Risk Management with Freight Futures

Market Background

Container freight futures were first launched in the early 2000s to provide hedging tools market participants looking to protect themselves against adverse freight rate moves. However, the first attempts at establishing this market failed to gain traction and it was not until August 2023, when the International Energy Exchange in Shanghai launched its new EC contract, that a liquid, regulated and electronically tradeabe container freight futures contract was successfully established.

Any successful container freight futures contract needs to fulfill three requirements to become a useful risk management tool: high liquidity, no counterparty risk and price transparency.

Liquidity

Industry participants like carriers, forwarders or shippers need to be able to reliably hedge large quantities. They also need to be able to get in and out of their positions easily without affecting the market too much. Thus, if the futures market is too small, it becomes impossible to trade the necessary volume without causing wild price swings that would disrupt the entire market and ultimately make any attempt at hedging futile.

Counterparty Risk

The market needs to be properly regulated and safeguarded to ensure that contracts can be enforced and each market participant can be confident that their counterparty won't simply walk away from an unfavourable trade.

Futures exchanges are strictly supervised by market regulators and have a variety of tools in place to compensate market participants in case any traders default on their obligations, including investor protection funds, initial margins and daily price limits. Most importantly, regulated futures markets rely on a centralised clearinghouse to act as the legal counterparty for every buyer and seller and thereby guarantee the performance of all contracts traded on the exchange.

Transparency

To be useful as hedging tools, prices in the futures market need to reflect the dynamics of the physical market. Unless hedgers can trust the futures market to ultimately converge with the physical market when the contract expires, they will not be able to use it to protect themselves from volatile shipping rates. Settlement prices must therefore be established reliably and objectively.

The INE EC Contract

The Shanghai International Energy Exchange (INE) launched its Containerized Freight Index (Europe Service) futures contract in August 2023 with the intention of overcoming the aforementioned challenges and establish a benchmark contract for the Shanghai - North Europe route. Commonly referred to as CoFIF, short for Container Freight Index Futures, or EC, its official exchange product code, the futures contract is different from its predecessors in several ways.

Based on Paid Spot Market Rates

The CoFIF contract is cash settled against the Shanghai Shipping Exchange (SSE) Shanghai Export Containerized Freight Index based on Settled Rates (SCFIS) Shanghai - North Europe route index. Launched during the Covid-pandemic as shipping rates surged to record levels, the index is based on the actual rates paid for containers exported from Shanghai to Hamburg, Rotterdam, Antwerp, Felixstowe and Le Havre, with settled prices submitted to the SSE after the departure of the vessel.

Thus, the contract's final (settlement) price is determined by the real prices paid in the underlying container freight spot market, avoiding the oft-cited concern by industry participants that the market may be overrun or broken by speculators and linking it tightly to the physical market.

A Mandate to Serve the Real Industry

From the day it was launched, the market reception of the new contract was exceptionally strong, with total daily turnover routinely exceeding USD 1bn. The Red Sea crisis then turbocharged interest in CoFIF trading as China - Europe rates rose dramatically following the blockade of the Suez Canal.

This primarily brought new speculative traders into the market, but, given the INE's government-issued mandate to serve the real industry, it quickly took action to rein in excessive speculation by raising margins and reducing daily new open position limits for speculative traders.

Risk Management

Due to the strong regulatory overview it has of the market, the INE was able to distinguish between hedgers and speculators and enact targeted measures to maintain a stable market environment. The immediate result was a drop-off in daily trading volume as speculative trading became more capital-intensive, but the futures market was prevented from drifting too far away from the underlying spot market.

As the market gradually priced in the existing disruptions, the restrictions were loosened and volumes quickly picked up again. The industry-first approach of the Chinese exchanges means they are willing to forego fee income from speculators to maintain an orderly market, and industrial hedgers tend to benefit from reduced initial margin requirements and exemptions from standard position limits to account for their hedging needs.

In addition to these pro-active risk management measures by the exchange, INE market participants are also covered by the China Futures Market Monitoring Centre (CFMMC)-managed Futures Investors Protection Fund in case of defaults by traders or brokers. Thus, with its own centralised clearinghouse to novate all trades and backing from the investor protection fund, the second key challenge - proper regulation and enforcement of contracts - is also addressed by the INE's CoFIF contract.