What Metal Buyers Need To Know About OTC Steel Scrap Hedging Part Three

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One subject we are frequently asked about from the floor at conferences or by clients in face-to-face meetings is a two-parter: how can they manage steel price risk, and do rumors of new over-the-counter (OTC) scrap hedging products offer the opportunity for steel buyers to offset price risk volatility? So when we caught up with Freight Investor Services and FIS’s new Senior Derivatives Broker Brad Clark (based in St Louis), we thought sharing a little of his insight via an interview was too good an opportunity to miss.

(Part Three of the interview continues below. Here are Parts One and Two.)

MetalMiner: Can you talk us through the sequence of events or steps a firm would need to take to access the swaps market?

Brad Clark: First, get yourself a broker (if I may suggest, such as those at FIS, who are the market leaders.) The broker will work with you to assess the degree of correlation between the index (in this case, steel scrap), and the products the firm is buying or selling. Without that correlation being sufficiently high, there is no basis for using swaps to hedge price risk.

The next step, and one I find to be much of my focus with new clients, is education. To thoroughly understand the swaps market, how they work and how they can work for you. Only then can you begin to profile the ideal deal shape and work with your broker to find another party to make the bilateral trade.

MM: You mentioned risk in a previous answer; what are the risks? What should any firm be aware of going into this market?

BC: Good question, and contrary to suggestions by the more sensationalist press, there are principally only two risks:

The first is entirely within the firm’s hands: thoroughly understanding how swaps work and how they would work best for the firm. A good broker should ensure a client does not commence such trades unless they can demonstrate that understanding. It’s not rocket science but it may be outside many CPO/CFO/CEOs’ immediate field of experience.

The second, and the reason for most problems down the road, is making sure the physical side of any deal is as reliable as the swap contract. For that construction company we discussed earlier, the swap will cover the firm’s rebar cost with greater than 95% accuracy and no counter-party risk it’s as reliably solid as the concrete they pour in the ground. The risk for the construction company is in the physical delivery of the rebar, the pace of construction and the financial reliability of their client. If there is a problem, it is 99 times out of 100 that the physical side of the deal does not happen as expected. The firm needs to realistically assess the risks for its physical trade happening as expected before structuring the hedge. For repetitive, reliable trades, swaps work extremely well for one-off speculative deals with a high possibility that contract compliance could fail; swaps could expose the firm to being locked in on one side.

Our thanks to Brad Clark for sharing his thoughts on and experience in the swaps market. We will be sure to bring you further details of the forthcoming steel scrap swap contract as further details are released.

–Stuart Burns

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