If you deal with steel, the word “hedging” is a magic spell to turn you off. “Thanks, but this is not for us.”
We know because we’ve been in your shoes. Year after year, we were battered by a pricing roller coaster when trading and financing steel. We tried to do something about it but were unable to find practical solutions. So we gave up trying.
Then a simple question came up one day: “Price hedging depends on financial intermediation. Why?”
This got us thinking, and the more we talked to fellow market participants and reflected on their feedback, the more we saw the limitations of finance for steel risk management but also the opportunity to overcome these limitations.
So, if you care about steel and its price swings, please bear with us. The decoupling of risk management from finance opens a world of opportunity where YOU become part of the solution centered on serving YOUR needs.
Is there a problem?
What is the utility of price hedging? Does price volatility pose a problem at all?
When your profit margins are slim, lower-than-planned revenues or higher-than-budgeted costs may turn them negative. In theory, the opposite should also be true, and unexpected losses and profits should offset each other over time.
In competitive markets, however, unexpected profits are less frequent and pronounced than unexpected losses because the competition (not least the cost leaders mentioned below) is there to win your business and grab your market share at every opportunity.
This means that price swings, left to their own devices, don’t offset each other. If this weren’t true, many steelmakers wouldn’t confine themselves to hand-to-mouth purchasing and spot market pricing, depriving their customers of a possibility to buy steel products in advance. Besides, as many of us have learned, success is taken for granted, but failure is not.
On the other side of the spectrum, certain companies make money in almost any market. Hedging may seem irrelevant for them: why bother if you are always profitable? Yet, we believe that even such cost leaders may find it useful—for example, when raising financing for new projects or ensuring pricing under long-term supply agreements with erratic customers or suppliers.
Despite intensive marketing over the last decade, traditional hedging instruments (futures, options, swaps) left the steel community largely indifferent. Some futures contracts were cancelled and some revamped, and some keep going but mostly attract speculators. Why?
We think because the concerns and inconvenience associated with financially intermediated hedging outweigh its benefits:
Traditionally, commodity hedgers have relied on financial intermediaries to develop derivative contracts and their markets, but steel is not a commodity. The diversity of steel products combined with increasing regional idiosyncrasies hinder the development of exchange-traded futures and OTC swaps with customization and liquidity required for steel risk management.
But what if . . .
- there were an instrument that could be closely customized for purchasing and sales across the product range, geographies, and currencies on the one hand
- and be sufficiently standardized for trading on the other?
Price hedging is a company-wide decision that needs support from several departments, but managing financial derivatives is not an easy task, especially for SMEs and companies that have never used them before. For those looking for safety, clearing financial derivatives doesn’t take into account very different risk profiles exhibited by hedgers and speculators.
But what if . . .
- there were a simple paper contract easily understandable across any organization and blending into physical supplies?
- one could find all steel products and raw materials in one place, without migrating from one siloed platform to another?
- one could choose from several post-trade processing options depending on a hedging transaction?
If you’ve never heard of commodity markets’ financialization, there is an elephant in the room that you may ignore at your own risk:
- Commodity derivatives link physical and financial markets.
- In financial markets, hedgers and speculators coexist but have diametrically opposed interests in market volatility. The latter want MORE volatility because it breeds trading opportunities.
- The last two decades have seen an unprecedented surge of speculation in commodity futures, which overtook hedging transactions by a wide margin. Speculators have become a prime source of revenue to many commodity exchanges.
- The more speculators engage in a futures market, the more they influence forward price curves and market volatility, which may have spillover effects on physical prices.
Small wonder then that steel market participants are cautious to use financial derivatives, fearing the loss of control over price formation.
Some financial institutions suggest that increased market volatility is a price to be paid for the availability of hedging instruments. To many of us, this sounds like a prescription to cure a hangover with more alcohol.
But what if . . .
- expectations about future prices (forward curves) could be replaced with reliable physical market indicators?
- there were a gated marketplace for commercial hedgers, insulated from speculative influence of financial markets?
Conventional wisdom says speculators are needed to provide liquidity. We vigorously disagree:
- Before the recent rise of speculation, most users of commodity derivatives were commercial hedgers representing the real economy.
- People needed centralized, physical locations to meet and trade in the past, but this is no longer the case.
- There is not much liquidity to talk about in all steel derivative markets except China, where they are mostly used for speculation.
Before discussing the liquidity question in more detail, let’s consider a significant opportunity that all this means for the steel supply chain.
The conundrum discussed above perpetuates a vicious cycle of low demand and low market liquidity. This has led us to the conclusion that steel risk management should NOT depend on financial derivatives.
Only a decade ago such a statement may have seemed mere lunacy. Now we can take advantage of newly available technologies and business models for a solution and a trading venue firmly centered on the needs of commercial hedgers and nobody else.
Guided by the insights from you, our peers, we went to the white board and reconstructed risk management in our best interests. This crystallized into the following:
- A decentralized steel hedging market disconnected from financial markets and powered by network effects;
- Simple and safe paper contracts that easily convert into or integrate with supply agreements;
- Flexible post-trade processing based on hedgers’ preferences and risk profiles.
Meet SteelHedge—a global risk management platform and ecosystem for steel and steelmaking raw materials. It is already online, and we invite you to try it free.
Why do we believe that a steel hedging market should be decentralized? Because such a market may grow much faster without external shocks that jump-started derivative markets in the past.
If you’ve already tried hedging with steel futures, you may empathize with our experience:
- An exchange or a broker convinces you to try hedging with steel futures;
- You persuade the stakeholders (this takes time!) and come back to the broker with a concrete order;
- The broker tells you there’s not yet enough liquidity in the market.
After this, if you don’t completely lose interest in hedging, chances are you’ll decide to try it again when there’s a safely liquid market. Since your potential counterparties think along similar lines, the feedback loop of low demand and low liquidity keeps feeding itself.
For a centralized market to function, offsetting buying and selling interests must be clearly expressed and meet in the same place at the same time. This is not required for decentralized markets. At SteelHedge, for example, we’ve found a way to make buying and selling interests “float” anonymously until they gravitate to each other following hedgers’ instructions. Think of algorithms that screen the market for hedging opportunities round the clock and culminate in a simple and safe bilateral contract.
Another problem with centralized markets is that sellers and buyers aren’t involved in market development. Every new customer is acquired by the market’s owner independently through a one-on-one marketing and sales process. Liquidity growth is limited by the resources of exchanges, brokers or swap dealers.
Decentralized markets can grow much faster through network effects. If sellers and buyers get financial rewards and other benefits by exposing the market to new participants, the ensuing liquidity may grow exponentially and result in a win-win for all involved.
Making a difference
Hedging without Big Finance may sound like a tall order until you dig into details. Thereafter, many ask: “If it’s so obvious, where have you been before?” The increasing uncertainty in steel markets poses a more important question about after.
Woody Allen once said that “eighty percent of success is showing up,” which holds true especially for peer-to-peer marketplaces, such as SteelHedge.
If you share our vision for a stronger, healthier steel community, contact us to start acting on it.