How Agricultural Cash Settled Contracts Work

In a contract that is physically delivered, the underlying physical market is inherently tied to the futures contract through the delivery mechanism. At contract expiration, any entity with remaining positions will be matched against an entity with an opposite position, and the process of physical delivery will begin. Eventually, the commodity will change hands between the maker of delivery and the taker of delivery – any entity still holding a position after the close on first position day is eligible to be matched for delivery, and every entity with a position after expiration will need to deal with the delivery process.

On the other hand, cash-settled contracts are not physically tied to the underlying commodity. At expiry, a final settlement price is determined, and each entity is either owed money or pays money to settle their position. No one involved in the futures market is at risk of being compelled to make or take delivery of a physical product.

In the Exchange’s agricultural markets, physically delivered products tend to have deeply liquid screen markets. They predominately trade via the central limit order book on CME Globex. For the most part, these contracts are liquid enough to establish reliable daily and final settlement prices solely from screen trading activity. Conversely, the Exchange’s cash-settled agricultural contracts are traded almost exclusively as block trades; bilaterally negotiated and entered by a broker into CME ClearPort or CME Direct for clearing. While the screen is available, these markets historically have remained privately negotiated. For this reason, they tend to function differently than physically delivered contracts. These cash-settled contracts need additional partners, like brokers and price reporting agencies (PRAs), to obtain settlement prices.

There are two types of settlement events for all futures contracts – the daily settlement, and the final settlement. The daily settlement is used internally to facilitate the marked to market transfers of funds, calculate margins, and establish daily price limits. It is used externally as a signal for the current price of a given commodity.

In most liquid, screen-traded, physically settled agricultural futures products, daily settlement is derived from a volume weighted average of trades on Globex during a given window of time before or at the daily market close.

However, for most cash settled agricultural products, the daily settlement is calculated using Exchange approved market indications and broker contributions. Most cash settled agricultural contracts do not experience enough day-to-day Globex activity to support a screen-based daily settlement, so daily settlements are calculated using market participants’ or brokers’ indications.

When the Exchange develops a new cash-settled agricultural product, one key component is finding and working with participants who are embedded in the cash market. Oftentimes, these market participants are brokers who collect information on cash transactions, bids, and offers to come up with a price range that represents their best indications for the products being quoted. Each broker submits daily quotes to the Exchange indicating the price of a given commodity at a specific time of day. For example, every trading day, several brokers contribute quotes on the market for urea in the U.S. Gulf as of 2:30 p.m. Central time. The Exchange aggregates and blends all broker contributions, of which the specific methodology varies depending on the product.

The other important settlement price that should be noted is final settlement. Final settlement is the price used by both the buyer (long) and the seller (short) to ultimately terminate a contract. In physical delivery, it represents the invoice price at which the commodity will be sold and change hands. In cash-settlement, it is the price to which all financial obligations will be marked.

In most traditional agricultural contracts, the final settlement price is derived in nearly the same way as daily settlement – a volume weighted average price calculated during a short settlement period on the day of expiry. In cash-settled agricultural contracts, a PRA or some other price reporting entity is necessary to determine final settlement. The role of the PRA is to combine data on underlying cash transactions, bids, and offers along with their knowledge of the market to come up with a price assessment – either daily or weekly – for a given commodity. The Exchange then employs calculations, which differ by commodity, to turn these assessments into final settlement prices. 

For example, the fertilizer suite has two PRAs providing weekly assessments on each product. These two PRAs, Profercy and ICIS, publish a price range for each fertilizer assessment every Thursday. The Exchange collects both assessments each week and removes the highest and lowest numbers regardless of source. On the last Thursday of the month after the PRA reports for that week are received, all assessments that occurred during the month are averaged, resulting in the final settlement price. Below is a numerical example of this calculation from Urea U.S. Gulf in January 2018.

Price reporting agencies play a vital role in derivatives markets. Any PRA chosen to supply assessments that underlie a final settlement price must be thoroughly trusted by the industry. Final settlement prices determined by the Exchange using PRA data represent the final valuation of a commodity for the entire marketplace. If the assessments published by a PRA are not accurate and respected by the industry, then the final settlement price will likely be skewed and not reflective of true value for the commodity. The Exchange puts serious consideration into the PRAs that it works with; customer validations are continually conducted to assure PRAs retain the highest confidence within the industry, and all PRAs that partner with the Exchange are expected to operate in line with the principles of the International Organization of Securities Commissions (IOSCO).

There are strengths and weaknesses with both physical delivery and cash settlement. Each commodity market is unique, and contracts should be developed to suit the specific needs of that given market. That said, there are several benefits afforded by cash settlement.

First, cash-settled contracts are less complicated to design and can work for a broader array of market participants. Setting up a physical delivery mechanism requires significant time and investment by the Exchange. Often, that effort is the best fit for an industry and physical delivery makes sense. However, some markets already have active over-the-counter (OTC) trades being valued to reliable PRA assessments. This existing infrastructure, already accepted by market participants, can make a cash-settled contract more straightforward and timely to launch.

Second, traders can participate in the expiration of a contract without the consideration of any aspects of physical delivery. It facilitates speculation near contract expiration since liquidity providers need not be concerned with notice days and delivery timing. Additionally, any market participant within a commodity’s value chain can hedge their risk without concern over physical delivery. Cash settlement allows a greater number of entities to participate late into a contract’s life because the end result is purely a financial exchange rather than optionality on a physical commodity.

Lastly, because cash-settled contracts tend to trade primarily via blocks and less on the screen, liquidity does not have to be present daily for transactions to occur. Since the trend has been that physically delivered contracts have seen considerable development in the electronic marketplace as opposed to bilateral negotiations, bids in the central limit order book need to be plentiful around the clock for sellers to engage. With block trades, a participant looking to hold long positions in a commodity can contact a broker to find a potential short participant without requiring continual offers being populated on the screen.