BASIC ELEMENTS OF A COMMODITY EXCHANGE

Introduction
Commodity trading history can be traced to the agricultural revolution of 8500BC during which
farmers and traders fashioned a means to secure prices of commodities against price fluctuation
caused by weather, conflict, and supply and demand gap. Trading evolution, excess supply and the
quest of merchants to raise money while commodity was in storage formed the basis for futures
agreement. The first recorded commodity futures trades occurred in the 17th century in Japan,
although there is some evidence that rice may have been traded some 6,000 years ago in China.
The first contract for a future price was created in the early 1800s in the US. This forward contract
allowed a buyer to pay for the commodity in advance of taking delivery of it. The Chicago Board
of Trade (CBOT) was set up in 1848; trading in contracts that were standardized in terms of
quantity, quality and delivery. The CBOT added soybeans contract in 1936 and has since merged
with the Chicago Mercantile Exchange to form the CME Group.
In 1861, the Egyptian Cotton Exchange was established in Alexandra and became one of the
earliest commodity exchanges in the world. It played a key role in global trade, attracting users
from the international community including Africa, Asia and the Americas. The exchange closed
100 years later in 1961 with the entry of the government as a player in the cotton trade. Uganda,
Zambia, Zimbabwe, South Africa, Kenya all established commodities exchange in the 1990s. The
African Union Abuja Treaty of 1991, identified the need for an African Commodity Exchange and
might have provided some awareness and push for the set - up of commodity exchanges in the
continent, at the time.
The South African Futures Exchange has been one of the most successful Exchanges in Africa and
remains operational to this day. Established in 1995 it was acquired by the Johannesburg Stock
Exchange (JSE) in 2001 and now is its subsidiary. The Zambian and Zimbabwe
A new wave to establish functional Commodity Exchanges arose in the 2000s and saw Nigeria set
up the Abuja Securities and Commodities Exchange (ASCE), now known as the Nigerian
Commodity Exchange (NCX), the African Commodities Exchange (ACE) in Malawi as well as
the East African Exchange in Rwanda. Another attempt to set up a commodity exchange was made
by Zambia through its Agricultural Commodity Exchange (ZAMACE). The Ethiopian
Commodities Exchange (ECX) that was established in 2008 is today often seen as a model for
other African countries as it is considered as one of the most successful in Africa. Based on a
model of standardized warehouse receipts, it initially experienced low trade volumes as trading
was then limited to maize, beans and wheat. However, its operations soured when the exchange
introduced export commodities in December 2008. Furthermore, trading volume significantly rose
on the back of government policies that mandated export trades such as coffee be carried only
through the Exchange.
Meaning of Commodity Exchange
A Commodity Exchange is a market designed to facilitate trading in spot or futures contracts in
agricultural commodities, precious metals, currencies, interest rates, and stock indices among
others.
A commodity exchange can be segments into spot and derivatives markets. In the spot market,
transactions are conducted for immediate delivery of commodities while in the derivatives market,
transactions are conducted for settlement at a future date. The derivatives market is further
segments into forwards, swaps, futures and options.

Economic Benefits of Commodity exchange:

1. Increased Production
It is expected that the operations of the Commodity Exchange will boost the supply side of the real
sector through increased agricultural production and commercial exploitation of solid mineral
resources. This will bolster the activities in the finance sector, as more financial derivatives will
be traded on the exchange. It is also believed that the increased production in the real sector will
stimulate additional investment and generate growth in GDP. As it is the case in most instances,
fluctuating prices would normally translate into fluctuating incomes, it is hoped that the hedging
facilities the exchange will provide, will ensure stable incomes of the producers in all sectors,
sustain their interest and trigger off a steady rate of growth in production.
2. Reduce Unemployment Rate
As a follow up to (i) above, increased investment in the real sector will naturally stimulate
employment generation as more labour will be nee4ed.to cultivate the farms, carry out exploration
and mining activities and other auxiliaries’ jobs. In effect, it will minimize rural urban drift.
3. Promotion of Direct Foreign Investment
The need to attract direct foreign investment in economic activities in the real sector has been on
top of the economic agenda of successive governments in Nigeria. The setting up of the commodity
exchange and the enactment of laws that will provide a conducive environment for foreign
investment in the solid mineral sector will ginger investment by foreigners and promote production
in this sector for trading on the exchange. This will in tum increase turnover of the exchange, its
earning and viability.
4. Realistic Pricing
Commodity Exchange through contracts initiated on it will ensure realistic pricing of the
underlying assets as it will engender huge presence of buyers and sellers in the market. That will
make it possible for buyers to have many sellers to buy from and sellers to have many buyers to
sell to at the best price. As market information will be made readily available to all operators by
the exchange through its efficient information dissemination mechanism.
This will serve as fillip to producers to make additional investment for enhanced productive
capacity and higher income generation.
5. Price Risk Management
Agricultural commodities, because of the attendant problem of storage, often suffer declining
prices due to glut occurring during harvest. To mitigate this, hedging on the exchange provides a
good mechanism for minimising loss due to adverse price movements. For example, a
manufacturer of cotton or soybeans can fix the price of his product a year ahead, if he uses the
futures market to hedge and lock-in his profit margin.
6. Improved Financing Terms
Another beneficial effect of hedging is that it enhances the credit-worthiness of the participants on
the exchange as banks, the world over, favour financing transactions that are hedged because the
risk of exposure is minimal and it is easier to recoup their investment. Companies making use of
futures market can free themselves from the daily inconveniences of finding markets or worrying
over changing prices and thus utilüe the resources at their disposal better to enhance production.
7. Improved Long-term Planning
As price trend is a- critical variable in economic planning, unstable prices of tradable commodities
in an environment without hedging facilities as in Nigeria today make planning not only difficult
but also unrealistic. Since commodity exchange provides hedging facilities for futures and option
contracts, producers and users of the underlying assets can plan under certain atmosphere and
achieve their targets.
8. Efficiency in the marketing Process
Commodity and futures markets are characterised by free information flow, stiff competition, large
trade volume or turnover, free entry and exit, which are all factors of a perfect market. There is
efficient interaction of market forces, as market information is promptly made available to all
participants. They ease the process of executing orders, which in tum benefits producers,
merchants, processors, consumers etc.
9. Effective Protection for Market Participants
Trading in a futures market is normally subject to specified rules and regulations. These rules,
together with a clearinghouse mechanism, which guarantees contract performance, provide
adequate protection for market participants. Trading is also orderly and fair when done under these
rules and regulations.

MARKET SEGMENTS
As said earlier in the class, there are two main segments in a commodity and futures market,
namely spot (cash or physical markets) and futures market segments. As the exchange will initially
trade on spot basis since Nigerians are already familiar with this kind of trading system, this class
will delve much on the spot market with particular reference to its benefits to the producers and
the Nigeria economy.
1. Spot Market
Spot market can be defined as a market for the purchase and sale of commodities for immediate
payment and delivery. It is also a cash market as payment for the commodities, sold is made
simultaneously with delivery. It can either be done over the counter or on an organised exchange.
Presently cash or spot market in commodities are conducted over the counter with or without a
written contract. The contract is usually conducted between two parties without any other party
acting as counter arty to the contract if conducted over the counter. This poses a risk, as there is
likelihood of default by one of the parties to the arrangement.
Spot Market for agricultural produce in Nigeria today
Presently, when a cocoa producer has cocoa for sale, the produce buyer could either meet him on
his farm or he could carry his products to the market where the produce buyers will buy them. In
doing this, the produce buyer will weigh the products on his scale and turn to his reckoner book to
announce the price or the value of the products that are being sold to him. In most cases, if the
weight of what the farmer brought is a tonne, the produce buyer will announce the price after
making allowance for the weight of the sack, weight loss after re-drying the product and possible
depreciation in quality. He has to do this as the produce will be re-weighed and it quality confirmed
when the produce buyer is in turn selling same to big produce merchants who will eventually
export the products overseas.
Pricing under this arrangement is done in a crude form, as there is no defined modus operandi for
determination of prices. Each produce buyer dictates the price to pay without much resistance or
negotiation by the seller because farmers have little or no choice as they may have very few
produce buyers in their locality to whom they can sell. This means the present spot market lacks
realistic pricing and had for long not guaranteed steady income for the farmers. The modern spot
market involving sale and delivery of commodities on the exchange will make most, if not all the
prospects earlier highlighted in this paper realisable and both the traders and the economy will be
better for it.
Spot Market in other parts of the world
In the spot markets like the one to be introduced on the exchange, traders will buy and sell actual
(physical) commodities and settle the transaction with cash within two business days. By the nature
of products traded on spot market, most of the transactions take place over the counter as each deal
is privately negotiated specifying a particular delivery date, location, quantity and quality of the
commodity. However, it will be recommended that all Nigerian agricultural cash crops be traded
on the spot market on the exchange with the exchange as counter party so as to avoid the inherent
risk of default. Unlike spot contracts traded on the OTC market, exchange trading of spot contracts
is highly regulated and standardised.
Other commodities that could be traded on the spot market segment of Abuja Commodity
Exchange are money market instruments such as treasury bills, treasury certificates, Nigeria Inter-
Bank Offer Rates (NIBOR), solid minerals, crude oil, etc. When traded, the contract terms may
not be reported or made transparent by the exchange since the contracts are private. However,
some exchanges, market makers etc., quote spot prices for physical delivery.
Trading Process
The trading process, just like in futures trading, involves placing an order either personally for
those trading for their own accounts or through a broker. The order may be a sale or buy order.
Once the order matches, both parties are notified and the transaction cleared, i.e. the buyer is
requested to deposit the Naira value with the exchange after which a warehouse receipt is issued
to him, and the seller is requested to deliver the commodities to the designated warehouse, for
delivery to the buyer within two business days of executing the contract on the exchange. However,
in energy products, spot delivery varies from two to fifteen days.

The trading procedure is same for both spot and futures market segments. Where they differ is in
the delivery procedure. Majority of trading these days takes place using derivatives contracts with
only about 10% for spot transactions.
Apart from the spot transactions that take place over the counter, commodity producers in their
quest to minimise risk and lock-in their prices also trade forward and swap contracts.

2. Forward
A forward contract is an agreement to buy or sell a given asset on a specified future date at a price
(known as the contract or forward price) specified at the time of entering into the contract. The
price may also be agreed on at the time of maturity of the contract. If at maturity the actual price
is higher than the forward price, the contract buyer makes a profit and the seller suffers a loss; if
the price is lower, the buyer suffers a loss and the seller makes a profit. For illustration, consider a
Nigerian exporter who in January was expecting to be paid a million-pound sterling in April. To
avert foreign exchange risk the exporter decides to buy an April Forward contract from a Bank for
the sale of one-million-pound sterling to it in April at the rate of N 128 to a pound sterling. If at
the end of April, one pound sterling exchanges for N 125, the exporter will still sell one million
pounds to the Bank at the rate already agreed at the beginning of the contract (i.e N128 for every
pound) and make a profit of N3, 000,000 (128 — 125 (1000,000)). On the other hand, the bank
will sustain a loss of the same amount. If it happens that at the expiration of the contract, one-
pound sterling exchanges for N130, the exporter will lose N2,000,000(130 – 128(1000000)) while
the bank will gain the same amount.
Secondly, a cotton producer who expects that there will be glut that will lead to a drastic fall in
cotton price in June, 2002, may enter into a forward contract with a yarn producer for 'June delivery
of say 20000 tones at N10,000 per ton. None of the parties is expected to make any payment before
maturity. If the cash price of yarn is N 12,000 in June, the yarn producer will gain N2000 per ton,
while the farmer will lose N2000 per ton, and vice-versa. At maturity, both parties are bound to
perform base on the agreed terms. Most forward are traded over the counter. However, these
contracts could be traded on the Abuja Commodity Exchange if parties will be mandated to provide
collaterals such as performance bond from a reputable bank. This implies that some of the terms
(e.g. quality, quantity, delivery location, etc) will be standardised by the exchange and parties to
the contract will adhere strictly to the terms of the contract, failing which a charge will be levied
on the collateral.
3. Futures
A futures contract can be defined as an agreement to buy or sell an asset at a certain time in the
future for a certain price. For instance, suppose in May an investor in Lagos instruct his dealing
member or broker to buy 10 tones of rice for December delivery. The dealing member or broker
will immediately transmit the instruction to his trader on the trading floor of Commodity
Exchange. In the same month, if a farmer in Abakaliki instructs his dealing member or broker to
sell 10 tones of rice for December delivery, his broker will also pass the instruction to his trader
on the trading floor of Commodity Exchange. The two floor traders will meet and agree on the
price to be paid for the rice in December, and the deal will be sealed. The price to be paid is known
as the futures contract price. Unlike in a spot market where all terms are negotiated, other terms of
a futures contract such as quantity, quality, and delivery date and delivery point are standardized
by the exchange.
The farmer who agreed to sell the rice has what is called a short position, while the investor who
agreed to buy it has a long position. Futures contract price is determined by the forces of demand
and supply; such that, if at a particular time the number of floor traders who wish to buy December
rice is more than those who wish to sell December rice, the price will go up, and vice versa. This
will attract more sellers into the market until equilibrium of buyers and sellers is maintained. Also,
developments and events in major producing countries of the underlying commodities influence
the price of futures contracts. For instance, a war in an OPEC member country will affect the
international price of crude oil futures contracts.
In futures contracts only an insignificant proportion of the contracts actually lead to delivery of
the underlying commodities. Normally, futures contracts are offset before delivery and no delivery
is made in the month for which they are named. The distinguishing feature between futures and
forward contracts is that, futures contracts seldom lead to delivery, while forward contracts always
lead to delivery of physical commodities on maturity. For in instance, if the above illustration
involves a forward contract, the farmer in Abakiliki must deliver ten tones of rice to the contract
holder on maturity in December, but if it is futures contract it might be closed out before maturity.
Forward contracts are mostly traded over the counter, while futures contracts are traded on a
futures exchange. Virtually, all the terms of a forward contract are negotiated between buyers and
sellers, while those of futures contracts are standardized by the exchange except price, which is
determined by the parties. Whereas forward contracts are not negotiable, futures contracts are
negotiable.
4. Options
An option is the right but not the obligation to buy or sell an asset in exchange for an agreed sum
called premium. The buyer of an option contract is not obliged to exercise it, while the seller is
duty bound to sell or buy the underlying asset if the option buyer decides to exercise it. If the right
is not exercised after a specified period, the option expires and the option buyer forfeits the
premium paid. Options are classified into call options and put options. For instance, if investor A
buys an option contract under which he is to sell 100 logs of timber to investor B in March at
N1,000 per log at an option price of N20, he would pay N2,000 (100 X N20) at the time of entering
into the contract. If at the end of March the price of timber falls to N900, he will not exercise it,
and the only amount he will lose is the premium of N2,000 he paid. However, if the price rises to
N 1,200 in March, he will exercise the option and the timber owner is obliged to sell it to him at
the agreed price of N1,000 per log.
A call option gives the holder the right and not the obligation to buy the underlying asset at a fixed
price on or before a certain date in the future. If the asset price is above the fixed price the holder
normally exercises his option, otherwise it is abandoned. A put option, on the other hand, gives
the holder the right but not the obligation to sell an underlying asset at a fixed price on or before a
given date. If the asset price is below the fixed price the holder normally exercises his option,
otherwise it is abandoned. There are two types of options, namely American and European options.
American option is that which can be exercised on or before the maturity date while the European
option is exercisable only on maturity.
5. Swap
A swap transaction is the simultaneous buying and selling of an underlying asset, or obligation of
equivalent capital amount where the exchange of financial arrangements provides both parties to
the transaction with more favourable conditions than they would otherwise expect.
It is an OTC transaction between two parties in which the first party promises to make a payment
to the second party, and the second party in turn promises to make simultaneous payments to the
first party. For instance, a user of a particular commodity who wants to secure a maximum contract
price for a long term may agree to pay a financial institution a fixed price, in return for receiving
payments based on the market price for the commodity involved. On the other hand, a producer,
who wishes to fix his income, may agree to pay the market price to a financial institution, in return
for receiving a fixed payment stream. The payments for both parties are calculated according to
different formulae but paid according to agreed set of future scheduled dates. The main
disadvantage associated with these instruments is that they are exchange traded and lack the kind
of flexibility that many market players require.

PARTICIPANTS
As the need to manage price and interest rate risks exist in virtually every type of modern business,
today's commodity and futures markets have also become major financial markets. Participants
include mortgage bankers, farmers, bond dealers, grain merchants, multinational corporations,
food processors, savings and loan associations, and individual speculators. They are classified into
floor traders/brokers, hedgers, speculators and arbitrageurs. To become acquainted with futures
markets, it is useful to have at least a general understanding of who these various market
participants are, what they do and why.
a. Floor Traders
A floor trader is responsible for executing orders in the trading pit or trading system. They buy
and sell futures contracts on their own account as well as the accounts of their clients ten the trading
floors of commodity exchanges. Like specialists and market makers in securities exchanges, they
help to provide market liquidity. If there isn't a hedger or another speculator who is immediately
willing to take the other side of an order at or near the going price, chances are that an independent
floor trader will do so, in the hope of making an offsetting trade at a profit. Floor traders, of course,
have no guarantee that they will realize a profit. They may end up sustaining a loss on any given
trade. Their presence, however, makes for more liquid and competitive markets. It should be
pointed out, that unlike market makers or specialists, floor traders are not obliged to maintain a
liquid market or to take the opposite side of customer orders.
b. Hedgers
Commodity production and marketing involve sizeable price risks, which affects the value of the
commodity. While there is no way to eliminate uncertainty, futures markets provide a competitive
way for commodity producers, merchants, processors, and others users to transfer some price risk
to speculators who will willingly assume such risk in the hope of making profit. This transfer of
price risk is termed hedging. Hedging is taking a position in a futures market opposite to a position
held in the cash market in order to prevent or minimize the risk of financial loss from an adverse
price change. It is the purchase or sale of futures as a temporary substitute for a cash transaction
that will occur later. Hedgers are individuals and firms that make purchases and sales in the futures
market solely for the purpose of establishing a known price level - weeks or months in advance -
for commodities they intend to buy or sell later in the cash market. In this way they attempt to
protect themselves against the risk of an unfavourable price change in the interim.
For example, a beverage manufacturer needs to buy additional cocoa from his supplier in six
months’ time. Between now and then, however, he fears the price of cocoa may increase. That
could be a problem because he has already published his price for a year ahead. To lock in the
price level at which cocoa is presently being quoted for delivery in six months, he buys a futures
contract at a price of, say N350 per ton. If, six months later, the Cash market price of cocoa has
risen to N370, he will have to pay his supplier the agreed price (N350) to acquire cocoa. However,
the extra N20 per ton cost will be offset by a N20 per ton profit when the futures contract bought
at N350 is sold for N370. In effect, the hedge provided insurance against an increase in the price
of cocoa, It locked in a net cost of N350, regardless of what happened to the cash market price of
cocoa. Had the price of cocoa declined instead of rising, he would have incurred a loss on his
futures position but this would have been offset by the lower cost of acquiring cocoa in the cash
market.
The number and variety of hedging possibilities is practically limitless. A cattle feeder can hedge
against a decline in livestock prices and a meat packer or supermarket chain can hedge against an
increase in livestock prices. Borrowers can hedge against higher interest and lenders against lower
interest rates. Investors can hedge against an overall decline in stock prices, and those who
anticipate having money to invest can hedge against an increase in the over-all level of stock prices.
Whatever the hedging strategy, the common denominator is that hedgers willingly give up the
opportunity to benefit from favourable price changes in order to achieve protection against
unfavourable price changes.

c. Speculators
The Speculators in the futures market accept the price risk the hedgers seek to avoid. A speculator
is one who attempts to anticipate price changes and, through buying and selling futures contracts,
aims to make profit. He does not use the futures market in connection with the production,
processing, marketing or handling of a product. The speculator has no interest in taking delivery.
Speculators wish to take position in the futures market. They are either betting that the price of a
commodity will go up or down. If you speculate in the market, the person that takes the opposite
side of your position is either a hedger or another speculator - someone whose opinion about the
probable direction of prices differs from your own. A speculator that expects a futures price to
increase would purchase futures contracts in the hope of being able to sell them at a higher price
later. This is known as "going long." Conversely, a speculator that expects a futures price to decline
would sell futures contracts in the hope of being able to buy back identical and offsetting contracts
at a lower price later. The practice of selling futures contracts in anticipation of lower prices is
known as "going short." One of the attractive features of futures trading is that it is equally easy to
profit from declining prices (by selling), as it is to profit from rising prices (by buying). For
example, assume it's now January and July cocoa contract ié presently quoted at N6.00, and over
the coming months you expect the price to increase. You decide to buy one July cocoa futures
contract. If by April the July cocoa futures price has risen to N6.40 and you decide to take your
profit by selling, you will realise a profit of N2,000. Since each contract is for 5,000 tons, your 40
kobo a ton profit would be 5,000 as shown below.

Price per ton Value of 5,000 tons

contract
January Buy 1 July cocoa N6.00 N30,000
futures contract
April Sell 1 July cocoa N6.40 N32,000
futures contract
Gain N0.40 N2,000
Suppose, however, that rather than rising to N6.40, the July cocoa futures price had declined to
N5.60 and that, in order to avoid the possibility of further loss, you elect to sell the contract at that
price, you will make a loss of N2,000.
Price per ton Value of 5,000 tons
contract
January Buy 1 July cocoa N6.00 N30,000
futures contract
April Sell 1 July cocoa N5.60 N28,000
futures contract
Loss N0.40 N2,000

In Nigeria, those who buy commodities during harvest when their prices are at the lowest ebb,
only for them to sell them during scarcity when their prices are very high could be described as
spot market speculators.
d. Arbitrageurs
These are also important participants in the futures market. Arbitrage is the simultaneous purchase
of cash commodities or futures in one market against the sale of cash commodities or futures in
the same or different market to profit from a discrepancy in price. It involves locking in a risk-less
profit by simultaneously entering into transactions in two or more markets. The transactions are
risk-less because an arbitrageur will only move from one market to another if the prices in both
markets are known and if the profit outweighs the cost of transaction.
Illustration: Suppose 1 ton of cocoa is traded on the New York Mercantile Exchange and London
Commodity Exchange at $172 and $l00 respectively at a time when the exchange rate is $1.75 per
pound. An arbitrageur could simultaneously buy 100 tons of cocoa in New York and sell them in
London to obtain a risk-free profit of:
100 x ($1.75 x 100 - $172) = $300
An arbitrageur takes advantage of temporary price difference or mispricing in the markets and
therefore makes an immediate and certain profit. The profit per deal is usually small. Nevertheless,
it is important because arbitrage forces the market price to a fair value price as upward movement
in price in one market is countered by a downward price movement in another market and vice
versa.
TRADING PROCESS
At this junction, we will explain trading and delivery procedure in futures and option contracts.
Parties to Trade
There are three parties to each trade that takes place on the exchange viz: investor, broker and the
exchange. The exchange is counter-party to every trade, as it has to guarantee that every trade that
takes place on the exchange trading systems is settled on maturity. This, in essence, means that
every investor will get value for his money if the contract is not terminated before maturity, as vast
a majority of the future contracts that are initiated on the exchange do not lead to delivery.
It is good to note that it is not the actual commodities that are bought and sold on the exchange but
the contract derived from them such as futures and options, which are called derivatives.

Contract Specifications
For any contract to be initiated on the floor of the exchanged, it has to be specified in a clear and
unambiguous terms and language understood by both parties to the contract. In trading futures and
options, the exchange on which they are traded has to specify in some details the exact nature of
the agreement between the two parties. In particular, it must specify the assets underlying the
contract ( e.g cocoa, thick wood, rubber, palm produce, cotton, etc), the contract size (that is,
exactly how much of the assets will be delivered under one contract), where delivery will be made,
and when delivery will be made (e.g 10th August, or any date) When the asset is a commodity, it
is important that the exchange specifies the grade or grades of the commodity that are acceptable.
The financial assets in futures contract are generally well defined and unambiguous. For example,
there is no need to specify the grade of a US dollar.
Daily Price Movement Limits
The exchange also has the responsibility of stating the daily price movement limit in the ordering
process. This can be stated either in percentage or absolute terms. For instance, the daily price
movement limit for crude oil futures was $1 in 1999. If on a particular day, closing price for crude
oil was $10 per barrel, the trading price the following day would be between $9 and $11 per barrel.
The exchange needs to set price limits to prevent large price movements from occurring because
of speculative excesses.
Trading on The Floor
Anyone who wishes to buy or sell a traded commodity would contact a registered trading member
pf Exchange to place a buy or sell order on his behalf. Also, an investor expecting a future price
rise may decide to buy a futures contract with a view to sell at a profit when the price rises, while
he may decide to sell in anticipation of a future price fall to avert sustaining loss. The order could
be transmitted to either of the Exchange's trading floors in Abuja or Lagos via VSAT, Radio Link,
Telephone, Lease line and Dial-up. On receipt of the order by the floor trader, it is timestamped,
endorsed and inputted into the trading system, indicating the price at which he or she is willing to
buy or sell. This price would be relayed throughout the system. Under an automated system, a
computer would match the buy and sell orders. If the order is matched, it is confirmed and
communicated to the trading member for onward transmission to his client. An order should
contain the number of contracts, month of contract type and quality of the commodity, price
specification and the period of validity.
The open cry auction is gradually being phased out with improvement in trading technology.
Types of Orders
Ordering on commodity exchanges can take any of the following form:
(a) Market order: An order that is executed immediately at the current market price.
(b) Limit order: An order that can only be executed at a specified or better price.
(c) Time of day or Good for the day order: An order that automatically expires if it is not executed
on the day it is entered.
(d) Good-till-cancelled or Open order: Order remains in force until it is filled, cancelled or until
the contract expires.
(e) Spread order: An order to simultaneously buy and sell at least two different contracts at a quoted
differential. Etc.
All these are contained in the existing STRIDE trading system of the Exchange.

Margin Trading
If two investors get in touch with each other directly and agree to trade an asset in the future for a
certain price, there are obvious risks. One of the investors may regret the deal and try to back out.
Alternatively, the investors simply may not have the financial resources to honour the agreement.
One of the key roles of the exchange is to organize trading so that contract defaults are minimized.
This is where margins come in.
i. Mark to Market
To illustrate how margin works, consider an investor who contacts his or her broker on Tuesday,
February 6, 2002 to buy June Iron futures contracts on the Abuja Commodity exchange
(ACOMEX). We assume that the current futures price of Iron on the exchange is N40,000 per ton
and the quantity he requires is 40 tons at a contract size of 10 tons. By implication the broker is
buying his client four (4) futures contract since the contract size is 10 tons at N40,000 per ton.
Because of the inherent risks, the broker will request his client to deposit funds (initial margin) in
his margin account. Suppose the minimum he can deposit per contract is N25,000 per contract or
NI00,000 in total. At the end of each trading day the margin account is adjusted to reflect the
investor's gain or loss. This process is known as marking to market the account.
Suppose, for example that by the end of trading on 6th February, 2002 the futures price had
dropped to N39 567. The investor had a loss of N433 x 40 or N17,320 as he could only sell the 40
tons of Iron he contracted to buy at N40,000 per ton for N39,567. The investor's margin account
will at end of the trading day go down immediately to N82,680.
Conversely, if the price goes up to N40,322 per ton at the end of the trading day, the investor's
gain is N322 x 40 or N12,880. The investor's margin account will be credited with this amount
immediately at the end of the trading day. That means his accounts will now have a balance of NI
12,880. A trade is first marked to market at the close of the day on which it takes place. It is then
marked at the close of trading on each subsequent day before the contract is closed out.
Marking to market is not merely an arrangement between broker and client. When there is a
N17,320 decrease in the futures price so that the margin account of an investor with a long position
(i.e. a buyer) is reduced by N17,320, the investor's broker has to pay the exchange N 17,320 and
the exchange will pass the money on to the broker of the investor with a short position. Similarly,
when there is an increase in the futures price, the broker of the parties with short positions pay
money to the exchange and the brokers of the parties with long positions receive money from the
exchange.
The investor is entitled to withdraw any balance in the margin account in excess of the initial
margin. To ensure that the balance in the margin account never becomes negative, a maintenance
margin, which is somewhat lower than the initial margin is set. If the balance in the margin account
falls below the maintenance margin, the investor receives a margin call and is expected to replenish
the margin account to the initial margin level the next day. To illustrate, the operation of the margin
account for one possible sequence of futures prices in the case of the investor considered earlier.
The maintenance margin is assumed go be NI 5,000 per contract:
DAILY MARGIN
FUTURES GAIN CUMMULATIVE ACCOUNT MARGIN
PRICE (LOSS) GAIN (LOSS) BALANCE CALL
DAY ₦ ₦ ₦ ₦ ₦
40000 100000
Feb 6 39567 -17320 -17320 82680
Feb 7 39400 -6680 -24000 76000
Feb 8 39620 8800 -15200 84800
Feb 9 40000 15200 0 100000
Feb12 39124 -35040 -35040 64960
Feb 13 39300 7040 -28000 72000
Feb 14 39369 2760 -25240 74, 760
Feb 15 39002 -14680 -39920 60080
Feb 16 38670 -13280 -53200 46800 53200
Feb 19 39020 14000 -39200 114000
Feb 20 39000 -800 -40000 113200
Feb 21 38680 -12800 -52800 100400
Feb 22 38787 4280 -48520 104680
Feb 23 39001 8560 -39960 113240
Feb 26 38544 -18280 -58240 94960
Feb 27 39000 18240 -40000 113200

The investors whose margin account is presented above took a long position in a futures contract
for 40 tons of Iron on February 6, 2002. He was made to deposit NI00,000 in his margin account
by his broker because of the associated risks in futures contract. For stance, once a contract is
purchased, it can be sold and closed out at any time prior to the settlement date. This has made the
exchange to, on every day, mark to market the investor's margin account to reflect the gain or loss
it might sustain at the end of each trading day. In the example above, the investor had sustained a
cumulative loss of N53,200 with a balance of N46,800 in his margin account as at February 16.
This is a violation of the exchange's rule that the balance in the investor's margin account should
at all-time be more than his maintenance margin. This will call for a deposit of N53,200 in his
margin account to beef up its balance to the initial margin (N100,000). This additional deposit is
called variation margin. This has to be made on or before the end of trading on February 19 or else
his broker will close out the transaction. As can be seen in the table above, the investor instructed
his broker to close out the contract on February 27 forestall further losses. As at the time the
instruction to close out the contract was received, the investor had sustained a cumulative loss of
N40,000 and had a margin balance of N113,200.
It has to be stated here that during the life of a contract, an investor is free to withdraw any "cess
over his required margin from the margin account. Please note that margin deposit is about 5-10%
of the contract value. However, different exchanges and contracts require different initial margins.
Additionally, initial margins are subject to change, depending on market volatility and risk
perception
ii. The Clearinghouse and Clearing Margin
The exchange clearinghouse is an adjunct of the exchange and acts as an intermediary or
middleman between buyers and sellers in futures transactions. It guarantees the performance of
the parties to each transaction. The clearinghouse has a number of members all of which have
offices close to the clearinghouse. Brokers who are not clearinghouse members themselves must
channel their businesses through members. The main task of the clearinghouse is to keep track of
all the transactions that take place during the day, so that it can calculate the net position of each
of its members.
Just as an investor is required to maintain a margin account with his or her broker, a clearinghouse
member is required to maintain a margin account with the clearinghouse. This is known as a
clearing margin. The margin accounts for the clearinghouse members are adjusted for gains and
losses at the end of each trading day in the same way as the margin accounts of investors. However,
in the case of the clearinghouse member, there is an original margin but no maintenance margin.
Everyday, the account balance for each contract must be maintained at an amount equal to the
original margin times the number of contracts outstanding.

In calculation of clearing margins, the exchange clearinghouse calculates the number of contracts
outstanding on either a gross or a net basis. The gross basis simply adds the total of all long
positions entered into by clients to the total of all short positions entered into by clients. The net
basis allows these to be offset against each other.
Suppose a clearinghouse member has two clients, one with a long position in 20 contracts, thc the
other with a short position in 15 contracts. Gross margin would calculate the clearing margin on
the basis of 35 contracts; while, net margin would calculate the clearing margin on the basis of
five contracts. Most exchanges currently use net margin.
The purpose of the margining system is to reduce the possibility of market participants sustaining
losses because of defaults.
Delivery
As earlier said, very few futures contracts that are entered into lead to delivery of the underlying
assets. The rest are closed out before maturity. Nevertheless, it is important to note that it is the
possibility of eventual delivery that determines the futures price.
Delivery Procedure
The period during which delivery can be made is defined by the exchange and they vary from
contract to contract. The decision on when to deliver is made by the party with the short position,
whom we shall refer to as investor A. When investor A decides to deliver, investor A's broker will
issue a notice of intention to deliver to the exchange's clearinghouse. This notice shall state how
many contracts will be delivered and, in the case of commodities, it will also specify where
delivery will be made and what grade will be delivered. The exchange will then choose the party
with a long position to accept delivery.
For instance, if the party on the other side of investor A's futures contract when it was initiated on
the exchange was B, there is no reason to feel that B will eventually take delivery as he might
closed out his position by taking a short position in a contract with C, investor C might also have
closed out his position by taking a short position in a contract with D, and so on.
The usual practice by various exchanges is to pass the delivery notice to the party with the oldest
outstanding long position in the contract. If the delivery notice is negotiable the party on whom
delivery notice is served has only half an hour after receipt of the notice to transfer same to any
party with long position or else, he has to take delivery.
In the case of commodities, taking delivery usually means accepting a warehouse receipt in return
for immediate payment (see pictorial demonstration of contract initiation and delivery on the
exchange in the attached appendix). The warehouse receipt may be negotiated between the time
of receipt and the time the contract actually expires or matures. The party taking delivery is
responsible for all warehouse costs. In the case of financial futures, delivery is made through wire
transfer.
For all contracts, the price paid is usually based on the previous day's settlement price adjusted for
grade, the location of delivery, and so on. Using the table on margin trading above, if the Iron was
to be delivered on 28th February, 2001 and a delivery notice is served on investor D (who owns
the margin account shown in the table) by the clearinghouse, the price investor D will pay for
delivery is the closing price as at February 27 which was per ton. In effect, investor will issue a
cheque for the sum of N1,446,800 in addition to the balance on his margin account to take delivery
of 40 tons of Iron supplied by investor A. The whole delivery procedure from the issuance of the
notice of intention to deliver to the delivery itself generally takes two to three days. To avoid the
risk of having to take delivery, an investor with long position should close out his or her contracts
prior to the first notice day.
SIMILARITIES AND DIFFERENCES BETWEEN STOCK AND COMMODITY
EXCHANGE OPERATIONS
It is important in this paper to consider below the similarities and differences in the operations of
Stock and Commodity Exchanges, as this will assist the Inter-Ministerial Committee in
determining to what extent the existing facilities (both human and material resources) would
facilitate the establishment of ACOMEX.
SIN ACTIVITIES/ITEMS STOCK EXCHANGE COMMODITY EXCHANGE
1 Regulation SEC SEC
2 SEC Requirements Same as in Commodity Same as in Stock Exchange
Exchange

3 Governance Board, Management or Same as in Stock Exchange.

council and
subcommittees

4 Mode of trading Floor based Floor based

5, Market Segments Equity and Debt Spot and Futures
Segments
6 Instruments traded Stocks Commodities and Financial
Instruments

7 Ordering Ordering is done by Same as in Stock Exchange

investors through their
respective brokers

ß Margin Deposits Prerequisite for trading Same as in Stock Exchange

9 Order matching Orders are matched by the Same as in stock trading.
mechanism trading systems

10 Settlement of trades Done by the Same as in stock exchange.

Clearinghouse
11 Membership Brokers Brokers
12 Trading infrastructure Computers hard and Same Requirements
software, VSAT, radio
link, etc
 13 Trading and Trading and Members' Same as in Stock Exchange
Membership conduct are regulated by
regulation the exchange through its
rules and regulation and
surveillance.

14 Popularity of concept Very popular and well Is a novel concept in Nigeria

known to even the non-
investors

As there are overwhelming similarities in the operations of Stock and Commodity Exchanges, the
task of converting the Abuja Stock Exchange to a commodity exchange will be achieved without
much problem since the facilities on ground (both human and material resources) will make the
conversion less costly.
IMPEDEMENTS OF COMMODITY EXCHANGE OPERATIONS
The prospects of a commodity exchange in Nigeria are indeed enormous, however, they may
remain illusive if the following problems are not addressed:
1. Poor State of Requisite Infrastructures: Commodity exchange is international in operation and
that informs the need for functional infrastructural facilities for its efficient and optimal
performance. For ACOMEX to operate optimally, there will be need for improvement in
infrastructural facilities such as power supply, telecommunications, transportation etc. to make
them more functional. For instance, there is no way the exchange can expect to operate optimally
in an environment where electricity and communication systems are epileptic and the
transportation system is grossly inefficient. In a bid to address these problems, the ASE had
acquired two stand by generating sets, VSAT and dial-up in its task infrastructure improvement
initiative.
2. Lack of Public Awareness: Commodity exchange is basically a new concept in Africa. If we
consider the low level of literacy rate in Nigeria and the age-long practice of spot and rudimentary
commodities trading in the agricultural sector, the exchange will have to spend a fortune to create
awareness among farmers and the informed Nigerian public. Many workshops, seminars, film
shows, etc will have to be organized to enlist the interest of the farmers in the new exchange.
Efforts also have to be made in placing advertorials in the print and electronic media for adequate
coverage.
3. Commodity exchange operations require the service of qualified personnel, which may not be
available in the required number locally. Therefore, there will be need for the exchange Ito
adequately train its staff as this will equip them to actively take part in the training of market
participants and exchange members.
4. With the present state of production in the agricultural sector, there is need for a deliberate effort
by government to stimulate production in this sector through provision of generous Incentives.
As the exchange may have to take-off by trading in agricultural commodities, there is the need for
this sector to be given the desired attention. However, it need be said here that concentration of
exchange trading activities on agricultural commodities which are price inelastic in the short run,
will make trading seasonal and the level of activities very low, if solid mineral products, crude oil
and financial futures are not traded in the next one year of its take-off.
5. Funding: Commodity exchange is a capital-intensive venture and as such require huge capital
outlay for its establishment and day-to-day operations.
6. Storage: Agricultural commodities are highly perishable and that is why production for export
is always very low, as a huge percentage of the output must have gone bad before they get to the
market. The Nigerian farmers need to be educated on how to preserve their commodities through
the use of modern storage facilities. They also have to be taught modern processing methods by
agriculture extension officers so that their products can meet international standards and command
higher prices. If meaningful trade will take place in agricultural commodities on the exchange, the
federal and state government should acquire more processing, preservation and storage facilities
to make these commodities available for trading throughout the year