 billion.

The rapid growth of urban demand should be seen in thelight of rapid urbanization of the continent. From 2010 to2025, the population of ten large African cities, such asLagos, Abidjan, Dar es Salaam and Kinshasa, is expectedto grow by more than 50 per cent. In 2025, there willbe 18 cities in Africa with more than 2 million people.Half of Africas fast-growing population will live in cities, upfrom a third now. Africa is already a large net importer offood which is used to feed its cities. It can hard afford tocontinue relying on imports for this purpose, in particularin the light of the trend towards higher global food prices.

Therefore, enabling African farmers to meet the demands ofAfrican cities should be a priority for African governments.Nevertheless, given that agriculture in most countries

is rainfall dependent, markets that are entirely nationalwould be highly volatile. It will be beneficial to have regionalmarkets for grains, other food products as well as certainother crops such as cotton (to supply the clusters of Africantextile companies). This is on the political agenda, and dis-cussions to create regional trade agreements have beengoing on for decades. While implementation has beenslow, the movement is by and large in the right direction.

Commodity exchanges cannot overcome the barrierscreated by government policies, but where such policiespermit, they can provide a backbone for regional trade.

They can then also act as catalyst for the growth of theindustries related to such trade, e.g., transport and otherlogistics services, information services, and even the finan-cial services needed in regional trade (banking, insurance).

Specifically, an exchange will develop a network of ware-houses into which sellers can make delivery18. It will alsodevelop a market information system that allows buyersto know the prices at these delivery points. This makesit possible for buyers to procure commodities evenin places where they have not previously been active(see Box 5). It may even enter into an arrangement with

the export credit agency in its country (if there is one) toguarantee transport of goods from one warehouse whichis not known to or trusted by market participants to onewhich does have a good reputation. As long as there are noregulatory or physical barriers to trade, long-distance trans-actions become possible.

17 NEPAD Secretariat, Agribusiness, Supply Chain, and Quality Control Initiative. CAADP Implementation Concept Note, Midrand 2005.18 It can be noted that in many countries, the warehousing infrastructure exists, but it needs proper management,


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Box 5

Does a commodity exchange solve physical infrastructure constraints?Certain critics of Africas commodity exchange projects allege that they are a waste of money because the basic

infrastructure for commodity trade is so poor that most people will not be able to use the exchange. Development

partners should instead spend their funds on basic infrastructure rural roads, grading systems, warehouses.

This argument fails to recognize the mismatch in funding requirements building an exchange is very cheap

compared to building rural roads and the fact that an exchange helps market participants to overcome physical

market constraints.

This is well illustrated by the founder-CEO of the Ethiopia Commodity Exchange, looking back to the exchanges,

and her, roadmap to success. She narrates her discussions with a trader she knows, Abdu, who is based in a

market town called Nekempt (Eleni Z. Gabre-Madhin, A market for Abdu Creating a commodity exchange in

Ethiopia, International Food Policy Institute, 2012):

I asked if he knew there was a shortage of grain in the country and that prices were rising. A bit impatient,I pressed him further and asked why he didnt think of selling his good maize in the markets of Tigray and

Wollo in the north and Dire Dawa in the east, where prices were high.

He looked at the ground, then looked at me, and said yes, he had thought of it. After a pause, he told

me that a few months earlier, he had done something that no trader in Nekempt had ever done: he went

looking for a new market.. After a lot of asking around, he found the phone number of a buyer and called

to arrange a deal. He told the trader in Mekele that he had good-quality maize, and they agreed on a

price. Then, with great excitement, he loaded up a truck and started the trip of 900 kilometers, crossing

three regional boundaries.

Things started going wrong immediately. He was stopped over and overmore than a dozen times

along the wayat road checkpoints where he paid bribe after bribe. The trip he thought would take three

days took two weeks. When he finally arrived in Mekele, the buyer, to Abdus dismay, claimed that thequality of the maize was poor and that prices had gone down. He was no longer interested in Abdus

maize. Abdu could hardly afford to take the maize back to Nekempt, so he had no choice but to sell at a

terrible loss and return home. He told me his story quietly, a bit angry as he recalled the bribes and the

trader who turned on him. He would never try that idea again, he said.

Her drive to create ECX was largely inspired by her experiences with traders like Abdu. A few years later,

the launch of the exchange was near, and she reflected:

As the start date of operations approached, I asked about my old friend Abdu Awol in Nekempt. I wanted

to invite him to join this new opportunity. I wanted him to know that from now on, he could sell his maize

to anyone in the country simply by depositing it in the ECX warehouse at Nekempt, trade it without a

single bribe or delay, and get paid in full at the agreed price the next day.

Trade is enabled by the creation of an institution the exchange rather than by the building of roads, the

development of a legal system that would protect farmers and traders against the default on commitments by

their counterparties, or a comprehensive anti-corruption programme.



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3. Conditions and constraints forAfrican commodity exchange development

An exchange can be made an island of excellence in anotherwise risky world. As long as the economic rationale isstrong enough, an exchange that is ring-fenced in an effec-tive manner can work even in difficult conditions. The ring-fencing mechanism normally works through contract lawand self-regulation: participants to the exchange sign up tothe conditions of the exchange, and commit themselves toabide by all its rules, including its financial regulations andthe judgments of its arbitration panels.

This suggests that in the African context, an exchange can

be set up even if the environment the way the physicalmarket operates, the legal and regulatory conditions is far from optimal. This is not an opinion shared by allobservers. For example, a recent policy brief argued thata commodity exchange can only assist in developing amarket-oriented agricultural sector where the underlyingspot market for physical commodities functions effectively. Functioning spot markets imply that a commodity itselfis tradable, which requires the existence and adoption ofgrades and standards; credible, enforceable and trad-able contracts; adequate storage facilities; and an openand efficient market environment.19The problem with this

view is that it does not reflect historical experience. Whenthe Chicago Board of Trade (now part of the ChicagoMercantile Exchange group, the worlds largest commodityexchange) was created, and for the first decades of itsexistence, none of these conditions was in place. Also, theMulti Commodity Exchange of India, which started tradingin 2003, became the worlds second largest commodityexchange in less than ten years despite these conditionsbeing largely absent in India.

Of course, an exchanges true potential can be realized onlywhen its environment is improved, and this is something for

which the exchange should actively lobby. It will be in a goodposition to do so once it actually start operating, as manygroups will see that they are actually hurt by inappropriateprevailing policy, legal and regulatory conditions; they willprovide momentum to the process of change. Experienceshows that first trying to create an optimal policy, legal andregulatory environment before moving towards introducingcommodity exchange trade does not work: it takes too longand there is not enough momentum to maintain the course.

However, while a commodity exchange helps improve theconditions of physical trade, it requires certain minimumconditions in order to reach critical mass. These conditionsbroadly fall in the following areas:

- Sufficiently large supply and demand forthe commodity;

- Sufficiently free determination of prices(little likelihood of price manipulation);

- Reasonably well-standardized commodity, andaccepted grades;

- Sufficiently large price fluctuations to warranthedging;

- Reasonably well-functioning spot market;

- Support from commercial interests for thefutures market;

- Sufficiently large group of speculators;

- Sufficiently well-developed infrastructure (grading,storage, etc.); and

- A supportive legal and regulatory framework.

This chapter will look at a number of these conditions inAfrica and draw conclusions from them.

3.1 Physical market structure

(i) The structure of production and trade flows

The total production of agricultural, fuel and mineral com-modities in Africa is huge some three times larger thanthat of India, which supports the worlds second largestcommodity exchange as well as a number of smallerexchanges.

However, the structure of production is complex. Productionin the fuel and mining sectors is often in the hands of multi-national companies, which make their marketing decisionsoutside of Africa and, if they want to manage price risks, caneasily use the established exchanges in the UK and USA.

19 Quinn, 2012


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AFRICAN DEVELOPMENT BA

Documents

2013 BD SpecialReport AfDBGuidebookonAfricanCommoditiesandDerivativesExchanges 28NOVEMBER 2013