Abaxx making the case for a new lithium benchmark

Do cash-settled futures contracts suffer from inherent weakness? David Greely, chief economist at new commodity exchange Abaxx certainly thinks so.

His firm sets out what sees as these flaws in a white paper “Back to the Futures”. And he quotes a 2011 blog post by Craig Pirrong — a finance professor at the University of Houston whose research focuses on the economics of derivatives markets and risk management — to best sum up the challenges of non-physically delivered contracts.

“Cash settlement works if there is an independent, reliable, relatively un-manipulable source of cash market prices that can be used to set a futures price at expiration. The markets for which these conditions prevail are very, very small,” Pirrong wrote.

“Cash settlement works in equities for contracts like the S&P500/E-mini because there is an active, transparent cash market for stocks. It works pretty well for live hogs because the USDA collects data on the price paid for every animal bought by processors.

"Beyond those examples, cash settlement is problematic, or in many cases, actually counterproductive. In the late ’90s/early ’00s, cash settlement in [US] natural gas indexes was rife with misreporting and fraud. In 2008, I wrote a few posts about reports that banks were putting the lie in Libor. Virtually no commodity market has enough active, transparent cash markets to support cash settlement,” the academic warned.

Of course, with Abaxx launching physically delivered lithium carbonate futures as a challenge to incumbent Western exchange the CME’s cash-settled instruments, there is admittedly a risk, in the immortal words of Mandy Rice-Davies, of ‘he would say, wouldn’t he?’ in Greely’s argument. So, EV inFocus sat down with Greely and his colleague Sacha Lifschitz, Abaxx’s head of battery materials, to find out more.     

What problem are the new instruments trying to solve? How are these solutions more optimal than existing i) non-physically delivered or ii) China-based alternatives?

Greely: The rapid growth in the use of electric vehicles is driving demand for battery metals like lithium. Despite the growing size and importance of the lithium market, it lacks a proper physically deliverable benchmark futures contract outside of China. A benchmark futures contract, like WTI in the crude oil market, is critical for facilitating price discovery and for the management of price risk, which is in turn critical to unlocking the investment capital to grow the supply of lithium to meet the increasing demand.

Abaxx’s three regional physically deliverable lithium carbonate futures contracts are US dollar-denominated and physically deliverable in Singapore, Rotterdam and Baltimore, respectively. They address an unmet demand for the entire lithium supply chain — producers, traders, converters, and consumers — by providing regional price discovery, and also a reliable and transparent, standardised and globally accessible set of pricing benchmarks with which participants can align for financing, supply chain planning, and long-term contracting. The design also better aligns trade flows with physical market realities.

The only currently existing physically deliverable lithium carbonate contract is traded at the GFEx and is RMB-denominated and customs cleared/duty paid. The Abaxx contracts are, as I said, USD-denominated, accessible outside of China and freely tradeable offshore.

Are there any specific changes in the wider lithium commercial landscape that have opened a gap for new physically delivered, ex-China instruments?

Greely: It is really that the move to EVs has driven increased demand for lithium and the importance of the lithium market, which has made having a reliable means of price discovery and the right tools to manage risk much more important.

Up until today, the global lithium futures market has been constricted by not being able to trade onshore Chinese futures markets.  Our contracts solve that issue and allow producers, carbonate processors and financial institutions the ability to trade a deliverable non-China, USD-denominated market.

Abaxx’s futures contacts contribute risk management tools for a nascent and rapidly evolving lithium industry. Owing to the downturn in lithium prices during the last one-and-a-half years, new lithium projects, existing producers, as well as consumers who are facing an ever-growing demand for these products, need tools to manage price risks and need efficient and transparent marketplaces that can act as buyers and sellers of last resort.

What range of actors do you hope to be active in the new contracts? How might these players differ from those currently using the existing cash-settled or Chinese solutions?
Lifschitz: We believe that our contracts are attractive to all types of market participants: from new project developers to existing producers, traders/merchants, converters, and OEMs, as well as financial players. The fact that our contracts are physically deliverable increases their usability beyond risk management, as the physical flow of the commodity creates alternative sourcing and sales opportunities.

Our contracts are designed to match the way in which lithium carbonate is bought and sold in the physical markets, while physical delivery guarantees convergence of the futures price to the price in the spot market. Cash-settled, index-related products in any futures market do not properly reflect the physical underlying price of the commodity.

Daily settlements from PRAs are based on surveys of market participants and not on actual physical trades.  In contrast, our Abaxx physically-deliverable lithium carbonate futures contracts establish an actual futures price for the underlying commodity, bringing more security and certainty to this growing global market.

What does success look like for these new contracts?

Lifschitz: Over time, success for these contracts is for them to become the recognised benchmark futures prices for the lithium market, like WTI is in the crude oil market or Henry Hub is in the US natural gas market. However, that will take time.

In the meantime, success is market participants viewing these contracts as providing them with the new source for price discovery and new tools for risk management for which they have been waiting, and these participants connecting with our exchange through their clearing firms and beginning to trade these new futures markets.

We are working every day to increase the liquidity in these markets — by, for example, increasing the number of deliverable brands and by building a liquid two-way market on a daily basis. And we believe that building this liquidity will enable these contracts, over time, to become recognised benchmarks.

If Abaxx is able to gain traction, is there any risk that larger rivals could launch copycat instruments in an effort to shift nascent liquidity onto their platforms?

Greely: Generally, we think that competition is good, and the market will ultimately decide which products and markets they will trade. Launching physically deliverable futures is a much more involved process than launching cash-settled contracts and, we believe, much more valuable to market participants. 

Liquidity tends to pool in one futures contract for any commodity, making these winner-take-all products. We believe that the relationships we have built with market participants while developing these contracts, the focus we place on making sure that our products meet their commercial needs, and our ability to evolve our products to meet changing market demands and changing market realities are competitive strengths that will keep participants in our markets, rather than move to a copycat contract.