Cotton, Commodity Volatility and Contract Risk — Getting Back to the Trust Basics

There's a frequent misperception in the non-financial world that futures and commodities exchanges were originally founded and fueled by speculators to take positions on markets. Nothing could be further from the spend truth. In large part, the Chicago Mercantile Exchange was originally founded as a risk management mechanism for farmers who could lock-in future prices for their crops, enabling them to take risk off the table (and even fund the purchase of necessary items and labor to bring a particular crop from seed to harvest). Ultimately, brokers and speculators would take more of a central role in traded volume and creating liquidity.

In fact, in certain commodities and contracts now change hands half a dozen or more times. A recent Wall Street Journal article from last week covering the plight of cotton suggests that each contract is typically traded seven times before delivery. In a market where everyone honors the basic trading (agreement to take delivery, agreement to pay, settlement date, etc.) such a turnover would not be a problem. But as the WSJ points out, a failure to honor the rules in the recent highly volatile climate is precisely the problem.

Specifically, "over the past two years, cotton prices nearly tripled before they fell by almost two-thirds, triggering the broken deals. Both cotton growers and the overseas mills that spin cotton into yarn have walked away from previously signed agreements after prices turned against them ... As much as 20% of the hundreds of thousands of contracts written since 2010 -- valued at as much as $12 billion -- have been reneged on or rewritten," one expert quoted in the article suggests.

In a world where commodity management platforms and advanced sourcing strategies (e.g., leveraged buying and demand aggregation for raw materials on behalf of a multi-tier supply chain) are becoming more ubiquitous in advanced CPG companies, retailers and manufacturers, cotton's recent market shortcomings are a painful reminder of the critical nature of placing trust in trading partners. Without this at the core, the best traders, the best sourcing professionals, the best market intelligence and the best software is absolutely meaningless -- from the farm to the loom.

- Jason Busch

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