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: “Risk management 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.

Definitions

First, let’s agree on the definition of “hedging” because it means different things to different people. This is not surprising given the variety of financial instruments offered for the task. Such misnomers as “hedge funds” only adds confusion.

We define price hedging as profit management. No hedging means that earnings are fully exposed to market forces outside one’s control. Hedging means that earnings are controlled by the business to some extent.

In material-intensive industries, such as steel, earnings depend on fluctuations of sale prices and the cost of raw materials. Hedging aims to minimize the effects of these fluctuations on the bottom line. Some people say they hedge by buying when the market is down and selling when the market is up. In reality, they speculate because nobody can consistently predict market gyrations. Hopes or expectations for the “down” or “up” market may never materialize.

If your company is exposed to international business, it is probably already engaged in hedging. Just ask your treasurer about reducing foreign exchange risk.

Now let’s debunk price hedging without the gung ho you’d usually hear from Big Finance.

Is there a problem?

What is the utility of price risk management? Does market 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. Too often success is taken for granted, but failure is not.

On the other side of the spectrum, some companies are profitable throughout the business cycle. Why bother with managing price risk? Even for the cost leaders, it helps stabilize earnings and stock performance, raise financing for new projects and ensure pricing under long-term supply agreements, among other things.

Existing solutions

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:

 

Standardization

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 customized across the product range, geographies, and currencies on the one hand
  • and be sufficiently standardized for trading on the other?

 

Inconvenience

Risk management is a company-wide decision that needs support from several departments, but trading financial derivatives is not an easy task, especially for SMEs and companies that have never used them before. As their clearing becomes more mandatory, it 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?

 

Financialization

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 with 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 speculative trading in commodity futures, which overtook hedging transactions by a wide margin. Financial investors have become a prime source of revenue to many commodity exchanges.
  • Many academic studies have demonstrated how excessive speculation distorts commodity markets and exacerbates their volatility, transmitting financial markets’ dynamics to prices and inventories, and misleading economic decisions.

Some financial institutions suggest that increased market volatility is a price to be paid for the availability of hedging instruments. This sounds like a prescription to cure a hangover with more alcohol.

Small wonder then that many market participants resist financial derivatives, fearing the loss of control over steel pricing.

But what if . . .

  • price expectations (forward curves) could be replaced with reliable physical market indicators?
  • there were a gated marketplace for commercial hedging, insulated from speculative influence of financial markets?

 

To grow derivative trading in more commodity markets, financial interests repeat the mantra that speculators are needed for 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 further, let’s consider a significant opportunity that all this means for the steel value chain.

Reframing

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 intermediation.

Only a few years 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 B2B commercial hedging market spanning the entire value chain, decentralized and powered by network effects;
  • Simple and safe paper contracts that easily 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.

Liquidity

Why do we believe that a steel hedging market should remain decentralized? In addition to the price formation argument, such a market may grow faster without external shocks that jump-started commodity derivative markets in the past.

If you’ve already tried steel hedging with futures, you may empathize with our experience:

  • An exchange or a broker convinces you to give it a try;
  • 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 risk management, 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

Risk management is part of a broader topic of steel market organization and pricing, which are shaped now for next decades.

Will our market remain decentralized and driven by commercial transactions, or become centralized to follow derivative trading?

In any case, financial intermediation is no longer needed for risk management. Ending its dependence on finance may sound like a tall order until you dig into details. Thereafter, some ask: “If it’s so obvious, where have you been before?” The ongoing developments pose a more important question about after.

Woody Allen once said that “eighty percent of success is showing up,” which holds true especially for B2B marketplaces, such as SteelHedge. A small action today can make a big difference for many years to come.

If you share a vision for a forward-looking and sustainable steel, order a demo to start acting on it.

Ruslan Kharlamov      Carlo Gorini 

SteelHedge Founders

 

Interested in a bigger picture?

Read this report on the financialization of commodity markets. Join the discussion on LinkedIn.

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