Derivative Developments

Suzanne Starbuck of Merlin Corporate Communications charts the development of Forward Freight Agreements (FFAs) in the shipping industry over the last decade and asks if they have a role to play in the future.

SINCE their launch in 1992, Forward Freight Agreements (FFAs) have grown in popularity. According to Clarkson Securities, there are now in excess of 150 players in the market with more than 3,000 deals taking place each year. Some sources say that the FFA market grew by as much as 25 per cent between 1995 and 2000 alone. But, what exactly is an FFA and does it have a future?

In simple terms, an FFA is a contract of difference between two parties – the buyer and the seller. The buyer contracts with the seller at an agreed price for a forward date on a particular route. When that date arrives, final payment is based on the difference between the agreed FFA price and the actual price on that day, normally as set by the Baltic Exchange Index.

It may sound a little risky but, given the inherent volatility of freight rates, FFAs are a useful risk management tool enabling companies to hedge their transactions as opposed to relying solely on the market. And, according to Ian Bland, director of Clarkson Securities, the benefits don’t stop there. “FFAs enable you to deal with a single cargo filling a gap not commonly available on the physical market. They are also simpler to trade than the physical market with most FFAs being completed in minutes not days,“ he says.

They can also be tailored to meet individual needs, are completely flexible in terms of the route, size and time period, and are purely financial transactions so involve no delivery of cargo or ships. But is it all really as simple as it sounds and are there any pitfalls to be aware of?

The collapse of Enron last year sent shivers through the shipping industry. Some shipbrokers estimated that Enron had been involved in as much as 30 per cent of paper trades in the capesize bulk market and about 20 per cent in the panamax market. With its own derivatives trading site and as a trader of freight futures with shipping companies, it was feared that Enron’s demise would severely dent confidence in the derivatives sector as a whole. “In reality, Enron actually had much less involvement in the shipping industry than the publicity  led us to believe. Its collapse posed no threat to either the FFA or physical market and the volume of FFA trade has increased since,“ says Bland.

What Enron’s spectacular fall from grace did highlight was the need for counterparty security. Shipping may be a small business where everyone appears to know everyone else but where do you stand when a counterparty defaults? Under normal circumstances, FFAs do not require deposits or any other financial instrument to back up the contract. If, however, a counterparty is found to be unsuitable, it may be necessary to establish a bank guarantee or letter of credit.

Shipping companies have, to date, tried to limit their trades to counterparties they are comfortable with and know well. But all that may change if the FFA market becomes a cleared market thereby making it far more accessible and allowing other players in the door. “FFAs are already attracting a lot of people and not just shipping companies,“ points out Wilhelm Holst of Norway-based Platou shipbrokers. “If the market is widened and players are dealing with people they don’t know, they will need the comfort of knowing it is a cleared market, eliminating counterparty security risk,“ adds Bland.

This elimination of counter-party security risk is one of the greatest advantages offered by the Oslo-based International Maritime Exchange, otherwise known as Imarex. Founded in early 2000, Imarex is a fully-regulated professional freight derivatives exchange for the global maritime industry. Initially launched in November 2001, aimed primarily at the tanker market, Imarex recently made its first forays into the dry bulk market.

When it comes to counter-party security, Imarex has addressed the issue by providing a central clearing service. The Norwegian Futures and Options Clearing House, which already covers financial derivatives on the Oslo Stock Exchange, acts as the counterparty to transactions completed on Imarex. Handling of transactions and funds relating to the clearing is carried out by Norway’s largest commercial bank, DnB.

And things seem to be going well. “On the tanker side, we have about 25 accounts including some of the world’s biggest oil companies. Even the dry cargo side has as many as 13 accounts already and we will be working to expand on this over the coming months,“ says Tom Even Mortensen, managing director of Imarex. Other potential areas of expansion include bunkers, second-hand tonnage and maybe even containers. Imarex also received a recent boost when BP Shipping announced its participation in the exchange as an active trader and shareholder. “Having BP Shipping on the exchange is an important step in expanding the central marketplace for trading of freight derivatives,“ says Mortensen.

It’s a somewhat different story, however, at the Baltic Exchange. The Baltic’s own electronic platform,, was launched in August 2001, providing users with electronic access to the exchange’s freight market information, which is published daily. Forming a key component of the electronic platform is the online facility for the trading of FFAs, launched in April this year. Recent months have seen the Baltic Exchange busy refining its FFA facility, with the help of the Forward Freight Agreement Brokers’ Association (FFABA), a lobby group representing the world’s major FFA brokers.

But, due to the lack of demand for on-line trading, the Baltic has recently announced that its FFA trading facility has been ‘mothballed’ until further notice. “On-line FFA trading is still an emerging market and with just a few players it will take some time to really come alive,” says the Baltic Exchange.

A Freight Market and Futures Consultative Group, which is due to meet for the first time in October, has been formed to enable the industry to discuss issues such as allowing principals to enter their own prices on the Baltic FFA trading system.

Despite the temporary suspension of the Baltic’s FFA trading facility, the high volatility of freight rates in the shipping industry is still proving particularly attractive to non-shipping players looking to get involved in the shipping markets without physically exposing themselves to the assets. The anonymity and flexibility offered by FFAs could, therefore, boost their use even further.

But, it’s still early days for FFAs in the shipping industry. According to Mortensen, there is a natural scepticism in the market so it is going to take some time. “But I’ve yet to meet anyone who doesn’t think this market can move forward,“ he adds. According to Bland, FFAs have grown from nothing into a highly viable choice and the growth looks set to continue. But in which direction this growth takes place is anyone’s guess. “There is no authority dictating how the FFA market will evolve so no one knows which way it will go. The market is directed by the consensus of its participants acting independently. Dictating the realistic dreams of such a disparate flock is beyond the scope of either the broking fraternity, an exchange, or even a group of principals to foretell,“ he says.

There does, however, appear to be sufficient scope for future growth. “There are currently 38 routes in the FFA market but new ones are coming on all the time as others disappear. Routes which two years ago were the bread and butter of the market are now marginalised,“ he adds.

Holst, who is also a board member of Imarex, is equally confident that the use of FFAs will continue to grow but warns that it’s not going to happen overnight. “Shipping is a conservative business so it’s still a matter of time.”

Traditionally wary of anything ‘newfangled’, the shipping industry has been somewhat slow on the uptake when it comes to FFAs. Players in the market, however, remain confident that FFAs have a role to play in the future but to what extent that role is and for how long remains to be seen.

ITIC can insure its Members for FFA broking, however, Members must first advise the Club. If you are insured as a shipbroker do not assume that FFA broking is included. It will need to be added as an additional insured service.

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