The decline in freight rates over the last quarter of 2008 has put a heavy strain on the freight derivatives market. So much so, that some market participants are questioning whether or not the OTC FFA market will survive and, if so, in what form. In this alert we share a few thoughts on the recent events and some of the lessons that can be learned from them.
What are FFAs?
A forward freight agreement (FFA) is a derivative, namely a cash settled contract, the value of which is derived from the value of freight. More specifically FFAs are a form of fixed-floating swap under which one party owes the other the difference between a price determined at the outset (the fixed price) and the price determined at future dates (the floating price) multiplied by a quantity (the notional quantity).
The floating price in this case is the average of the rates published by the Baltic Exchange over a calendar month. In relation to time charters, the prices made available by the Baltic Exchange are the average daily rates recorded in the short term spot market to charter ships of a certain tonnage along certain routes. The notional quantity is a number of days.
At each monthly settlement date, if the floating rate in respect of the preceding month is higher than the applicable fixed rate, then the floating rate payer (referred to as the 'seller') will have to pay the fixed rate payer (the 'buyer') the difference between the two rates multiplied by a specified number of days. The reverse happens if the fixed price is higher than the floating price.
Like most derivatives, FFAs were first used as risk management tools. In other words, as a protection against the fluctuation of freight prices, known as a "hedge." FFAs started to be used as risk management tools in the mid nineties and the hedging rationale became ever more important in the highly volatile markets of the early 2000s. The FFA market grew rapidly with the number of traded "lots" quadrupling between 2004 and 2008.
Such a liquid, yet volatile, derivatives market inevitably attracted new players such as investment banks and hedge funds. In 2003 financial institutions were a party to about 2% of FFA trades by mid 2008 the figure had leapt to 35%. Such players engage predominantly, if not exclusively, in proprietary trading which in essence is the "betting" on the movement of freight prices. Between 2004 and 2008 the ratio of physical freight to FFA volumes went from 2:1 to 1:1.1 meaning that FFAs had grown larger than the "real" physical market and had become a major market in its own right. Proprietary or, as some would say, speculative trading nowadays accounts also for a good part of the FFA trading carried out by more traditional players in the shipping industry who have become increasingly interested in leveraging rather than simply hedging their physical positions.
Some traditional players in the shipping market created subsidiaries exclusively dedicated to FFA trading. Some would be supported by the holding company, others would be provided with tangible assets, typically ships, and made to trade on a stand alone basis. The characteristic of the FFA market participants is an important factor in understanding the impact that the fall in prices had on individual companies and on the market as a whole.
To give a sense of the scale of the problem that a party being "long" (namely with a trading position that would gain from an increase of the rates, for instance being a buyer under an FFA) on FFAs faced in the fourth quarter of 2008, the daily rates to charter the largest ships—known as Capesizes—carrying dry bulk fell from $234,000 per day on June 5 to $2,773 per day on 1st December 2008. This 98.8% decrease represents a correction of almost unprecedented violence.
What effect did the fall of freight prices have on the FFA market?
In order to answer this question a distinction must be drawn between exchange traded and over-the-counter (OTC) FFA markets. We have seen that all FFAs are essentially swap transactions which are, by definition, bilateral contracts. So what is meant by "exchange traded" in the context of FFA and what are the defining features of two such separate markets? Let's take a step back.
All FFA contracts are governed by FFABA namely the terms published by the Forward Freight Agreements Brokers Association. Two versions of FFABA are currently used in the market: the FFABA 2005 and the FFABA 2007 with a prevalence of the latter.
Each FFABA 2007 is deemed to be a transaction under the International Swaps and Derivatives Association Master Agreement version 1992 (ISDA) which is incorporated by reference in the FFABA.
The ISDA is the most widely used standard form of agreement to document derivatives transactions. Each ISDA contract comprises a Master Agreement and a Schedule. The Schedule specifies which of the terms in the Master Agreement apply to the actual contract (e.g. the governing law) and incorporates any further terms that the parties wish to include, be it amendments to the Master Agreement or additional provisions. The advantage of using the ISDA is that the enforceability of its provisions in all major jurisdictions is supported by legal opinions commissioned by the International Swaps and Derivatives Association.
The core provision of ISDA enables a party to terminate and liquidate all outstanding transactions upon the occurrence in respect of the other party of an "Event of Default". Events of Default include the failure by a party to pay and deliver as well as the commencement of an insolvency procedure against the relevant party. Other Events of Default are linked to the determination of the credit worthiness of the party. These are the "credit provisions" referred to below.
FFABAs are designed to perform the function of a very basic ISDA Schedule. In fact, clause 9 of FFABA makes only the barely essential elections such as the governing law and jurisdiction, namely English law and courts.
Every FFA is documented by means of a FFABA. Hence, irrespective of whether OTC or exchange traded, a FFA is a bilateral contract entered into by two parties as principals. Whilst OTC FFAs are privately negotiated by the principals that are ultimately the only parties to it, exchange traded FFAs are entered into via brokers who match sellers and buyers in the market place. The FFAs are then cleared through a clearing house which acts as a central counterparty. Therefore, sellers and buyers both end up having the clearing house as their counterparty. The FFA clearing houses are NOS Clearing (Norway), LCH Clearnet (UK) and SGX (Singapore).
So whilst under an OTC FFA, a party bears the risk of the other party defaulting, under a cleared contract there is, at least in theory, no such risk because the clearing house obtains collateral from buyers and sellers very much like a futures exchange obtains collateral in cash (usually both upfront and variation margin) from anyone holding a futures position. That is probably why cleared FFAs are commonly, and somehow misleadingly, referred to as "futures".
Going back to our original question concerning the effect that falling freight rates have had on the derivatives market, the short answer with regard to cleared FFAs is that clearing houses have been able to absorb such massive price movements. In fact, none of them has been brought down by cumulative individual defaults. That is not to say that the market as a whole has not suffered hugely. One clearing house reported a 50% fall in traded volumes between October and November 2008.
As for the OTC FFA market, the picture looks considerably worse. A number of significant defaults by individual participants has caused the OTC FFA market virtually to disappear. In order fully to appreciate the nature and extent of the problem one must consider the characteristics of the players in the OTC FFA market. Often, a buyer under a FFA is the seller in an equivalent transaction and, crucially, many specialized FFA traders rely heavily on incoming FFA cash flows to finance their FFA obligations. Consequently, a payment default by one market participant can easily cause a chain of defaults which undermines market confidence bringing trading to a virtual standstill. This is what has happened in recent months.
The flaws of the OTC market
Why is the systemic risk we just described an issue particularly in the OTC FFA market and not, for instance, in other OTC derivatives markets for other asset classes that have also been hugely volatile in the recent months?
Firstly, the sheer scale of the fall of prices is totally unprecedented. Even for the FFA market which is used to high volatility – price movements of more than 400% over a six month period are not uncommon—a downward correction of about 1000% between the second and third quarter of 2008 has been exceptional and may well have caught most off guard.
Secondly, and perhaps more importantly, in the OTC FFA market participants would typically trade with each other on "open credit" terms; that is to say without taking any form of protection from the counterparty not performing its obligations.
We described OTC derivatives as contracts negotiated and executed bilaterally. As with most OTC commodities derivatives, the great majority of FFAs are entered into orally by agreeing the commercial terms of the transaction. In the case of FFAs such conversation is usually held between the respective party and the broker. After a trade is agreed, the broker sends to the parties a summary of the terms of the transaction (so called trade recap) referencing the standard FFABA terms and, depending on the individual broker, also a FFABA agreement complete with the commercial terms of the transaction, the names of the parties and occasionally some "house" elections under clause 9 (most typically the exclusion of automatic early termination from the FFABA 2007). The FFABA sent by the broker to confirm the trade would typically not include credit provisions tailored on the parties.
Forget about OTC FFAs?
In their current form? Probably. The recent turmoil in the FFA OTC market has exposed inadequacies in the model and documentation widely used by the market. A standard framework of provisions was adopted as the main basis contracts without being customised to suit counterparty risk.
It is actually difficult to tell if the OTC FFA market will at all survive to any significant extent. Well before the recent crisis there had been a shift from the OTC market to the cleared market. If in October 2007 the OTC market accounted for two thirds of the dry bulk freight volumes by September 2008 the ratio was reversed. In November 2008, the OTC volumes were less than one sixth of the overall FFA volumes. So even disregarding the recent crisis it appears that the OTC market as we know it was becoming marginal. In perspective, it has certainly served the purpose of getting the FFA market started in the first place by bringing to the table the traditional players of the physical shipping markets. The simplicity of the FFABA contracts was certainly instrumental in persuading those otherwise unfamiliar with derivatives.
Does this mean that one should forget about OTC FFAs altogether?
Probably not. There is a case for OTC FFA trading for as long as there are people out there who are unwilling to pay a commission fee to the clearing houses, to post margin to them and who, at the same time, are prepared to address counterparty risk in the relevant OTC contract. Such contract could alternatively be a fully fledged ISDA or a tailored FFABA 2007.
One can trade all sorts of derivatives under an ISDA. But it takes a relatively long time to agree one. So is it worthwhile for the occasional player in the FFA market to trade under ISDA? Probably not. The traditional participants in the shipping market seek a simple model exclusively for their FFA trading and FFABA provides that. Much can be achieved by including a minimum amount of credit provisions in the FFABA by means of making simple but necessary elections in it.
Counterparty risk can be mitigated or eliminated for instance by means of guarantees being provided by a third party, typically a parent company.
By simply including a reference in the FFABA to any such guarantee or its provider one can rely on the Credit Support Default provisions of the standard 1992 ISDA Master Agreement.
By specifying a counterparty's affiliates for the purpose of the "Default Under Specified Transaction" clause one can "import" into the FFABA contract a default by any such affiliate under a different contract so that such default also constitutes a default under the FFABA, thus enabling the innocent party to terminate the FFABA contract upon a breach by a counterparty's affiliates.
The inclusion of a set-off provision enables parties to net exposures under FFAs and physical contracts, such as charterparties. Further protection can also be achieved through a separate multilateral agreement providing for the netting of exposures across affiliates.
One may ask why bother going through the difficulties of tailoring a FFABA if a similar result, namely the elimination of counterparty risk, can be achieved by clearing?
Firstly, the security the clearing house provides comes at a price.
Secondly, because the "peace of mind" the clearing house offers is a relative one. In fact if, on the one hand, no FFA clearing house has yet defaulted, it cannot be ruled out that it eventually could happen. In 2004 a sharp increase in market rates caused a market player not to post the variation margin to a clearing house. On that occasion, the clearing house averted disaster by covering the cash calls owing to other members with its own funds.
One is left to wonder if that would necessarily be the outcome if, for instance, one of the big financial players with a commensurately significant FFA position were suddenly to default. Incidentally, none of the financial institutions that recently collapsed was involved, at least significantly, in the FFA market. So their demise has not really affected the FFA cleared market and therefore tested it.
Thirdly, exchange traded FFAs has the inherent flaw of every cleared market. By essentially allowing parties to trade "blind" – namely not knowing who is ultimately on the "other side" of the trade – they can end up causing bigger problems than those they are supposed to solve.
It is not uncommon to receive enquiries from clients who find themselves in the following scenario. A cleared FFA trade has been entered into (or has it?) and the client has received the confirmation for it by the broker. Subsequently, the broker informs the client that the trade has not been registered by the clearing house. After enquiries with the clearing house, perhaps via client's clearing broker, it is confirmed that the trade had not been registered because the counterparty or its clearing broker was not meeting its margin requirements with the clearing house. The bottom line being that, well after the trade was logged into client's system, our client does not know if it has a "good trade" and, if not, whether it has any recourse against the brokers, the clearing house or indeed anyone else.
The recent collapse in the price of freight has proved to be a major test for the FFA OTC market and has exposed certain inadequacies and areas for an improvement. As a result, in the future it is likely that participants will adopt a more structured approach to trading using some of the concepts outlined above to mitigate risk.
The alternative to OTC—namely cleared trading—comes at a cost and still involves a theoretical risk in an extreme scenario.
Cleared trading also poses problems of certainty and timing of trade execution. Such problems can and must be addressed when setting up the relationship with the brokers and the clearing house.
Further, the suitability of the clearing house itself must be assessed in a wider perspective. Not only is it necessary to understand the rules and internal mechanisms of the clearing house but one must also look at a wider legal framework in which it operates, for instance local bankruptcy law. Let us not forget that the clearing house is effectively the central counterparty and, as all undertakings, it can become insolvent.