FINANCIAL MARKETS SERIES

COMMODITIES TRADING
MARCH 2011

TheCityUK is an independent membership body, established in June 2010, promoting the UK financial and related professional services industry. TheCityUK’s key areas of activity include: • Promoting the UK-based industry as a world leader offering unrivalled service and expertise to partners around the world. • Creating a partnership for a sustainable industry: demonstrating the industry’s role in enabling growth and prosperity in the wider UK economy. • Using research, evidence, insight, data and analysis to meet the needs of its members and to provide the evidence to support our promotional objectives.

COMMODITIES TRADING
MARCH 2011
The trading of commodities consists of physical and derivatives trading. This report mainly focuses on commodity derivatives that are traded on exchanges and OTC derivatives markets. The report also gives an overview of the global bullion market and London’s importance as the largest market in the world for gold and silver trading.

exchange trading of commodities

up 47% in three years

SUMMARY
Commodities have seen an upturn in the volume of trading on exchanges in recent years. The number of contracts traded increased by nearly a half in the three years up to 2010 (Chart 1), following on from strong growth seen since the start of the decade. This was largely a result of the growing attraction of commodities as an asset class and a proliferation of investment options which has made it easier to access this market. On the other hand, the notional value outstanding of OTC commodities derivatives fell by twothirds during this period, as investors reduced risk following a five-fold increase in value outstanding in the previous three years. London is one of the main global centres for commodities derivatives trading along with New York and Chicago. While Chicago is predominantly a domestic market, London and New York source a large volume of international business. Commodity assets under management more than doubled between 2008 and 2010 to nearly $380bn. Inflows into the sector totalled over $60bn in 2010, the second highest year on record, down from the record $72bn allocated to commodities funds in the previous year (Chart 2). The bulk of funds went into precious metals and energy products. The growth in prices of many commodities in 2010 (Chart 3) contributed to the increase in the value of commodities funds under management. For example, the price of gold posted a record high during the year and silver a 30 year high.

Chart 1
Commodities trading
% change 500 400 300 200 100 0 -100 97 47 52 -2 Exchange trading2 Physical exports -66 OTC derivatives3 2005-2008 2008-20101 486

1 3

June 2010 for OTC derivatives; 2 Number of contracts traded; Notional value outstanding Source: BIS, IMF; FIA; TheCityUK estimates

Chart 2
Commodity assets under management
$bn, assets under management (bars) 400 350 300 250 50 200 40 150 100 50 0 2005 2006 2007 2008 2009 2010 30 20 10 $bn, annual inflow (line) 80 70 60

OTC derivatives trading The notional value outstanding of OTC
commodities’ derivatives contracts fell 3% in the six months to June 2010 to $2.9 trillion, extending the fall from the previous two years. Precious metals accounted for 19% of the value outstanding at the end of 2010, down from 41% a decade earlier as trading in energy derivatives rose. A large proportion of trading in precious metals takes place on the OTC market in London. The average daily volume of gold and silver cleared at the London Bullion Market Association (LBMA) in December 2010 was 18.0 million ounces (worth $25.0bn) and 99.7 million ounces ($2.9bn) respectively. This means that an amount equal to the annual gold mine production was cleared at the LBMA every 4.4 days, and to the annual silver production every 7.5 days. London is also a leading centre for energy brokers operating in energy and carbon markets.

Source: Barclays Capital

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COMMODITIES TRADING

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Exchange-traded commodities The value of commodities trading on exchanges increased by around a fifth in 2010 to over 2,500 million contracts. Trading on exchanges in China and India has gained in importance in recent years due to their emergence as significant commodities consumers and producers. China accounted for more than 60% of exchange-traded commodities in 2009, up on its 40% share in the previous year.
The outstanding value of funds invested in commodity markets through indices, medium term notes and exchange traded products (ETPs) totalled $310bn at the end of 2010, up from $215bn at the end of 2009 and $113bn in 2008 (Chart 4). The increase in value was primarily triggered by strong inflows into precious metals backed ETPs. Major derivatives exchanges located in London account for around 15% of global trade in commodities: Euronext.liffe, Europe’s biggest exchange for ‘soft commodities’; London Metal Exchange, the leading global exchange for non-ferrous metals; and ICE Futures Europe, the biggest exchange for energy products in Europe. The UK is also home to a number of international commodity organisations such as the International Coffee Organisation, International Cocoa Organisation and International Sugar Organisation. London as the leading international financial centre benefits from being the preferred location for many international firms trading in commodities as well as investment banks and other financial institutions that trade in commodities derivatives.

commodity assets under management double in three years

to $380bn

Chart 3
Commodities, stocks and bonds
Index, 2000=100 200 Goldman Sachs Commodity Index 150 Barclays Aggreg. Bond Index

100

S&P 500

50

2000 2002 2004 2006 2008 2010 2001 2003 2005 2007 2009

Source: GSCI, Barclays, S&P

COMMODITIES MARKETS
Trading of commodities consists of direct physical trading and derivatives trading. Commodities include a range of diverse products (Table 1). More recently there has been growing sophistication of commodities investments with the introduction of new “exotic” products such as weather derivatives, telecommunications bandwidth, gas and power derivatives and environmental emissions trading. Other products that are traded on commodity markets include foreign currencies and financial instruments and indexes. These are the focus of separate TheCityUK reports.

Chart 4
Commodity exchange traded products and indices
$bn, assets under management 300 250 Exchange traded products Indices

50%

Commodities markets
Exchange trading (standardised contract size and maturity dates) Physical trading accounts for a small proportion of trading on exchanges. It is typically used to balance out an excess of demand or supply on the physical market (not a focus of this report). OTC trading (individually tailored) accounts for most OTC trading. Participants include farmers, refiners, wholesalers. Trading is done on the spot and forwards market and is delivery based (not a focus of this report). Precious metals and more recently energy contracts are often traded through OTC derivatives markets.

200 150 100

9%
50 0

91% 2005 2006

2007

2008

2009

50% 2010

Source: Bloomberg, ETP issuer data, Barclays Capital

Derivatives accounts for most of trading on exchanges. Traders include trading hedgers, speculators and arbitragers. Dominates soft commodities’ trading.
1

In placing reliance on other organisations’ statistics, we cannot guarantee a total distinction between physical and derivatives trading statistics.

2

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COMMODITIES TRADING

MARCH 2011

Commodities trading is conducted on OTC markets and exchanges, and consists of spot trading, physical forwards and derivatives.

OTC commodities markets
Physical trading OTC commodities markets are essentially wholesale markets in which individually-tailored contracts are traded. The most popular physical commodities contracts can be broken down into: metals, energy, grains and soy, livestock, food and fibre and exotic commodities. A large proportion of OTC commodities’ trading is transacted between producers, refiners and wholesalers on the spot market. Trading is delivery based and typically done through intermediaries. For most commodities that are physically traded there is no market in a central meeting place and where it exists it typically handles only a small part of the total trade. Derivatives trading The notional value outstanding of banks’ OTC commodities’ derivatives contracts fell 3% in the six months to June 2010 to $2.9 trillion (Chart 5). This was down two-thirds on the value outstanding three years earlier as investors reduced risk following a five-fold increase in value outstanding in the previous three years. Commodities’ share of the overall notional value outstanding of OTC derivatives fell during this period from around 2.0% to 0.5% as investors retreated from this market due to uncertain global economic conditions. Precious metals accounted for 19% of the total in 2010, down from their 41% share a decade earlier as trading in energy derivatives rose. The vast majority of OTC derivatives trading is in interest rate contracts and foreign exchange contracts. OTC trading accounts for the majority of trading in gold (Chart 11). Twice as much gold was traded on OTC markets than on exchanges in 2010. Around 40% of silver is traded on OTC markets. London is by far the largest global centre for OTC transactions in precious metals and accounts for much of global physical trade. Other important centres include New York, Zurich and Tokyo. London is also a leading centre for energy brokers operating in energy and carbon markets. More on this can be found in TheCityUK reports Derivatives Trading 2010 and Carbon Markets 2010.

Twice as much gold
is traded on OTC markets than on exchanges
Chart 5
OTC derivatives trading of commodities
Notional value outstanding, US dollars billions, end-year2 9,000 8,000 7,000 6,000 5,000 4,000 3,000 2,000 1,000 0 Other commodities 81% Other precious metals 4%

59% 8% Gold 15% 33% 2000 2002 2004 2006 2008 20101 2001 2003 2005 2007 2009

1 June; 2 BIS interpretation of commodity derivatives Source: Bank for International Settlements

Chart 6
Commodity trading on exchanges
Annual number of contracts traded, millions (bars) 3,000 2,500 2,000 Number of contracts outstanding, millions (line) 70 60 50 40 1,500 30 1,000 500 0 20 10

Exchange traded commodities Exchange trading provides a central regulated market in which large numbers of buyers and sellers can come together to deal in a competitive, transparent and open environment. Derivatives exchanges are more standardised in terms of contract sizes, maturity dates and margin requirements than OTC markets and tend to dominate trading of ‘soft commodities’. The vast majority of trading on commodity exchanges is in derivatives.
Table 1
Physical commodity breakdown
Grains Corn Soybeans Wheat Oats Soy meal Soybean oil Rice Meats Cattle Hogs Industrial metals Aluminium Copper Lead Nickel Palladium Zinc Precious metals Gold Platinum Silver Food & Fiber Cocoa Coffee Cotton Lumber Orange juice Rubber Sugar Energy Crude oil Heating oil Natural gas Unleaded gas

0 2000 2002 2004 2006 2008 20101 2001 2003 2005 2007 2009 1 September 2010 for number of contracts outstanding Source: Bank for International Settlements, TheCityUK estimate

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COMMODITIES TRADING

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TheCityUK estimates that commodities trading on exchanges increased by around a fifth in 2010 to over 2,500 million contracts. This follows a 19% increase in the previous year (Chart 6). Most of the growth in trading in these two years was in non-precious metals and agriculture contracts. The outstanding value of funds invested in commodity markets through indices, medium term notes and ETPs totalled $310bn at the end of 2010, up from $215bn at the end of 2009 and $113bn in 2008 (Chart 4). The outstanding value of funds invested in ETPs more than tripled in value in the two years up to the end of 2010 to $155bn. Precious metals accounted for more than three quarters of assets under management, commodity indices 13%, and energy products for most of the remainder (Chart 7). The outstanding value of funds invested in commodities indices increased to $155bn in 2010 from $111bn in the previous year. Commodity exchanges have gradually developed from physical markets where deals were made out of warehouses to futures markets which allow for both hedging to protect again losses in a declining market and speculation for gains in a rising market. The derivatives markets for futures were developed initially to help agricultural producers and consumers manage their price risks. Commodities accounted for 9.0% of the value of global exchange-traded derivatives in 2010. This was up from 6.4% two years earlier and less than 3% in 2005. During these five years commodities’ share of the number of contracts outstanding increased from 8.7% to 12.3% (Chart 8). Largest commodity exchanges Worldwide, there are around 50 major commodity exchanges that trade in more than 90 commodities. ‘Soft commodities’ are traded around the world and dominate exchange trading in Asia and Latin America. Metals are predominantly traded in London, New York, Chicago and Shanghai. Energy contracts are mainly traded in New York, London, Tokyo and the Middle East. More recently a number of energy exchanges have emerged in several European countries. In terms of the number of futures contracts traded, in 2009 China and the UK had three exchanges amongst the largest ten, the US two and Japan and India one each (Table 2). The Dalian Commodity Exchange was the largest commodities exchange in the world followed by the Shanghai Futures Exchange and CME Group. The UK’s ICE Futures Europe was fifth and the London Metal Exchange seventh. Trading on exchanges is fairly concentrated. In 2009 the top five exchanges accounted for 86% of contracts traded globally up on their 82% share in the previous year. China and India have gained in importance in recent years with their emergence as significant commodities consumers and producers (Chart 9). Over the past decade a number of large exchanges have opened in China and India such as the Shanghai Futures Exchange, Zhengzhou Commodity Exchange and the Dalian Commodity Exchange in China and the National Commodity and Derivatives Exchange and MCX in India. Chinese exchanges accounted for more than 60% of exchange-traded commodities in 2009, up on their 40% share in the previous year.

Chart 7
Exchange-traded commodity securities
Assets outstanding of exchange-traded products, end-2010 Agriculture Industrial metals,1% Energy 3% 6% Indices 13% Precious metals

77%

Total: $155 billion Source: Bloomberg, ETP issuer data, Barclays Capital

Table 2
Largest commodity derivatives exchanges
Number of futures contracts traded (millions), 2009 Dalian Commodity Exchange Shanghai Futures Exchange CME Group Zhengzhou Comm. Exchange ICE Futures Europe Multi Comm. Exchange of India London Metal Exchange ICE Futures U.S. Mercado a Término de Buenos Aires NYSE Liffe China China US China UK India UK US Argen. UK Agriculture Non-prec. met. Energy, metals, agr. Agriculture Energy Agricul. met. ener. Non-prec. metals Energy Agriculture Agriculture 834 435 431 227 165 161 106 39 14 11

Source: World Federation of Exchanges

Chart 8
Relative importance of exchange trading
Commodities as % share of global derivatives exchange trading

15

12

Number of contracts outstanding

9

6

3
Turnover (contracts)

0

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Source: Bank for International Settlements

BULLION MARKETS
TheCityUK estimates that the market value of above-ground gold stocks totalled around $7.6 trillion at the end of 2010 with turnover of $25.1

Commodities’ exchange traded products

triple in value in two years
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COMMODITIES TRADING

MARCH 2011

trillion during the year (Chart 10). The value of turnover increased by over a quarter in 2010, and nearly doubled on the value of turnover three years earlier. Around two-thirds of gold trading was conducted on OTC markets, and the remainder on exchanges. The value of above-ground stocks and estimated turnover of the silver market totalled $22bn and $3.2 trillion respectively. The value of nearmarket silver or silver that is easily available from above ground stocks (in bullion form or scrap) is however much higher. The value of silver turnover increased by 57% in 2010. Around 40% of silver trading was conducted on OTC markets, and the remainder on exchanges. Although the value of above ground gold and silver is relatively small compared to the global equity and bond market, the gold and silver markets have a much higher turnover as a proportion of market value. It should be noted however that estimates in Charts 11 and 12 of the volume of gold and silver trading are conservative as they do not include all exchange-traded volumes or OTC trading that is cleared outside of London.

Chart 9
Regional split of exchange-traded commodities
% share, number of contracts 80 70 60 50 40 30 20 10 0 Americas Asia Pacific Europe, Africa, Middle East 2009 2008

Source: World Federation of Exchanges

OTC trading Most trading in gold and silver is conducted on the OTC
market. Because the minimum lot size of trading is typically high, the OTC market is dominated by institutional investors and gold market professionals. The OTC market trades 24 hours per day and has no formal structure and no central meeting place. Business is mainly conducted by telephone or through electronic dealing systems. The global centre for such trading is London. Other large OTC markets include New York, Zurich, Tokyo, Sydney and Hong Kong. Some OTC business in kilogram and smaller bars for jewellery manufacture and personal investment is conducted in several other cities in Asia and the Middle East. Although the physical market for gold and silver is distributed globally most wholesale trades are cleared through London. It is difficult to quantify the size of the OTC market as it is less transparent than exchanges. London Bullion Market Association’s (LBMA) clearing statistics however provide an indicator of the trend in market turnover. The average daily volume of gold and silver cleared at the LBMA in December 2010 was 18.0 million ounces (worth $25.0bn) and 99.7m ounces ($2.92bn) respectively (Charts 13 and 14). This compares with annual global mine production of gold and silver of approximately 80m ounces and 750m ounces respectively. This means that an amount equal to the annual gold mine production was cleared at the LBMA every 4.4 days, and to the annual silver production every 7.5 days. Reported LBMA turnover in both gold and silver has risen sharply in recent years in terms of value traded partly due to the increase in prices in these commodities and their “safe-haven” appeal. Reported volumes significantly understate actual volume of London market turnover which is probably three to five times the reported value because transactions are increasingly netted out and cleared without appearing in the statistics. Because most gold is traded through London, LBMA clearing figures represent the result of worldwide gold trading. It is estimated that around three-quarters of gold and a half of silver transactions originate from outside the UK. Notional amounts outstanding of OTC derivatives gold contracts totalled

Chart 10
Size of the gold and silver market
$bn, 2010 25,000 20,000 15,000 10,000 5,000 0 Market capitalisation 25,088 63,054 53,727 Turnover $bn, 2010 70,000 60,000 50,000 40,000 30,000 7,618 20,000 3,182 Gold 22 Silver Equity market 10,000 0

1 includes COMEX, TOCOM and 3 times LBMA turnover; Source: TheCityUK estimates

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COMMODITIES TRADING

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$417bn in June 2010, down 2% on previous year (Chart 5), and 35% below the peak in June 2008. The value traded in gold futures and options is on a long-term upward trend, and has nearly doubled during the past decade.

Chart 11
Gold market global turnover
Billions of ounces (bars) 25 Exchange trading OTC market $bn (line) 25,000

Trading on exchanges Gold and silver can be traded on exchanges in the form of futures and options, and gold and silver backed securities:
Futures and options trading of gold and silver has gained in importance in recent years. Turnover of gold increased more than 60% in 2010 to a record $8.2 trillion (Chart 15). This was partly due to the increase in the price of gold during the year. The value of silver traded on exchanges nearly doubled in 2010 to $1.9 trillion (Chart 16). The main commodity exchanges for gold and silver are Comex in New York, Tocom in Tokyo and more recently MCX in India. Gold can also be traded on other commodity exchanges including the Chicago Board of Trade, Istanbul Gold Exchange, Chinese Gold and Silver Exchange Society, the Shanghai Gold Exchange and Dubai Commodity Exchange. Only a small percentage of the futures market turnover ever comes to physical delivery of the gold or silver represented by the contracts traded. Gold and silver backed securities Precious metals trading in the form of securities on exchanges is based on fixed delivery dates and transaction sizes. These forms of securitised investments include for example Exchange Traded Funds or Exchange Traded Commodities (ETFs or ETCs) and Exchange Traded Notes. ETFs, which represent equity market securities that follow physical commodity returns, account for around 70% of such trading. The value of ETFs for both silver and gold trading have increased strongly in recent years. These securities have had a major impact on the market, representing over 10% of total demand in 2010. Gold ETFs holdings totalled over 60m ounces at the end of 2010. Total silver ETF holdings ended 2010 close to their peak at around 500m ounces.

20

20,000

15

15,000

10

10,000

5

5,000

2009 2007 2005 2003 2010 2008 2006 2004 2002 1 OTC data is three times LBMA turnover, exchange data is TOCOM, COMEX and MCX trading Source: TheCityUK estimates 2001

0

0

Chart 12
Silver market global turnover
Billions of ounces (bars) 200 Exchange trading OTC market $bn (line) 3500 3000 2500 2000 100 1500 50 1000 500 2003 2005 2007 2009 2002 2004 2006 2008 2010 1 OTC data is three times LBMA turnover, exchange data is TOCOM, COMEX and MCX trading Source: TheCityUK estimates 0 2001 0

150

Gold and silver supply and demand
Supply TheCityUK estimates that the total volume of identifiable aboveground gold at the end of 2010 was around 169,000 tonnes or 5.4bn ounces. About three-quarters of this has been mined in the past 100 years. As gold is not consumed, like most commodities, virtually all of the gold that has been mined is still in existence. Jewellery accounted for more than a half of above ground gold stocks in 2009, private investment 18%, official holdings 16% and other fabrication for most of the remainder. The overall quantity of silver mined throughout history totalled 47bn ounces. Silver's above ground supply is however only about one quarter of the above ground supply of gold (Chart 12) as most silver is used up for industrial purposes. However near-market or easily mobilisable silver supply may well exceed that of gold. Gold supply in 2010 was at around the previous year’s levels of 135 million ounces. Mine production accounted for over 60% of the total supply. Old gold scrap generated 38%, and net central bank sales most of the remainder.

Chart 13
Volume of London bullion market clearing
Gold, moz transferred, daily turnover average 25 Gold (LH scale) Silver, moz transferred, daily turnover average 150

20

120

15 Silver (RH scale)

90

10

2000 2002 2004 2006 2008 2010 2001 2003 2005 2007 2009

60

Source: London Bullion Market Association

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COMMODITIES TRADING

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There has been a gradual shift in production from ”traditional” gold producing countries (South Africa, Australia, US and Canada) to “emerging” countries (China, Peru, Russia and Indonesia) over the past decade. Gold production in China increased by 62% between 2001 and 2009 to 10 million ounces, while world output fell by 9.6% during the same period. In 2007, China overtook South Africa to become the world’s largest gold producer. Australia overtook South Africa in 2009 to become the second largest producer with 7 million ounces. South Africa had been the biggest gold producer for more than a century. Gold annual production in South Africa has almost halved between 2001 and 2009 to 7 million ounces. Silver supply totalled around 770 million ounces in 2010. About 70% of the annual silver supply consists of newly mined production and most of the remainder comes from recycled above-ground stocks and net Government sales. The largest silver mining country in 2009 was Peru with 17% of the total, followed by Mexico 15%, China 13% and Australia 7%. Around 60 countries mine silver annually although the bulk of production is concentrated in 15 countries. Over the past two decades the amount of silver extracted from primary silver mines has fallen, while silver mined as a co-product of copper, lead, zinc, gold, or poly-metallic deposits has risen. Demand Annual demand of both gold and silver exceeds annual mining production. The shortfall is made up from recycling metal scrap and from central bank sales. Gold demand is much harder to estimate than supply because it is widely dispersed; many buyers are deliberately secretive; and demand that is met from recycled scrap and demand transacted on the OTC market is difficult to measure. Identifiable physical demand increased 8% in 2009 to 137million ounces. This was despite a 16% decline in fabrication demand, driven by a sharp decline in jewellery demand. Jewellery manufacturing typically accounts for most of the gold demand, over 40% in 2009. A geographical breakdown of gold fabrication shows that India is by far the biggest consumer with more than a quarter. Global investment demand nearly doubled in 2009 to over 61million ounces, worth around $60bn. This was largely due to fears about the global economy and financial stability which triggered a wave of safe-haven buying. Gold demand is expected by the World Gold Council to be higher in 2010 than in 2009 as a result of growing demand in India and China and sustained global demand for gold investment. The status of silver is gradually changing from a precious to an industrial metal. Demand for silver increased marginally in 2009 to 889 million of ounces and is likely to increase by more than 10% in 2010 due to an increase in fabrication demand and investment demand which is projected to grow to an all time high in 2010. By far the largest use for silver is for industrial fabrication such as in the electronics industry as silver has superior electrical conductivity. The main consumer countries for silver are the US, Japan, India and China. The main factors affecting these countries demand for silver are macro economic factors such as economic growth, industrial production and income levels.

London gold and silver fixings
London gold and silver fixings are internationally published benchmarks for precious metals. The silver fixing started in 1897 and the gold fixing in 1919. For gold, the market participants get together twice every working day for a "fixing", while a similar procedure takes place once a day for silver. The prices are used in contract arrangements around the world. The fixing of the gold price is conducted by telephone at 10:30am and 3:00pm each working day. There are five members of the Gold Fixing, all of whom are Market Making members of the LBMA. They are the Bank of Nova Scotia– ScotiaMocatta, Barclays Bank Plc, Deutsche Bank AG, HSBC Bank USA and Société Générale. Each representative keeps an open phone line to their firm's trading room which has orders from other bullion banks and customers from all over the world. The fixing lasts until a single price representing an equilibrium between supply and demand is found. The fixing of the silver price is conducted by three Market Making members of the LBMA under the chairmanship of The Bank of Nova Scotia–ScotiaMocatta by telephone at 12.00 noon each working day. The other two members of the Silver Fixing are Deutsche Bank AG and HSBC Bank USA. Many gold and silver dealers and their customers agree in advance to use the London fixings as a basis for transactions.

Chart 14
Value of London bullion market clearing
$bn, gold, daily turnover average 25 $bn, silver daily turnover average 2.0 Silver (RH scale) 20 1.5

15 Gold (LH scale) 10

1.0

0.5

5

2000 2002 2004 2006 2008 2010 2001 2003 2005 2007 2009

0.0

Source: London Bullion Market Association

77% of investments
7

Gold and silver ETPs account for

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COMMODITIES TRADING

MARCH 2011

LONDON AS A CENTRE FOR COMMODITIES DERIVATIVES TRADING
London is one of the main global centres for commodities trading along with New York and Chicago. While Chicago is predominantly a domestic market London and New York source a large volume of international business. Major derivatives exchanges located in London account for around 15% of global trade in commodities (Table 3): NYSE.Liffe, the international derivatives business of Euronext which trades ‘soft commodities’; the London Metal Exchange (LME) which specialises in nonferrous metals; and ICE Futures Europe which trades in energy products. The London Bullion Market association is the world’s largest market for OTC precious metals trading. The UK is also home to a number of international commodity organisations including the International Coffee Organisation, International Cocoa Organisation, International Sugar Organisation, International Grains Council and Grain and Feed Trade Association.

Chart 15
Annual turnover of exchange-traded gold
Millions of ounces 7,000
MCX

$bn, (line) 9,000
TOCOM COMEX

6,000 5,000 4,000 3,000 2,000

8,000 7,000 6,000 5,000 4,000 3,000 2,000

1,000 0

1,000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 0

London Metal Exchange is the world’s largest exchange for nonferrous metals with a 90% share of global trading. The LME offers futures and traded options contracts on six primary metals: aluminium, copper, nickel, tin, lead and zinc and two aluminum alloy contracts, as well as a composite index of these metals. Consumers as well as producers of metals use the official prices of LME for their long term contracts pricing. Since May 2005 the range of contracts traded has been widened to include plastics contracts including polypropylene and linear low density polyethylene. LME also offers LMEminis, smaller-sized contracts for copper, aluminium and zinc, plus an index contract. The primary functions of the exchange are pricing, hedging and delivery: In order to facilitate delivery, the LME approves storage facilities where traders can make and take delivery. There are over 400 LME approved warehouses in over 30 locations covering the US, Europe, the Middle & the Far East. Trading on the exchange consists of open outcry trading in ‘the ring’, supported by a 24 hour telephone market and screen-based trading on LME Select. Despite its London location the LME is a global market with an international membership and with more than 95% of its business coming from overseas. Turnover of LME contracts increased by 7% in 2010 to reach a record 120 million lots, equivalent to $11,600bn. Aluminium, copper and zinc were the three largest contracts by volume with 50.1 million, 33.1 million and 18.8 million lots traded respectively. Of the base metals, trading in lead saw the highest growth rate with a 30% increase, while copper trading rose by around a quarter.

Source: TheCityUK estimates based on TOCOM, COMEX, MCX data

Chart 16
Annual turnover of exchange-traded silver
Millions of ounces 90,000 $bn, (line) 2,000

MCX 80,000 70,000 60,000 50,000 1,000 40,000 30,000 20,000 10,000 0
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

TOCOM COMEX 1,500

500

0

Source: TheCityUK estimates based on TOCOM, COMEX, MCX data

Chart 17
Stocks of gold and silver
Billions of ounces 50 Stocks at end-2010 Total volume mined throughout history 47.0

40

ICE Futures Europe, a subsidiary of Intercontinental Exchange, is the
leading electronic regulated futures and options exchange for global energy markets. Energy contracts traded including crude oil, heating oil, natural gas and unleaded gas. It is used by producers, distributors and consumers of energy to manage their price exposure in the physical energy market. Turnover grew for the thirteenth consecutive year in 2010 to reach 217 million contracts or more than twice the level four years earlier. The three most traded futures contracts were ICE Brent Crude with 100.0 million contracts traded during the year, followed by WTI Crude futures with 52.6 million and Gas Oil contracts with 52.3 million.
30

20

10 5.6 0 Gold 5.4

COMEX 0.7 Silver

Source: TheCityUK estimates

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COMMODITIES TRADING

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NYSE.Liffe is the is the global derivatives business of the NYSE Euronext group. It offers a single, electronic market for products listed on its Amsterdam, Brussels, London, Lisbon and Paris exchanges. NYSE.Liffe is Europe’s biggest exchange for ‘soft commodities’. It began trading in derivatives in 1982 and expanded to include a wide range of derivatives products. Derivatives markets supported by its electronic trading platform, LIFFE CONNECT, are available to customers at over 825 locations in 31 countries.
In 2010 there was a total of 1,223 million contracts traded on NYSE.Liffe, of which 16.7 million were in commodities. Trading in commodities on the exchange have grown steadily in recent years and more than tripled over the past decade. Wheat milling was the most widely traded commodity contract and accounted for 32% of commodity contracts in 2010, followed by cocoa with 27% and robusta coffee with 20%.

Table 3
Turnover of London-based derivatives exchanges
Millions of contracts traded each year NYSE ICE Futures LME Europe1 Liffe2 66.4 2000 25.5 131.1 59.4 2001 26.4 619.1 58.6 2002 30.4 697.0 72.3 2003 33.3 695.1 71.9 2004 35.5 787.8 78.6 2005 42.1 759.3 86.9 2006 92.7 730.3 92.1 2007 138.5 949.0 113.2 2008 153.0 1,049.7 111.9 2009 165.7 1,056.0 120.3 2010 217.2 1,222.6
1

of which Total commodity 96.6 223.0 90.5 704.9 94.7 786.0 112.2 800.7 115.4 895.2 129.2 880.0 189.5 909.9 243.4 1,179.6 297.4 1,315.9 289.7 1,333.6 354.2 1,560.1

IPE before 2005; 2Includes other Liffe exch. in Europe from 2001 Source: Exchanges

APX-ENDEX operates power and gas exchanges for the wholesale market, providing markets for short-term trading in the Netherlands, the UK and Belgium. APX-ENDEX is headquartered in Amsterdam but also has offices in London and Nottingham. London Bullion Market Association (LBMA) London has the largest market in the world for gold and silver trading, and the one with the longest history. OTC gold and silver transactions around the world, particularly those of central banks and mining companies, are conducted through the "Loco London" market in which the two metals are traded for delivery in London. The London bullion market is a wholesale market, where minimum traded amounts for clients are generally 1,000 ounces of gold and 50,000 ounces of silver. Other centres which typically trade gold and silver “Loco London” include: in Asia, Hong Kong, Tokyo, Sydney and Singapore; in Europe, Zurich and Frankfurt; and in the US, New York. This market does not require physical delivery and trades can be conducted on a deferred basis in which delivery is postponed until positions are liquidated. The “Loco London” market serves various purposes including hedging, investment and speculation.
The London gold and silver markets operate under the auspices of the London Bullion Market Association (LBMA). This is not an exchange. Rather it is a representative body for the bullion market whose members include banks, fabricators, refiners, shippers and brokers. Members of the London bullion market typically trade with each other and with their clients on a principal-to-principal basis. All risks, including those of credit, are between the two parties to a transaction. LBMA members are classified into market making members, which include all of the participants in the twice-daily London gold fix as well as other bullion houses and ordinary members. The London bullion market relies on a daily clearing system. A number of LBMA members offer clearing services. Clearing members net out between each other their own and third party gold and silver transactions so that only the net difference between purchases and sales is actually transferred. This system reduces the security risks and costs that would be involved in the physical movement of bullion. A bullion clearing bank may however also take physical delivery of bullion. Most bullion houses act both as brokers for customers and as primary dealers who hold their own positions.

Forms of gold and silver investments
Bullion bars and coins are offered in a variety of weights and sizes. These include for gold, the kilobar (32.15 troy ounces) and "London Good Delivery" bar (400 troy ounces). Buying gold and silver bullion coins is a popular and traditional means of investing among medium and small investors. Bullion certificates A certificate of ownership can be held by investors, instead of storing the actual bullion. Certificates allow investors to buy and sell the security without the inconvenience associated with the transfer of actual physical bullion. Accounts Some banks offer gold accounts where gold can be bought or sold just like any foreign currency. Gold accounts are backed through unallocated or allocated gold storage. Mining shares Many investors access the precious metals market by investing in gold or silver mining firms. They offer capital appreciation opportunities, as well as the opportunity to earn a dividend. Mutual funds offer investment opportunities in gold and silver. Mutual funds diversify their precious metals holdings thus reducing the risk as the investor is buying the general market risk instead of a company-specific risk. Bullion derivatives The precious metals derivatives market has grown rapidly over the past decade. Futures and options offer certain advantages such as speculative appeal, leverage which reduces capital tie-up, no storage risk and high liquidity. Trading on stock exchanges Gold and silver can also be traded on the London, New York, Johannesburg and a number of other exchanges. This is a relatively recent addition to the “portfolio” of alternative investments and provides a transparent, secure and cost-effective way to invest in gold.

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They may service private clients wishing to deal in large quantities but normally this trade would go through the client's private bank.

Chart 18
World official gold holdings
% share, end-2010

The London Energy Brokers Association (LEBA) is the industry
Association representing the FSA regulated wholesale market brokers in the OTC and the exchange traded UK and liberalised European energy markets. These brokers intermediate and facilitate bilateral contracts to be concluded between banks, trading houses, commercial enterprises, public utilities and integrated energy businesses, providing liquidity and price discovery to these markets as well as contributing significant liquidity to European exchange traded markets. The major products that LEBA members deal in include crude oil and refined petroleum products, gas, electricity and emissions. In 2010, member firms of the London Energy Brokers’ Association, traded a total of of 2,596,521,515MT of CO2 equivalent (CO2e) emmissions contracts. There was also 3,044,220,988MT traded in coal contracts, 9,258,799,248MWh in power contracts and 20,076,044,650MWh in natural gas contracts.

US Others 27% 39%

11% 3% 3% 8% China France 8%

Germany

Switzerland

Italy COMEX

World total: 978 millions of ounces

Source: World Gold Council

Chart 19
Performance of GSCI subindexes
% return, 2010

COMMODITY INVESTMENTS
Commodity assets under management more than doubled between 2008 and 2010 to nearly $380bn. Inflows into the sector totalled $62bn in 2010, the second highest year on record, down from the record $72bn allocated to commodities funds in the previous year. Commodity prices have increased sharply from the lows in late 2008 and early 2009 at the height of the global financial crisis (Chart 2). The cost of cereals, oil and iron ore has for example increased between 40% and 150% to two year highs at the end of 2010. Prior to this, between 2003 and 2008 commodity prices increased by an average of 131%, the biggest five year increase for more than a century. Besides the recovery in the global economy and commodity specific factors, a number of more general factors are behind the recent rise in prices. Emerging economies have driven demand for various commodities (particularly markets in China, India and the Middle East); biofuels have boosted the demand for specific food crops; slow supply responses have amplified price pressures; and low interest rates and the weakening of the dollar have been a supporting factor. Gold and silver prices have posted strong gains in recent years. Gold prices increased 29.5% in 2010 and closed the year at a record high of $1,423 with an average price during the year of $1,226 per ounce. Towards the end of 2010, silver breached $30 per ounce for the first time in 30 years. The 80% rise in silver prices during the year was largely a result of strong investment demand. The sharp rise of commodity prices in recent years is in contrast to the 1980s and 1990s when returns on commodities were not competitive with either stocks or bonds. Commodity prices, measured in inflation adjusted terms, reached levels equivalent to their 1930s lows in 1999. Many factors have contributed to this including: falling demand for commodities as a hedge against inflation in market conditions of low inflation in developed

Total return Energy Industrial Metals Precious Metals Agriculture Livestock 0 Source: GSCI 5 1.91%

9.03%

16.73% 34.46% 34.19% 10.49% 10 15 20 25 30 35

Chart 20
Annual average price of gold and silver
US dollars / troy ounce 1,300 1,200 1,100 1,000 900 800 700 600 500 400 300 200 100 0 1990 Source: Kitco 1995 2000 2005 0 2010 Silver (RH scale) Gold (LH scale) 5 10 15 20 US dollars / troy ounce 25

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Types of commodities investments
Commodities can be used to diversify a portfolio of financial assets (Table 4). In recent years there has been increased investment in commodities, not only by institutional investors, but also by hedge funds, retail investors and sovereign wealth funds. Factors that have contributed to this include: the significant rise in prices of many commodities; their function as a hedge against inflation; economic uncertainty in global markets; underinvestment in commodities production in the past two decades; rising demand particularly in emerging markets such as China and India; and diversification benefits. The development of investment products that passively track a broad range of commodities have also made it easier for investors to access this market. Investors can gain exposure to commodities through: direct investments in physical commodities; direct investments in commodity-related companies and investments in commodity futures through exchange traded standardised contracts. Exchange traded products in particular have transformed the range of investment choices available in commodity markets. They are relatively young compared with other commodities’ investment instruments. The first developed, the Gold ETC, was launched in 2003. One of the simplest ways of investing in commodities is through indexed commodity strategies. These offer access to a basket of commodities which reduces the risk of investing as commodities themselves have low correlations. There are a number of commodity indices such as the Goldman Sachs Commodities Index (GSCI), Dow Jones AIG commodity index, Deutsche Bank Liquid Commodity Index (DBLCI) and the DBLCI-Mean Reversion Index, Standard & Poor’s commodity index (SPCI) and Reuters/Jefferies CRB Index. Another way of investing in commodity indexes is to invest in tilted indices, towards a certain commodity or groups of commodities. The GSCI has, for example, six sub-indices.

Table 4
Correlation of commodities and other asset classes
Correlation of S&P GSCI sub-indices with major indices 1999-2009 Agriculture Energy Industrial metals Livestock Precious metals 2004-2009 Agriculture Energy Industrial metals Livestock Precious metals Bonds -9.6 -8.9 -13.2 -8.5 8.4 S&P 500 14.4 13.1 22.5 10.5 -2.8 S&P GSCI -9.6 -8.9 -13.2 -8.5 8.4

-16.3 -16.3 -18.4 -11.8 3.5

22.0 27.5 27.5 15.6 1.7

-16.3 -16.3 -18.4 -11.8 3.5

Source: DB Global Markets Research

Table 5
Commodities as an asset class
Annual return 2010 5 year Since 1999 Source: S&P S&P GSCI 9.0 -6.5 9.9 S&P 500 15.1 2.4 9.2 JPM Govt Bond Index 3.4 3.5 6.8

countries; consumer spending in the U.S. which dominated global demand during the period, shifted towards services that require fewer commodities to produce than manufactured goods; and much higher returns on equity markets. Commodity exports continue to play an important role in emerging market economies although their exports have become much more diversified in terms of both composition and destinations. The Middle East and North Africa and to a lesser extent sub-Saharan Africa and Latin America have been the main beneficiaries of the recent increase in commodity prices. Fuel exports play the most critical role in the Middle East and north Africa, where they now account for more than one-third of GDP. Latin America depends on both fuel and nonfuel commodities whereas nonfuel commodities are particularly important in sub-Saharan Africa.

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LINKS TO OTHER SOURCES OF INFORMATION
Bank for International Settlements www.bis.org Ice Futures www.theice.com Euronext.liffe www.euronext.com Futures and Options Association www.foa.co.uk Futures Industry Association www.futuresindustry.org GFMS Ltd www.gfms.co.uk London Bullion Market Association www.lbma.org.uk London Metal Exchange www.lme.co.uk The London Energy Brokers’ Association www.leba.org.uk The Silver Institute www.silverinstitute.org World Gold Council www.gold.org World Trade Organisation www.wto.org

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THECITYUK RESEARCH CENTRE:
Report author: Marko Maslakovic For further information about our work, or to comment on the programme/reports, please contact: Duncan McKenzie, Head of Research duncan.mckenzie@TheCityUK.com, +44 (0)20 7776 8976 Marko Maslakovic, Economic Research Senior Manager marko.maslakovic@TheCityUK.com, +44 (0)20 7776 8977 TheCityUK, 65a Basinghall Street, EC2V 5DZ www.TheCityUK.com © Copyright March 2011, TheCityUK

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