The risk management revolution

NZX is home to the fastest growing derivatives market for global dairy ingredients.

New Zealand has one of the world's fastest growing global dairy-based derivatives markets, as Kathryn Jaggard explains.

Global dairy markets are undergoing a revolution, albeit one not heralded in the daily news or talked about over kitchen tables. This revolution is important - and yes, it involves futures and options.

I can almost hear the blinds coming down. To the average person, these financial products are the complicated cousins of our equity markets, often only talked about at parties as protagonists of global financial failures, rather than a core cog in making our capital markets work.

For more than 150 years, derivatives contracts have provided sellers and buyers of agricultural products with a way to manage price risk - which result from demand and supply swings. Derivatives play a key role in creating price predictability.

For decades, most of the products bought at our local supermarkets have been connected to a futures or an options contract - and up until recently dairy has been the glaring omission.

Before 2010 only a small dairy derivatives market operated in the United States, for domestic users to manage their own risk. For those wanting to manage price risk in global dairy ingredients the market was virtually non-existent.

Over the past 10 years global dairy trading has expanded rapidly, creating a new paradigm of swings for our farmers, and the buyers of their products. Farmers' demand for price stability has prompted the launch of several dairy based futures and options risk management products, which are now flourishing.

Today, NZX is home to the fastest growing derivatives market for global dairy ingredients.

NZX launched its global dairy futures and options market back in 2010 with the aim of supporting farmers, producers, and manufacturers to better manage their price risk.

Since then the market has continued to expand its offering, launching whole milk powder futures and options, skim milk powder futures, anhydrous milk fat futures and butter futures. More recently NZX launched a New Zealand dollar liquid milk contract - its aim was to offer a tool specifically for dairy farmers to manage their milk price risk.

NZX celebrated one year since the launch of its NZ milk price futures contract in May. This product has traded the equivalent of more than 45 million kilograms of milk solids (kg/ms) to date - that's equivalent to more than 2 per cent of New Zealand's milk supply.

By comparison, NZX's whole milk powder futures contract, which launched in October 2010, traded the equivalent of 0.4 per cent of the physical market in its first year, and today trades almost 20 per cent of the related physical market.

A mature derivatives market trades a multiple of the volume traded in the related physical market. For example, palm oil derivatives trade approximately five times more than global palm oil production, while cocoa derivatives can trade almost eight times its physical global production.

The early success of the NZ milk price futures contract has contributed to overall growth of NZX's Dairy Derivatives Market, with volume traded up 147 per cent in the six months to 30 June 2017 compared to the same period in the prior year.

The market also reached a new record for open interest (outstanding positions) of more than 62,000 contracts in April 2017.

This followed fresh highs in March when the market experienced its busiest first quarter on record with total volume traded up 130 per cent on Q1 2016. The market then exceeded this in the second quarter of 2017, with total volume traded climbing 179 per cent on Q2 2016.

As thinking around risk management in the dairy industry has moved from "do nothing" to "do something", trading and interest in NZX's risk management tools has grown rapidly.

The number of end-users accessing the market has continued to climb up 67 per cent in 2016, reinforcing the market's global popularity and long-term growth potential.

For New Zealand's dairy industry the ability to offer our local farmers the opportunity to better manage risk and compete with global peers, while creating income predictability is a significant step forward. Creating income certainty means farmers are able to better manage their businesses, plan for the future, and feel increasingly confident when making investment decisions. This helps strengthen our dairy industry, and in turn our broader economy.

While other exchanges aren't quite trading at the same levels as NZX's Dairy Derivatives, several are also experiencing unprecedented activity.

The European Energy Exchange posted another record month in June with dairy volume traded up 106 per cent on the prior period, while the Chicago Mercantile Exchange enjoyed record March 2017 dairy volumes, with open interest levels breaking February records - proving that if dairy has been late to the derivatives party it is now a welcome guest.

Budding markets are now becoming increasingly liquid, exchanges in Europe are investigating the possibility of launching an EU liquid milk contract similar to NZX's, and Australia is also exploring risk management options for its own farmers.

Europe and the United States are now firmly part of the global export market, and New Zealand is subject to more international demand and supply swings than ever before.

And, as the old policy of government intervention to mitigate risk slowly fades in regions such as Europe, volatility will only increase. It is therefore to NZX's advantage that New Zealand is pulling up the blinds on derivatives markets, and leading the charge in global dairy markets.

NZX's success in dairy derivatives is impressive, if not unprecedented. Historically new derivatives contracts have a high failure rate, most never making it to global benchmark status. New Zealand's dairy contracts, with the help of local and global participants, are well on their way.

New Zealand is competing with the largest derivatives exchanges in the world, which have vastly more resources and global reach. Despite this landscape, NZX's Dairy Derivatives Market is outperforming competitors.

To say New Zealand is punching above its weight is an understatement. The development and success of these contracts doesn't just create new global opportunities, it creates fresh opportunities for our local dairy industry, broader economy, and capital markets.

The world is now looking to NZX's Dairy Derivatives Market for price direction, and advice on how to manage their risk - and for our capital markets, this is a revolution.

Kathryn Jaggard is NZX Executive Consultant - Derivatives,