Fifth, once the producer has entered into a position which, in principle, provides him with a hedge against unfavourable price movements, he may well prefer to just wait until he can unwind his physical position (that is to say, sell his coffee). But this is not how a futures exchange works. Rather, the exchange has a clearing department or clearing house which has to ensure that at any moment in time, those who have entered into futures contracts or sold options are able to meet their commitments. The clearing house does so through a system of margining: an initial margin has to be paid upon entering the position, and then “maintenance margins” or “margin calls” may have to be paid in order to ensure that at no moment in time, it becomes attractive to default on one’s obligations. In the case of a producer who has hedged his future production, this implies that if futures prices go up, he will be asked to pay margin calls (note that his crop is still in the field and he may not have easy access to ready cash). The producer needs to have mechanisms in place, including relevant authorizations, to ensure that such payments are made in time.
Finally, when the physical position that was hedged disappears (that is to say, the product is sold at a fixed price), the producer needs to unwind his hedge position. Again, this involves discretionary decisions: at what time of the day does he buy futures or sell his put options? Or if the futures market trend seems favourable, should he perhaps wait a few days?
On the OTC market, producers can obtain tools that may overcome some of the weaknesses or impracticalities of directly using the organized markets. In particular:
Nowadays, it is not easy to open a credit line with a broker and start trading on the London or New York exchange. Stringent Know Your Customer (KYC) rules have been introduced in recent years. Brokers who wish to enter into a commercial relationship with a new client (and for that matter, banks which wish to enter into an OTC transaction) have no choice but to meet all the KYC rules of their jurisdiction, and this brings high fixed costs. They can never recuperate this for a client that will trade less than a few million dollars a year. So while in the mid-1990s, a coffee trader from Burundi was able to deposit £ 5,000 with a London broker and start managing the risks of his operation, now only the large companies in developing countries have access to developed country brokers. And for a number of reasons (including, until fairly recently, currency controls in most developing countries) there are not many brokers based in developing countries that can offer access to western exchanges.
OTC markets allow bilateral negotiations on margin deposits and margin calls. As noted above, users of futures markets have to pay an initial deposit, and additional margin calls when their position moves against them. Such margin calls may have to be made within hours, if not the client’s position is forcibly closed out. This can be problematic. If a producer has sold futures to protect the price of the coffee that he expects to harvest a few months hence, and futures prices increase, then the value of the coffee “on the tree” increases. Unfortunately, his increased wealth does not give him the cash needed to cover the losses on the futures position. With an OTC transaction, one can negotiate a different margining system—e.g., payment of margins only once every three months. As an alternative, a producer could use PTBF contracts with traders which allow a producer to do the same as he could do with futures, but without any obligations in terms of deposits or margins.