Ethiopian Development Research Institute(EDRI) and IFPRI Ethiopia Strategy Support Program 2 (IFPRI-ESSP2) Seminar Series April 30, 2009

1. Commodity Exchanges:
Setting the Rules of the Game
Eleni Gabre-Madhin
April 30, 2009
1

2. 2

3. One form of exchange, market exchange, has been
allowed to encircle the globe and penetrate deeply into
societies. It is therefore a matter of no mean irony that so
little is known about how markets work in developing
countries.
Barbara Harris-White, 1999
It is part of an institutional ritual in development
economics, as in much of economic theory, to relegate all
institutional matters into a „black box.‟ The box is
supposed to contain something vaguely important, but it
does not usually receive more than a nodding, if
somewhat intriguing, recognition in passing.
Pranab Bardhan, 1989
3

4. Why do Institutions Matter for Markets?
Three I‟s of Market Development:
INCENTIVES
PUBLIC SECTOR
SECTOR
INFRASTRUCTURE INSTITUTIONS
FARMERS
TRADING FIRMS
PROCESSORS
TRANSPORTERS
STORERS
4

5. What are Institutions?
Can they be identified with formal laws,
informal norms, established organizations,
contracts, people‟s mindsets, culture, or
some combination of some or all of these?
How do institutions emerge and evolve?
Are they endogenous (internally-derived)
or exogenous (externally-driven) or both?
5

6. What are Institutions?
Different definitions using game analogy:
 Institutions are the “players of the game”
– organizations, agencies, church, school,
etc
 Institutions are the “rules of the game” -
the humanly devised constraints that
shape human interaction (Douglass North)
informal: sanctions, taboos, customs,
traditions, and codes of conduct
formal: laws, contracts, constitutions 6

7. What do Institutions Do?
Institutions are efficient solutions to
minimize transaction costs of economic
organization in a competitive framework
(Williamson) (INTERNALLY DRIVEN - NO STATE ROLE)
Institutions, as the rules of the game, are
devised to create order, reduce uncertainty,
and shape the incentives of players (North)
(EXTERNALLY DRIVEN - ACTIVE STATE ROLE)
7

8. Historical record
“The inability of societies to develop
effective, low-cost enforcement of
contracts is the most important source of
both historical stagnation and
contemporary underdevelopment in the
third world.”
North (1990)
8

9. A Unified Definition of Market
Institutions
Institutions for markets can be defined as
the set of constraints – formal or informal,
exogenous or endogenous – that govern
relations in the exchange process
This includes: contracts, trading practices,
community norms, commercial laws and
regulations, supply chains, etc.
Focus on relations between actors, rather
than actors, and behavior of actors rather
than outcomes 9

10. Institutions as Links in the Market Chain
Transaction costs
PRODUCER CONSUMER
FIRM
Norms
Trust
Rules STATE
Laws
Codes of conduct
10

11. Approach to Institutional Design
 Synchronic Problem – understanding the role and
complexity of institutional arrangements in the
market:
 Enforcement: How are market interactions enforced?
What are formal and informal rules that define interaction?
What and where are the constraints and costs of
enforcement?
 Coordination: What are costs of coordination? What are
sources of costs? How do these costs determine the
economic organization of the market?
 Diachronic Problem – understanding the process of
institutional change:
 Where do the rules of the game come from? Who should
alter them: internally versus externally? How context
dependent are the rules? What would be impact of
change on the existing institutional arrangements
11

12. Enforcement
Enforcement mechanisms depend on
market complexity and type: local, distant,
complex, …
Complexity linked to technical
characteristics of product and production
process
As markets scale up, move from internal to
external role of either private or public 3rd
party
12

13. Enforcement along Market Continuum
LOCAL
EXCHANGE
DISTANT
EXCHANGE
BAZAAR
MARKET
SPOT MARKET
trust; networks, 3rd party laws morality
repeated norms clientelism culture
13
Enforcement costs, Complexity, Specialization

14. Coordination
 Changing the extent or nature of underlying transaction
costs will achieve a different configuration of market
coordination outcomes: this is the policy challenge of
external intervention
 Appropriate market coordination emerges, depending on
market type, that is, type of transactional attributes
(local, distant, spot,..): this is the internal part
 Commodity type is less relevant than market type and
nature and extent of transaction costs: eg. export vs.
staple is not meaningful - staples can be tradable in
anonymous domestic or world market)
14

15. Market organization and transaction
costs
SPOT HYBRID INTEGRATED
MARKET (vertical or horizontal
FIRM
coordination, or both
in supply chains)
Asset specificity, Uncertainty, Complexity, Frequency
15

16. The Problem of Economic Order
The peculiar character of the problem of a rational economic order
is determined precisely by the fact that the knowledge of the
circumstances of which we must make use never exists in
concentrated or integrated form but solely as the dispersed bits of
incomplete and frequently contradictory knowledge which all the
separate individuals possess. The economic problem of society is
thus not merely a problem of how to allocate "given" resources.
It is rather a problem of how to secure the best use of resources
known to any of the members of society, for ends whose relative
importance only these individuals know. Or, to put it briefly, it is a
problem of the utilization of knowledge which is not given to
anyone in its totality.
Friedrich Hayek, 1945
16

17. Information is at the heart of the
institutional problem of order
 Information transmission on prices, quantities
supplied, quantities demanded, actors, product
quality and attributes, and processes is the key to
market coordination
 Information incompleteness or asymmetry leads to
different concerns and debates (echoes still at
present):
 Central Planning Debate: Hayek versus Mises
 Bounded rationality: Herbert Simon
 Missing markets and risk: Joe Stiglitz
 Transaction cost economics: Williamson
17

18. Enforcement and coordination
through a commodity exchange
 When information is missing or incomplete,
coordination is weak, and contracts are unreliable
 markets don‟t clear, risk is high, search costs are
high, enforcement costs are high
 A commodity exchange is a particular institution
that has emerged (for certain commodities) to
overcome this problem
18

19. Why is an exchange needed?
By setting the “rules of the game,” an exchange
reduces transaction costs
Coordination:
Facilitating contact between buyers and sellers
Standard product grades
Standard contract terms
Price discovery mechanism
 Information:
Broad dissemination to all actors
 Enforcement:
 Contract enforcement through payment and delivery
systems
 Rules based and compliance monitoring
 Risk transfer : forwards, futures 19

20. Price Discovery
 Price discovery is the most important function of
an exchange. The most reliable prices in any
market are derived from those where the greatest
concentration of trading takes place.
 Price discovery methods include: open outcry,
ring trading, auction bidding, electronic bidding
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21. Price information transmission
Open dissemination of market data is the
second most important function of an
exchange, that is integrally linked to
fostering a price discovery process that
reflect true underlying supply and demand
21

22. Contract enforcement
 Ensuring that the contract is enforceable
and reliable is another key function of an
exchange.
Integrity of the product (grades)
Integrity of the actors (membership)
Integrity of the transaction (order
matching, payment and delivery)
22

23. Risk transfer
 In addition to the transfer of goods across space, market
actors may seek to transact over time, that is, enter into
contracts for future delivery, as opposed to “spot”
transactions.
 This is particularly appropriate for agriculture, where there is
a time lag between the decision to produce and harvest,
which incurs risk
 By selling their production forward, producers can reduce
price risk (or “hedge”) by locking in a price for future delivery
 Forward contracts are individually negotiated contracts
between buyers and sellers for future delivery. Futures
contracts are standardized contracts with pre-specified
delivery dates and other terms offered on exchanges.
 As markets evolve, “speculators” engage in buying and
selling futures contracts independent of physical delivery,
based on their evaluation of risk and price trends. 23

24. A Note on Speculation and Volatility
 Much conceptual confusion: speculation, arbitrage, and
volatility are considered bad
 To the contrary: modern financial economics suggests
that
Speculation is a socially beneficial activity
speculation is at the heart of price discovery
An efficient market must exhibit volatility
 new information is rapidly captured into prices
Arbitrage where “buy low and sell high” enables the
“law of one price” or market efficiency
24

25. Exchanges emerging around the
world
Country has active
futures exchange(s)
Country has active
exchange(s) trading
in contracts for spot
or forward delivery
Plans for the creation
of a commodity
exchange
25

26. Commodity exchanges in emerging markets
Catching up fast
Explosive growth
and reach to the
poor in India 26

27. When not to “exchange”?
When goods are not easily standardized
(highly differentiated)
When goods are not storable (perishables)
When trade is highly decentralized with no
central hub of market flows
When there is weak volume and few
buyers and sellers
27

28. The Ethiopian experience
 Need to address rampant market failures
in the commodity market: exchange
considered an appropriate approach given
structure of market (many buyers and
sellers, high search costs, high risks)
 Powerful combination of political will
coupled with market need
28

29. The ECX model
 Membership based
 Demutualized commercial entity: PPP
 Spot-and-futures
 Open outcry and electronic bidding
 Rules-based (surveillance and
compliance enforcement)
 In house physical management and
delivery
In house payment clearing and settlement
 Aggressive data dissemination
29

30. The ECX Edge… Integration
Laws and Regulationsb
COMMODITY EXCHANGE AUTHORITY
National Arbitration Tribunal
Exchange Actors
Association Market Information
System
EXCHANGE Trading System
MEMBERS
Trader Remote Access
Centers
Clients
Data center
Clearing and
Settlement
Exchange Warehouses Exchange Settlement Banks
Grade Warehouse 30
certification receipt

31. Integrated ECX Technology Solution
REGULATORY BODY
AND CLIENTS
DATA
CENTER
MEMBERSHIP
MEMBERS
MANAGEMENT MARKET
SURVEILLANCE
PRICE TICKERS
WAREHOUSE GOODS
DATA FEEDS
WEBSITE
RECEIVING (QUALITY AND MARKET DATA
QUANTITY PROCESSING
CERTIFICATION)
WAREHOUSES
CENTRAL CLEARING AND
DEPOSITORY OF SETTLEMENT
WAREHOUSE
RECEIPTS
BANKS
TRADE ORDER
MATCHING AND
RECONCILIATION
31

32. Powerful Market Platform
 Zero contract default
 Zero payment default
 Zero delivery default
 Real time information transmission
 Flexible contract design to accommodate
product heterogeneity
 Flexible membership system to
accommodate actor diversity
32

33. Impacts: early assessment avenues
 Price information “ripple” effect
 Impact on trade flows
 Impact on arbitrage behavior
 Impact on quality improvement
 Contract enforcement effect
 Impact on market risk
 Impact on transaction costs
 Market coordination effect
 Impact on volumes, participation 33

34. Aweke Teshome
Farmer, member of Wedera Union (Farmers Union)
“Now we are members of the ECX and are happy that big volume
sales can take place in a risk free environment. Additionally, as a
result of our involvement with the ECX our knowledge regarding the
concept of grading has increased and our resolve to produce quality
products has strengthened.
We are so happy to have a market which is
transparent and risk free.” 34