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NZX milestone 200k of dairy derivative trades shows it's on track to be 'global dairy hub'

17 Mar 2015

NZX says reaching 200,000 dairy derivative contracts traded across its platform shows the market operator is on track to become the global hub for trading tied to New Zealand's biggest export commodity.

Trading exceeded the trading milestone this month on the NZX Global Dairy Derivatives Market, which was launched in October 2010 to offer risk management for the dairy industry. It followed the establishment of Fonterra Cooperative Group's online auction platform GlobalDairyTrade in July 2008.

The market started with whole milk powder futures and has since added skim milk powder, anhydrous milk fat and butter futures, and whole milk powder options. Trading so far this year is almost triple the volume of the same period in 2014.

"The 200,000 mark is really an example of how the market is growing exponentially," said Kathryn Jaggard, head of derivatives at NZX. "The contracts are on the way to becoming benchmark futures and options contracts on a global scale."

NZX has been developing new products that give investors exposure to New Zealand's agricultural commodities, which are under-represented among companies listed on the bourse relative to their size in the economy. It is aiming to become the dairy hub for financial markets in the same way that the Chicago is the hub for corn, London is for coffee, cocoa and sugar and Malaysia is for palm oil.

Jaggard says New Zealand is already the leader in global dairy derivatives. The Chicago Mercantile Exchange delisted its global skim milk powder contract, although it still offers a US dairy contract. London's Liffe never gained traction with a contract launched in 2010, and its Euronext offshoot has suspended its European skim milk powder contract, although it may reinstate the contract to coincide with the expiry of European milk quotas next month. Germany's Eurex trades only a fraction of the volume of New Zealand.

"In the context of the launch of derivatives markets, you might see one in 30 contracts succeed that are launched globally," said Jaggard, who has worked in derivatives markets for 16 years, including 10 in the London futures exchange. "This is an extremely challenging exercise to be involved in. Launching the contracts is easy, getting liquidity in them is the difficult part."

"When they become liquid, they have a longevity of decades and that really creates the home for that financial contract," she said. "Once you get liquidity in these contracts, that's their home for a very, very long time."

Jaggard says increased volatility in the global dairy prices and a lack of long-dated contracts in recent years has helped stoke demand for its derivatives.

"The dairy industry globally has never had a risk management tool to manage that volatility," she said. "A whole lot of dairy industry participants say there's a massive amount of volatility and I have no risk management tool so there was a huge amount of demand for it and there are participants in the dairy industry who were prepared to come in and provide liquidity."

For the past six months, NZX has traded 500 to 1,000 lots a day in the dairy derivatives market, a level considered viable and enough to support an options contract.

It had a record day on March 9, trading 3,200 contracts including 1,600 options. That was the day before New Zealand government officials said police had been investigating threats to contaminate infant formula and related dairy products with the pest-killing poison 1080.

NZX said it wasn't aware of any link between trading volatility and the announcement. Still, as part of its routine surveillance processes, trading ahead of price sensitive announcements would be assessed in detail.

For NZX, once a derivative market becomes established with good liquidity, they are very high revenue, low marginal cost businesses, generating significant upside over sustained periods, chief executive Tim Bennett said in announcing the company's annual profit last month. "While development takes time, the long-term payback far exceeds the initial investment," he said.

Revenue from dairy derivatives more than doubled to $254,000 in 2014, from $109,000 in 2013, however it represents less than 1 percent of NZX's $65.2 million total annual revenue.

The New Zealand market is still dwarfed by established derivatives markets such as Malaysia's palm oil contract, which has been running for about 20 years and trades between 15,000 to 20,000 lots a day.

Trading in established futures markets is often four to six times the related physical market. NZX dairy derivatives trading currently represent only around 5 percent of the underlying market.

While there has been some demand for NZX to launch derivatives markets for other agricultural commodities including red meat, wool and forestry, the conditions aren't yet ready to support the launch of such contracts, Jaggard says.

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