So what are container derivatives?


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Time to ditch standard contracts and go hedging instead?


Flexible contracts, rate stability and service performance can all be improved by derivatives. It’s a bold claim, but is it true, asks Andrew Traill.


they thought they needed to. Some carriers don’t want to lose potential revenue if they settle at a rate which turns out to fall below the market during the course of the contract.


So many contracts between shippers and liner shipping carriers are little more than verbal or emailed agreements. They may constitute contracts from a legal perspective, but they give little legal clarity to either party. Even when a more solid contract is negotiated with service conditions included, the moment a shipper signs a bill of lading the contract which went before it has little more value than the paper it was written on - the bill of lading terms and conditions will take precedence unless the shipper has been savvy enough to agree with the carrier an alteration to those conditions. It is understandable therefore that many shippers and carriers have treated contractual obligations with a pinch of salt. They are something which has a degree of flexibility, which they can wriggle out of, sometimes through an adversarial relationship where the shipper threatens the carrier with removal of future business, or the carrier threatens roll-overs. This flexibility can suit both parties if they feel the market conditions could vary in their favour – and let’s face it, these are volatile times. Some shippers don’t like to be held down to specific commitments, just in case it means they end up paying more than the going market rate or paying for more freight than


But the present situation seems to be benefiting nobody in the long run. Carriers’ finances are precarious one moment and amazing the next, only to slump again in the next market cycle. Shippers don’t know what rates they will be paying by the end of the contract, or what type of service they will be getting; there is a strong correlation between low rates and poor service reliability, possibly because there is little incentive for carriers to improve service levels and incur extra costs for doing so. How can this be good for the sustainability of any business? Container freight derivatives look like a potential solution: they can allow the continued flexibility that shippers and carriers have become accustomed to, and yet protect earnings of carriers and transport budgets of shippers; they appear also to remove the disincentives which can result in poorer levels of carrier service. The Shippers’ Voice published a co-authored paper recently focussing on how the container freight derivatives market worked. The Shippers’ Voice called for a debate on the subject, because it seemed there were too many conflicting messages being put around which confused people – myself included.


Confusion generally


leads to people deciding against something, on the basis that it is better to deal with what you know than that which you don’t. I admit, I began as a sceptic on the subject. I now think I have a better understanding and believe


it really can work for many shippers.


I was persuaded by the realisation that you could manage your contracts however you wanted, with whatever flexibility you wanted, but have the certainty of knowing exactly what it would all cost you at the end of the contract. The hedge provided by the derivatives system ensures shippers are compensated for any actual rate increase (inclusive of surcharges)over and above that which they were prepared to pay and budgeted for. True, if the rate in the market falls below what was budgeted for, then the difference is collected instead by the carrier. But the end point is stability, and a carrier no longer needs to see a low paying freight rate as a reason to leave the cargo on the quayside in favour of better paying freight. With their position protected, shippers no longer need to focus on the rates in


contract negotiations with


the carriers – which means the focus can switch to service and performance issues. That’s what I call a result.


All you need is a reliable rate index which matches the movements in the real freight market to calculate what compensation is owed to which party. For all the criticisms levelled at it, the Shanghai Containerised Freight Index appears to do just that for many commodities and trades. Other indexes might also do the same. What is important is ensuring the derivatives market chosen is underwritten to ensure payments are guaranteed. If this sounds appealing, read the paper on The Shippers’ Voice website to find out more:


www.shippersvoice.com


We’re all familiar with the term hedging, as in to ‘hedge one’s bets’ – which the Concise Oxford Dictionary defines as to “avoid committing oneself when faced with a difficult choice”. And many of us will have engaged in hedging activity, when we have taken out a fixed-rate mortgage or savings scheme. Essentially, they allow us to ‘lock’ in’ a specific interest rate, knowing that that is the rate we will be paying (or receiving) whatever happens to the market in the coming months and years.


Derivatives perform much the


same function in markets where prices of goods or services can fluctuate. They are sometimes described as a ‘bet’ on the future level of freight rates; more charitably they can be termed an insurance policy against a surge in rates. They do not mean that the buyer will pay less than they would otherwise – at least, not necessarily - but they do give a guarantee that they will pay no more than a specified amount for the goods or service required. As far as shippers are concerned, container freight derivatives have one purpose – to remove or reduce the uncertainty


How they work: CFSAs... Container Freight Swap


Agreements (CFSAs) In January, a shipper buys a CFSA from a seller for March at $1300 per teu for 100teu.


Options are more like an insurance policy. As the name suggests, they give the buyer the option – but not the obligation – to buy a CFSA at a future time at a price fixed today. They have the advantage that the shipper need not exercise them if it is not in their interests to do so; on the other hand, they pay a premium to take out the option, payable whether it is exercised or not.


... and CFSA options


Using the example above, In January the shipper takes an option to buy a CFSA contract in March at $1300 per teu, paying a premium of $40 per teu. Say, in March, the shipping lines are charging $1400 per teu. So, the shipper exercises the option to buy at only $1300teu. That means the shipper is $60 per teu better off than without the option ($100 saved on the freight rate less $40


to take out the option). On the other hand, if freight rates have dropped in March to only $1250, the shipper would obviously not take out the option and would be $40 worse off, as that is the price of the option taken out but not used. (For a more detailed description how


of container derivatives


work, download the paper at www.shippersvoice.com)


Stability in a volatile world


Derivatives in the container market are still quite a new idea, but they could catch on, especially if current market volatility continues. All derivative contracts need a buyer and a seller, known as the principals. Trade between them


is usually


effected by a broker who will find suitable trading parties and conduct all negotiations between them. Very often, a third party clearing house will be involved – this is seen as an additional safety measure against one of the two principals defaulting. All container freight derivatives are traded on an index, which provides the final spot price on which the agreements are settled. So far, the vast majority of transactions have been settled against the Shanghai Containerised Freight Index, a panel-based index on which 15 carriers and 15 freight forwarders submit prices each week. Other organisations have also hinted that they too may set up their own indexes.


An average of these rates for each route is published every Friday. Freight rates reported include not only the ocean freight rates but also add-ons such as bunker adjustment factors or peak season surcharges.


It is not essential that the index


is an exact match for the freight capacity that is being hedged but it is important that the trend in the index accurately matches that of the real market. While there has been a lot of criticism of derivatives traded on the Shanghai index on the grounds that the index is not an accurate reflection of actual rates, this should not be seen as a problem. However, it is probably important that the freight space being traded has a close correlation with the Shanghai Index – trading transatlantic freight derivatives against it would probably not be successful, for example.


While still a very young market, a number of brokers are beginning to offer services. The broker will probably ask the shipper how many boxes they plan to hedge and on which trades. The number of boxes that should be hedged is a moot point; however, most advice suggest that it is close to the minimum number of boxes that are likely to be shipped, rather than attempting to hedge every box that the shipper might want to move. This is because your actual volumes could drop below the amount you first predicted: if the volumes do drop, you do not want to be hedging on boxes you don’t have, unless you are speculating, of


course. It is usually possible to take out additional contracts at short notice should the number increase. One argument against derivatives is that they ‘encourage speculation’. While it is possible for speculators to operate in this, as in any other traded market (possibly, some already do) that shouldn’t be a reason for shippers not to get involved. Speculator activity may push up the value of the index, but that shouldn’t affect the ‘real’ shipping market, at least not in theory; and remember, it is the trend which matters most, and the spot price at conclusion of the contract: the index should follow any movement in actual rates based on what the panel in Shanghai report, rather than what speculators think. However, it is possible that the hedge (the paper


rate chosen) might be


influenced by forward projections which itself could be influenced by speculators rather than supply- demand and market economics; but, at least you still have stability in knowing what rate you will pay. If you think the forward projections for the index are too high then settle for a lower paper rate if your broker can get one, or choose an option - or don’t hedge.


But, say, in March the shipping


lines are actually charging $1400 per teu. The contract is settled and the seller pays the shipper $100 per teu. It can of course go the other way


of freight rates and surcharges that they will pay in the future. And as most businesspeople will tell you, uncertainty is what they hate most. Crucially, they exist completely separately from the actual freight rates and contracts paid by the shipper to the shipping line.


Derivative contracts are


financial instruments - a ‘paper’ market - not a contract for the actual vessel space. Container Freight Derivatives are available in two forms – Container Freight Swap Agreements and Container Freight Swap Options.


if the market softens: Say, in March, the shipping lines are only charging $1250 per teu. In this case, the shipper pays the seller $50 per teu.


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