As demand for iron ore continues to grow and a new pricing system between mining companies and steelmakers comes into effect, the City of London faces huge competition from Asia to position itself as the leading centre for this market.

The financial derivatives market in iron ore has continued to grow rapidly since its creation in 2008. London hopes to position itself as a leading centre for this market which analysts value at anything from $200 billion to $500 billion annually.

After over 40 years of pricing iron ore on annual contracts at a benchmarked price, iron ore producers and steelmakers have abandoned this traditional pricing system and moved towards pricing iron ore on shorter-term contracts based on the spot market. There is an expectation that the expanding swaps market in iron ore will evolve into a market that will rival the liquidity and value of other commodities.

Following in the footsteps of commodities such as crude oil and aluminium, the reform of the pricing system is a result of the ever increasing importance of iron ore in the last decade, over which the steel demands of China and other developing Asian countries soared.

Pricing System

Traditionally, during the lengthy annual negotiations, the price agreed between producers and large steelmakers set a benchmark to be followed by the rest of the industry for one year, effective as of 1 April. Thus, a single price would be negotiated once per year. Many steelmakers, however, did not feel that this process dealt sufficiently with increasing price volatility and in 2009, Asian steelmakers in particular pushed for the first price cuts in seven years.

Despite a reduction in prices of 33 per cent by the three largest iron ore producers, growing price volatility has led to an increase in demand for spot iron cargoes and swaps.

Under the new iron ore pricing system, quarterly contracts will be used in place of annual ones, ,and the cost of iron ore will be set against an average of the spot market level. The swap market allows iron ore producers to lock in volumes and prices based on their requirements, rather than being tied to a benchmark that may not reflect their current demand. The derivative enables steelmakers to hedge the main raw material.

Recently, Rio Tinto (the world’s third largest mining and exploration company of the earth's mineral resources, including aluminium, copper, industrial minerals and iron ore) became the latest company to change to quarterly pricing. This Anglo-Australian company is increasing its production of iron ore after a 39 per cent increase in first quarter output compared with the same period in 2009.

London as a Leading Market

The City of London is currently the world’s largest trading centre for metals, carbon, bullion and currency, and it now hopes to seize the leading position in the iron ore derivatives market. The City will have to repel huge competition from Singapore and Hong Kong to become the world leader in the emerging multi-billion dollar iron ore derivatives market. At present, London accounts for 40 per cent of iron ore derivatives, with Asia accounting for the remaining 60 per cent.

As one of the last remaining commodity markets without a significant financial presence, City of London-based financial institutions will become more engaged in the market, and London may emerge as the leading centre for trading another commodity financially.