CHINA'S steel mills may be left behind in the booming iron ore swaps market that already has an annualised value of $US8 billion ($9.1bn).
Having been established less than 19 months ago, the market is expected to grow exponentially since the collapse of the decades-old contract system and some predict it to reach between $US150bn and $US200bn by 2015.
But although China's small steel mills and traders have been responsible for the early success of the market through offshore companies, there are major hurdles expected for the world's largest consumer of resources.
Principal among these is a deep-seated distaste among powerful sections of the country's government towards derivatives and hedging.
China's state-owned Assets Supervision and Administration Commission, the nominal owner of the country's 130 biggest government-owned companies, threatened last year to renege on oil derivatives bought by several major state-owned enterprises.
These included a number of airlines, the state sheeting home blame to the banks that sold them.
China has strict government rules regarding derivatives for the state-run enterprises that still dominate all the key sectors of the economy, including steelmaking.
The threat to walk away from oil hedging losses followed a crackdown by Chinese authorities last year on companies buying derivatives, and the introduction of quarterly reporting for SOEs on their derivatives exposure.
China's official stance is to blame large investment banks for causing the global financial crisis.
The swaps market gained prominence a fortnight ago by way of a landmark deal with Japanese conglomerate Mitsui, one of many companies from Japan, as well as South Korea, that are lining up to hedge their iron ore exposure.
"The Mitsui deal is significant as we believe it will be the first of a number of non-China Asian players that will become involved in the swap market," London-based Credit Suisse Hedge Funds director Kamal Naqvi says.
Steel mills have long been keen on annual contracts, also known as benchmark pricing, because it gave them 12-month certainty over the largest input by value into their products.
But the collapse of contract pricing has removed that certainty, flinging open the door for hedging strategies and products.
"A sustainable commodities paper market must reflect the reality of the physical market," Naqvi says.
"Ever since the big three changed their pricing structure, we have seen a significant rise in interest, especially from non-China Asia.
"Europe is also watching the development of the market," he says.
Credit Suisse and Deutsche Bank started a market that began officially in April last year.
"It has been a fast ramp up -- it's arguably the most successful launch of a commodities paper market in 20 years," Naqvi says.
There are more than 100 counterparties with contracts worth $US300 million already signed and there is a strong pipeline of deals with producers, mills and traders, many putting on experimental trades this quarter.
"Parties that have bought swaps so far include freight traders, physical traders and small Chinese steel companies with trading subsidiaries outside China," Naqvi says.
Miners, steel consumers and financial investors are expected to enter the increasingly liquid market. It is understood that BHP Billiton, which has led the charge over the past five years for a change in the annual pricing system, has also been a driving force behind the market's development.
It sees it as a way of offering more price stability despite the fluid nature of short-term contracts based on spot market prices that dominate the iron ore market.
Naqvi says it is generally assumed bilateral over-the-counter trade is about the same volume as swaps cleared through the Singapore Exchange.
SGX cleared swaps trades on 2.4 million tonnes of iron ore last month, an annual run rate of almost 30 million tonnes.
It has cleared 9 million tonnes for the year so far and 15 million tonnes since May last year.
Naqvi says Credit Suisse saw current annualised swaps volume of almost 60 million tonnes a year.
Given the seaborne market for iron ore is about 1 million tonnes a year, the swaps market could equal physical volume by 2015 at between $US150bn and $US200bn.
The emergence of the iron ore swaps market follows the rapid ramp up of three global steel futures market that began in Dubai in October 2007 and was quickly taken up by the London, New York and Singapore exchanges.
More recently, Shanghai Futures Exchanges joined the fray. Naqvi says the dramatic success of Shanghai has demonstrated the latent demand for tradable ferrous futures.
Other banks are joining the iron ore hedging game, including Morgan Stanley and Macquarie.
Leading brokers are Freight Investor Services and DBS Vickers.
Still, despite the impediments to China's state-owned steel mills using iron ore hedging, they are expected to become involved through necessity and the need to compete for global customers.
"We do expect the Chinese steel industry eventually to become involved in the swaps market, as a number are already in hedging LME metals," Naqvi says. "For example, if the market corrects savagely as we saw in 2008, we could expect to see interest in locking in a fixed price by using the swap market for a multi-year hedge."
Source: The Australian