Exercise care with commodity swaps

In theory, these tools allow a farmer to lock in a fixed price for future delivery windows, thereby hedging against potential price declines. However, for such an instrument to be genuinely useful and deliver on its promise of risk mitigation, a number of conditions must be met, many of which are routinely overlooked or inadequately explained to producers by those marketing these products.

At the heart of any swap contract is a reference price or index against which settlement will be made. This index must closely align with the price that the producer is likely to receive in their local physical market for the contract to function as an effective hedge. The term used to describe the difference between the physical market price and the index value is “basis.”

Basis risk, therefore, refers to the chance that this difference moves in an adverse direction, even if the broader market trend is favourable. For example, a producer may enter a swap at a seemingly attractive fixed price, but if their actual sale price reflects a widening discount to the index due to regional supply pressures or localised demand collapse, the net result could be worse than if they had remained unhedged.

Compounding this issue is the opacity surrounding the underlying index itself. Many of these indices are proprietary, with access gated behind subscription models. Producers are asked to hedge against a price that they cannot routinely see, let alone verify. Without transparency on how the index is constructed, where the data originates, and how representative it is of the producer’s own livestock type, location and selling method, the hedge becomes more a bet on correlation than a true risk management tool. For these instruments to be of meaningful value, the pricing mechanism must be publicly available, subject to scrutiny, and reflective of real transaction data from across the relevant supply chain.

Another significant consideration is the presence or absence of margin calls and cash flow obligations. In standard swap contracts, the party who is on the losing side of a price move must pay the difference to the other at maturity. While some swaps may only settle at expiry, others could require variation margin to be posted during the contract period if the mark-to-market moves against the producer. These obligations can be sudden and substantial, and without proper forewarning or financial buffers, may place undue stress on farm liquidity. It is incumbent on those selling these products to clearly explain not only how the instrument settles, but what the producer might be required to pay, and when.

Perhaps most concerning is the lack of publicly reported data on the volume and liquidity of these swap contracts. A robust and well-functioning risk management market is typically characterised by visible turnover, narrow bid/offer spreads, and ease of entry/exit. In the case of some agricultural swaps, the absence of public data on traded volumes or open interest limits the ability of producers to judge whether they are entering into a well-supported market or a niche product with minimal uptake and questionable exit options.

Equally, it is unwise for producers to engage with complex financial instruments on the basis of a few phone calls or marketing presentations. These are not simple forward contracts. They are derivatives, and like all derivatives, they carry embedded risks that may not be apparent until it is too late. A well-designed swap can be a useful tool, but only in the hands of a fully informed user.

If you are an unsure farmer reach out to Episode 3 for some independent assistance and education before you make the leap into swaps.