Commodity market

Trading of commodities consists of direct physical trading and derivatives trading. Commodities include a range of diverse products. More recently there has been growing sophistication of commodities investments with the introduction of new “exotic” products such as weather derivatives, telecommunications bandwidth, gas and power derivatives and environmental emissions trading. Other products that are traded on commodity markets include foreign currencies and financial instruments and indexes.

OTC derivatives trading

The notional value outstanding of OTC commodities’ derivatives contracts fell 3% in the six months to June 2010 to $2.9 trillion, extending the fall from the previous two years. Precious metals accounted for 19% of the value outstanding at the end of 2010, down from 41% a decade earlier as trading in energy derivatives rose. A large proportion of trading in precious metals takes place on the OTC market in London. The average daily volume of gold and silver cleared at the London Bullion Market Association (LBMA) in December 2010 was 18.0 million ounces (worth $25.0bn) and 99.7 million ounces ($2.9bn) respectively. This means that an amount equal to the annual gold mine production was cleared at the LBMA every 4.4 days, and to the annual silver production every 7.5 days. London is also a leading centre for energy brokers operating in energy and carbon markets.

Exchange-traded commodities

The value of commodities trading on exchanges increased by around a fifth in 2010 to over 2,500 million contracts. Trading on exchanges in China and India has gained in importance in recent years due to their emergence as significant commodities consumers and producers. China accounted for more than 60% of exchange-traded commodities in 2009, up on its 40% share in the previous year. The outstanding value of funds invested in commodity markets through indices, medium term notes and exchange traded products (ETPs) totalled $310bn at the end of 2010, up from $215bn at the end of 2009 and $113bn in 2008. The increase in value was primarily triggered by strong inflows into precious metals backed ETPs.

OTC commodities markets

• Physical trading

OTC commodities markets are essentially wholesale markets in which individually-tailored contracts are traded. The most popular physical commodities contracts can be broken down into: metals, energy, grains and soy, livestock, food and fibre and exotic commodities. A large proportion of OTC commodities’ trading is transacted between producers, refiners and wholesalers on the spot market. Trading is delivery based and typically done through intermediaries. For most commodities that are physically traded there is no market in a central meeting place and where it exists it typically handles only a small part of the total trade.

• Derivatives trading

The notional value outstanding of banks’ OTC commodities’ derivatives contracts fell 3% in the six months to June 2010 to $2.9 trillion (Chart 5). This was down two-thirds on the value outstanding three years earlier as investors reduced risk following a five-fold increase in value outstanding in the previous three years. Commodities’ share of the overall notional value outstanding of OTC derivatives fell during this period from around 2.0% to 0.5% as investors retreated from this market due to uncertain global economic conditions. Precious metals accounted for 19% of the total in 2010, down from their 41% share a decade earlier as trading in energy derivatives rose. The vast majority of OTC derivatives trading is in interest rate contracts and foreign exchange contracts.

Exchange traded commodities

Exchange trading provides a central regulated market in which large numbers of buyers and sellers can come together to deal in a competitive, transparent and open environment. Derivatives exchanges are more standardised in terms of contract sizes, maturity dates and margin requirements than OTC markets and tend to dominate trading of ‘soft commodities’. The vast majority of trading on commodity exchanges is in derivatives.

Largest commodity exchanges

Worldwide, there are around 50 major commodity exchanges that trade in more than 90 commodities. ‘Soft commodities’ are traded around the world and dominate exchange trading in Asia and Latin America. Metals are predominantly traded in London, New York, Chicago and Shanghai. Energy contracts are mainly traded in New York, London, Tokyo and the Middle East. More recently a number of energy exchanges have emerged in several European countries.

Bullion Markets

TheCityUK estimates that the market value of above-ground gold stocks totalled around $7.6 trillion at the end of 2010 with turnover of $25.1trillion during the year . The value of turnover increased by over a quarter in 2010, and nearly doubled on the value of turnover three years earlier. Around two-thirds of gold trading was conducted on OTC markets, and the remainder on exchanges.

The value of above-ground stocks and estimated turnover of the silver market totalled $22bn and $3.2 trillion respectively. The value of nearmarket silver or silver that is easily available from above ground stocks (in bullion form or scrap) is however much higher. The value of silver turnover increased by 57% in 2010. Around 40% of silver trading was conducted on OTC markets, and the remainder on exchanges. Although the value of above ground gold and silver is relatively small compared to the global equity and bond market, the gold and silver markets have a much higher turnover as a proportion of market value. It should be noted however that estimates in Charts 11 and 12 of the volume of gold and silver trading are conservative as they do not include all exchange-traded volumes or OTC trading that is cleared outside of London.

OTC trading

Most trading in gold and silver is conducted on the OTC market. Because the minimum lot size of trading is typically high, the OTC market is dominated by institutional investors and gold market professionals. The OTC market trades 24 hours per day and has no formal structure and no central meeting place. Business is mainly conducted by telephone or through electronic dealing systems. The global centre for such trading is London. Other large OTC markets include New York, Zurich, Tokyo, Sydney and Hong Kong. Some OTC business in kilogram and smaller bars for jewellery manufacture and personal investment is conducted in several other cities in Asia and the Middle East. Although the physical market for gold and silver is distributed globally most wholesale trades are cleared through London.

Trading on exchanges

Gold and silver can be traded on exchanges in the form of futures and options, and gold and silver backed securities:

• Futures and options trading of gold and silver has gained in importance in recent years.

Turnover of gold increased more than 60% in 2010 to a record $8.2 trillion. This was partly due to the increase in the price of gold during the year. The value of silver traded on exchanges nearly doubled in 2010 to $1.9 trillion. The main commodity exchanges for gold and silver are Comex in New York, Tocom in Tokyo and more recently MCX in India. Gold can also be traded on other commodity exchanges including the Chicago Board of Trade, Istanbul Gold Exchange, Chinese Gold and Silver Exchange Society, the Shanghai Gold Exchange and Dubai Commodity Exchange. Only a small percentage of the futures market turnover ever comes to physical delivery of the gold or silver represented by the contracts traded.

• Gold and silver backed securities

Precious metals trading in the form of securities on exchanges is based on fixed delivery dates and transaction sizes. These forms of securitised investments include for example Exchange Traded Funds or Exchange Traded Commodities (ETFs or ETCs) and Exchange Traded Notes. ETFs, which represent equity market securities that follow physical commodity returns, account for around 70% of such trading. The value of ETFs for both silver and gold trading have increased strongly in recent years. These securities have had a major impact on the market, representing over 10% of total demand in 2010. Gold ETFs holdings totalled over 60m ounces at the end of 2010. Total silver ETF holdings ended 2010 close to their peak at around 500m ounces.

Types of commodities investments

Commodities can be used to diversify a portfolio of financial assets. In recent years there has been increased investment in commodities, not only by institutional investors, but also by hedge funds, retail investors and sovereign wealth funds. Factors that have contributed to this include: the significant rise in prices of many commodities; their function as a hedge against inflation; economic uncertainty in global markets; underinvestment in commodities production in the past two decades; rising demand particularly in emerging markets such as China and India; and diversification benefits.

The development of investment products that passively track a broad range of commodities have also made it easier for investors to access this market. Investors can gain exposure to commodities through: direct investments in physical commodities; direct investments in commodity-related companies and investments in commodity futures through exchange traded standardised contracts. Exchange traded products in particular have transformed the range of investment choices available in commodity markets. They are relatively young compared with other commodities’ investment instruments. The first developed, the Gold ETC, was launched in 2003.

One of the simplest ways of investing in commodities is through indexed commodity strategies. These offer access to a basket of commodities which reduces the risk of investing as commodities themselves have low correlations.

There are a number of commodity indices such as the

• Goldman Sachs Commodities Index (GSCI),
• Dow Jones AIG commodity index,
• Deutsche Bank Liquid Commodity Index (DBLCI),
• DBLCI-Mean Reversion Index,
• Standard & Poor’s commodity index (SPCI) and
• Reuters/Jefferies CRB Index.

Another way of investing in commodity indexes is to invest in tilted indices, towards a certain commodity or groups of commodities. The GSCI has six sub-indices.