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GAFACADEMY
Transforming the Global Dairy Industry with an Innovative Trading Platform
Bradley A. Miller
Margarita Sapozhnikov
2014
CONTENT
Transforming the Global Dairy Industry with an Innovative Trading Platform. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
Transforming the Global Dairy
Industry with an Innovative Trading
Platform
Technical Paper Authors: Bradley A. Miller, Ph.D., Vice President Margarita Sapozhnikov, Ph.D., Associate Principal Company: CRA International, Inc. d/b/a Charles River
Associates Topic: Modern trading platform supporting the product
chain Sector: Dairy Pages: 15
The conclusions set forth herein are based on independent research and publicly available material. The views expressed herein are the views and opinions of the authors and do not reflect or represent the views of CRA International, Inc. d/b/a Charles River Associates or any of the organizations with which the authors are affiliated. Any opinion expressed herein shall not amount to any form of guarantee that the authors have or CRA International, Inc. has determined or predicted future events or circumstances, and no such reliance may be inferred or implied. The authors and CRA International, Inc. accept no duty of care or liability of any kind whatsoever to any party, and no responsibility for damages, if any, suffered by any party as a result of decisions made, or not made, or actions taken, or not taken, based on this paper. Detailed information about Charles River Associates, a registered trade name of CRA International, Inc., is available at www.crai.com. Copyright 2014 CRA International, Inc.
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1. Introduction
Today, internationally traded dairy products either are bought and sold on
GlobalDairyTrade (GDT) — an innovative auction-based online trading platform — or
are strongly influenced by transactions that take place on it. GDT is the centralized
marketplace for globally traded dairy commodities, establishing reference prices used
by the industry that arise from GDT’s regularly scheduled auction-based trading
events.
However, leading up to the initial GDT trading event in July 2008, industry
expectations and acceptance of the concept were mixed. Previously, there had been
nothing comparable to the GDT trading platform, so there were some misplaced
views, including: (i) that auction-based competitive bidding would result in sales only
to the lowest common denominator — i.e., that price would be bid only to the level of
the lowest-paying customer with all the upside of higher paying customers lost; (ii) an
auction could work only for pure commodity products and that it would not work for
differentiated food products where the identity of sellers is important; and (iii) to some
extent it was thought it would be tarnished with an “eBay image” where low quality,
downgraded products were being disposed of at fire sale prices.
Also, shortly after the launch of GDT, some in the industry were skeptical of its
potential success because many participants in commodity and financial markets had
lost confidence in organized marketplaces due to the worldwide financial crisis.
Some believed it was the worst time to introduce a marketplace like GDT. However,
there were those who felt there was no better time to test the industry’s appetite for
this electronic trading platform.
In its first twelve months (July 2008 through June 2009), less than 200,000 MT of
dairy products were transacted, and the only seller was Fonterra Co-Operative Group
Limited (Fonterra) of New Zealand. In comparison, today more than 900,000 MT are
transacted annually on GDT and there are seven sellers representing the major dairy
producing regions around the world. To date, more than US$14 billion has been
bought and sold on the platform.
This article examines the motivation for developing GDT, how it works, its design,
and how it has grown.
2
2. Motivations for a new way of transacting dairy products
In 2007, Fonterra, the largest dairy exporter in the world, was motivated to find a
better way to market, sell, and establish prices for its mostly commodity dairy
products.1
Inconsistent pricing and unreliable market indicators made it challenging for Fonterra
to make planning decisions, manage risk, and invest optimally. Limited or dated
market price information complicated capacity planning, transfer pricing, and herd
management. There was no recognized benchmark to clearly and quickly signal
market conditions. And transacting commodity products using bilateral negotiations
with so many parties was not the best use of the marketing, selling, and
administrative resources and budget. Moreover, without transparency, Fonterra’s
farmer-owners could not always verify that they were receiving the full value for
providing their milk supply to Fonterra.
Buyers of commodity dairy products — Fonterra’s customers — seemed most
interested in securing supply at competitive market prices no higher than the prices
paid by their competitors. The buyers wanted predictable prices and flexibility in
sourcing supply over their preferred delivery periods, which would improve their
business operations, risk management, and strategic decisions.
When Fonterra approached the market design experts at CRA International,
Inc. (CRA) in 2007, Fonterra wondered whether there was a better way than the
traditional means (such as bilateral negotiations) to market and sell its more
commoditized, internationally traded dairy products. Fonterra was looking for a more
transparent and consistent transaction process. One that produced objective,
credible prices and market information that could be relied on by both sellers and
buyers. These objectives led CRA’s market design experts to recommend an online
trading platform based on sound economics and business principles, similar to other
CRA trading platforms but tailored to the particular circumstances of the dairy
industry.
1 Fonterra is a multinational dairy co-‐operative owned by 10,600 New Zealand farmers. It is responsible for about 30 percent of the world’s dairy exports, and competes in both branded and intermediate products.
3
3. Designing a trading platform
A trading platform is a general term that suggests a consistent and predictable
structure, a technically efficient way to communicate, and a set of rules agreed to by
sellers and buyers in order to transact in goods or services. With the growth of the
Internet, “trading platform” often refers to an online mechanism (for example,
accessed via a Web browser) in which one or more sellers and one or more buyers
participate and transact business through a bidding process.
There are many ways to design a trading platform, and there is no one market design
underlying a trading platform that is best in all situations. In determining the optimal
market design, we start with three key considerations:
(1) The objectives to be achieved
(2) Characteristics of the products to be bought and sold
(3) Attributes of the participants
3.1. Objectives
When we were first approached, Fonterra’s primary objective was to create a
transaction mechanism for globally traded dairy products that provides an effective
price discovery process, one that consistently produces reliable, credible prices. Two
other important objectives were to provide security of supply and better tools for
price-risk management. The market signals arising from a new marketplace that
accurately reflected current and expected future supply and demand conditions
would enable not only Fonterra and its customers to make better business decisions
and plans, but also would benefit all participants involved in these dairy products.
One over-riding objective was to lower the information and transaction costs involved
in transacting these products. This included making it easy for buyers to participate
and minimizing the time needed to conduct the transactions. This would free up
resources to be dedicated to higher valued uses in market participants’ businesses.
3.2. Product characteristics
One of our principles is that if the products to be transacted are related in value, they
should be transacted simultaneously. Products can be related in value for one or
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more reasons: (a) they are substitutes, (b) they are complements, or (c) buyers have
budget constraints.
From an auction design perspective, two products are substitutes for each other if,
when the price for product “A” increases more than the price for product “B”, buyers
tend to buy less of A and more of B. Two products are complements with each other
if a buyer is willing to pay more for the combination or package of A and B than the
total they would pay if they were required to purchase A and B independently (think
of having to buy a left shoe before you were certain you could buy the matching right
shoe). Finally, if buyers have budget constraints, the optimal allocation of their
budget across products depends on knowing the prices for the products
simultaneously.
An effective mechanism is needed to enable market participants to switch among
substitute products (i.e., price arbitrage) as their relative prices change, to purchase
their preferred portfolio of products which depends on prices, and to allocate their
budget optimally. Only then can there be confidence that clearing prices accurately
reflect market conditions, and market participants have no regrets about what they
have purchased (or not purchased).
Another consideration is whether the products have “common value” or “private
value”. With common value, there is some uncertainty in the value of the product or
what its fair market value should be, but the ultimate value is the same or nearly the
same for all buyers (think of bidders bidding to win a jar of coins with unknown value
at the time of bidding). Commodities often are characterized by strong common
value. In contrast, private value arises when the ultimate value of the product varies
quite a bit among potential buyers.
Unless the trading mechanism addresses common value, the problem of the
“winner’s curse” will arise in which prices that buyers are willing to pay understate the
buyers’ valuations of the products. No buyer wants to offer to pay a price that is
above market levels, so they offer lower prices than they would otherwise in order to
avoid the risk of paying prices above market levels. An effective mechanism
addresses the winner’s curse by assuring bidders they will be paying a fair price; only
then will buyers fully reveal what they are willing to pay for the product and only then
will market clearing prices truly reflect market conditions.
5
A final comment is that the products and their terms of sale must be known in
advance and must be attractive to buyers. The product specifications must be
provided to the buyers, shipping and delivery options need to be acceptable, and the
contracts to be signed must be fair and reasonable. A well-designed trading
mechanism cannot compensate for products and contracts that are poorly marketed
and specified.
3.3. Attributes of the participants
The optimal trading mechanism also depends on the participants: the number of
sellers and buyers, the extent to which sellers are committing their product supply to
the mechanism, whether demand from buyers is sufficient for the supply being
offered, how much variation there is among bidders (for example small versus large
market presence), location of the sellers and buyers, and so forth. The design and
implementation of the trading mechanism needs to be tailored to meet the needs of
the market participants.
4. Design of the GDT trading platform
Given the objectives, the product characteristics, and attributes of the likely
participants, CRA determined that the optimal trading platform was a version of a
multiple-product, ascending-price clock auction, a bidding format that it had
customized and implemented for many other industries previously.2 The analysis
that led to this determination applied market design principles, auction theory, game
theory, and CRA’s experience in tailoring the principles and theories to particular
industries.
When customized and implemented correctly, this auction format provides for
effective price discovery, enables simultaneous bidding on products that are related
in value, and produces credible, reliable clearing prices and quantities that reflect
market conditions. Proper implementation of the auction design, the participation
requirements, and the market information it provides all lower information and
transaction costs for both sellers and buyers.
2 CRA has designed and implemented a wide range of market and competitive bidding designs, including variations of clock auctions and other auction formats.
6
The auction format CRA customized in this instance actually is a hybrid in that it
provides buyers two bidding options: (a) the ascending-price clock auction format in
which the bidder needs to bid in each round of the auction or (b) an “auto-bid” feature
(more generically referred to as a “proxy bid”) in which a bidder submits a bid
specifying the quantities and maximum prices the bidder is willing to purchase at (as
in a one-shot sealed-bid auction format). Together, these options provide desired
flexibility for all participants.
5. How the GDT trading platform works
In addition to designing the GDT platform, CRA was retained as the independent
Trading Manager. CRA customized its trading platform and processes to manage
the auctions. Each GDT auction is referred to as a trading event. The first trading
event (TE-001) was held in July 2008 with one seller (Fonterra) offering nine
products: one product group (whole milk powder or WMP) with three product
specifications in three contract delivery periods. In comparison, for trading events in
2014, seven sellers typically offer more than one hundred products across six
contract delivery periods.
Prior to a trading event, each seller announces the products it will offer for sale in the
event: product specifications, minimum and maximum supply quantities, and starting
prices. Each buyer must be previously approved by each seller that the buyer
wishes to purchase from — that is, to become a “qualified bidder” for that seller.
Each trading event is held at the same time of day and with the same product
specifications for every auction so that bidders know what to expect. Unlike many
popular auction sites, such as eBay for example, an ad hoc seller cannot participate
on GDT and list any product that they simply wish to dispose of.
In the multiple-product ascending-price clock auction, bidding takes place in a series
of rounds, simultaneously on all products within each round. On the GDT trading
platform, the start and end times of each round are announced prior to the trading
event. The number of rounds is not pre-specified: the auction will continue round by
round until each product clears (that is, demand equals supply). Typically, GDT
trading events last 10-15 rounds, or two to two and a half hours.
7
The GDT trading events are managed by CRA on CRA’s secure trading platform
system. Participants access the trading platform system using Web browsers and
private, unique login credentials that are provided to each participant.
Prior to each bidding round, there is an announced price for each product. When a
bidding round opens, each bidder bids by entering for each product the quantity they
are willing to purchase at the announced prices for the products. If a bidder chose to
use the auto-bid feature (i.e., the bidder need not be logged into the trading platform
during the bidding rounds), the trading platform will enter the bidder’s bid on their
behalf — consistent with the bidder’s auto-bid parameters — as if the bidder actively
entered the bid during the bidding round.
When the bidding round closes, CRA’s algorithms and software underlying the
trading platform process the bids submitted. Among other tasks, the event-closing
criteria are checked to see if the trading event can close. If there is at least one
product that is over-subscribed — i.e., more quantity was bid on it than the maximum
supply for the product — then the trading event will continue for at least one more
round. Any product that is over-subscribed receives a price increment; that is, the
announced price is increased by some increment for the next bidding round. A
product that is under-subscribed — i.e., the quantity bid on the product at its current
announced price is less than the minimum supply for the product — does not receive
a price increment for the next round.
One of the key rules of the trading platform is that a bidder is not allowed to reduce
the quantity it bids on a product from one round to the next unless the announced
price for that product increased between the two rounds. If the product’s price did not
increase, the bidder cannot reduce the quantity it bids on the product (although it is
allowed to increase the quantity bid on the product, subject to other trading platform
rules). This promotes serious, sincere bidding and supports an effective price
discovery process.
The trading event continues round by round until there is a round in which no product
is over-subscribed. At this point, the event-closing criteria have been met. CRA’s
software determines the closing price and quantity for each product. Note that
nothing is cleared or won at the end of any round other than after the last round of
the trading event. All products remain available for bidding in all rounds, even if a
8
product has not received new bids for several rounds. This feature is required in
order to fully reflect the characteristics of substitutable and complementary products.
Figure 1 below illustrates the round-by-round bidding process. The vertical axis
shows quantity: the intersection of the green horizontal line with the vertical axis
indicates the supply quantity being offered for sale. The horizontal axis shows the
announced price for each bidding round. In round 1, the announced price is $3,000.
At that price, the height of the black bar indicates the quantity bid (i.e., demand at the
price of $3,000). It is taller than the horizontal green line (i.e., the supply quantity
offered for sale), so the product is over-subscribed (i.e., it has excess demand) at a
price of $3,000. A price increment is imposed, in this case an increment of $500 so
that the announced price for round 2 is $3,500. At that higher price, there is less
quantity bid in round 2 than in round 1: the height of the black bar is shorter in
round 2 than in round 1. But the product still is over-subscribed, so it receives
another price increment resulting in an announced price of $3,900 for round 3. The
auction continues round-by-round, with the price increasing each round as long as
the product is over-subscribed. Eventually a round is reached in which the product
no longer is over-subscribed, at which point the auction is over and the clearing price
and quantity are determined.3
3 The rules of the trading platform specify what happens in case a price increment causes the product to become under-‐subscribed — i.e., the demand quantity that is bid falls below the supply quantity being offered for sale.
9
Figure 1 — Round-by-Round Ascending-Price Bidding
The example above shows how the bidding process works for a single product. Most
GDT trading events have more than 100 products that are being bid on
simultaneously, so there would be many such charts as shown above.
At the close of the trading event, CRA as the independent Trading Manager confirms
the results, computes various data such as updating historical price indexes, and
transfers the results data to GlobalDairyTrade Holdings Limited (GDT Ltd). The
results subsequently are published to the public information Website
(www.globaldairytrade.info).
10
Figure 2 below shows a schematic of the activities before, during, and following a
trading event.
Figure 2 — Process Before, During, and After Auction
6. How the GDT platform differs from a commodities exchange
A standard commodities exchange is not well suited to achieve the objectives that
motivated the design of the GDT platform. Many commodities exchanges are used
to transact standardized contracts used for financial hedging and speculative
purposes. Such contracts include forwards, futures, options, and more complex
financial arrangements. Speculators and investors often trade on commodities
exchanges.
In contrast, transactions on the GDT platform are for physical delivery of dairy
products. The sellers are manufacturers of the dairy products and the buyers
(winning bidders) take physical delivery of the products. Also, the sellers establish
their own product specifications and contracts. Moreover, all the products are
11
available for bidding simultaneously at pre-scheduled trading events. This facilitates
effective price discovery, particularly for substitutable and complementary products.
One of the important differences with a commodities exchange is that GDT does not
allow anonymous trading — all bidders know which sellers they are bidding on and
each seller decides which buyers can bid on their products. Sellers are responsible
for marketing their product to prospective bidders and are responsible for contract
execution (as shown in Figure 2 above). GDT does not have any clearing or
settlement processes that put a barrier between sellers and their customers. Thus,
GDT opens up opportunities to strengthen customer relationships because sellers
are in front of customers twice monthly and they have a credible reference price on
which to negotiate value-added services and products, which removes some
bargaining tensions and improves transaction efficiency.
7. Results and indicators of success
After the first trading events in 2008, there was anecdotal evidence that bilateral
trading in dairy commodities slowed or stopped as the next GDT event approached:
market participants were waiting for the results of the next GDT event. This indicated
that the GDT trading platform results were relied on as a reference for the industry
even after only a few trading events. Today, transactions in dairy markets are widely
influenced by GDT, and the results of each trading event are reported and discussed
in the industry trade press.
The use of the GDT trading platform has increased significantly over time. Table 1
below summarizes some of the indicators suggesting how widely adopted and
successful the platform has become. The trading events initially were held monthly
but that increased to twice per month starting in September 2010. The number of
sellers has increased from one to seven, representing the major geographical regions
of internationally-traded dairy supply around the world. The number of qualified
buyers has increased from 150 over the first twelve months of trading events to 800
now. On average, 200 buyers bid in each event now, an increase from about 60 per
event in the first events. Nine product groups and six contract delivery periods are
offered now rather than just one product group and three contract periods; the total
number of products offered in each event has increased from nine to typically more
than 100. Annual quantity and transaction value on the GDT trading platform has
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increased from 180,000 metric tons (MT) and US$0.5 billion over the first 12 months
to about 980,000 MT and US$4.7 billion for the most recent 12-month period. More
than US$14 billion has been transacted on the platform to date.
Table 1 — Growth of GDT Trading Platform
July 2008 – June 2009
(TE-001 - TE-012) May 2013 - April 2014
(TE-091 - TE-114)
Trading event frequency Monthly Twice per month
# Sellers4 1 7
# Qualified buyers Approx. 150 Approx. 800
# Bidders per event Approx. 60 Approx. 200
# Product groups5 1 WMP
9 AMF, Butter, BMP,
Cheddar, Lactose, MPC70, RenCas, SMP, WMP
# Contract delivery periods 3 6
# Products per event 9 Typically > 100
Metric tons sold 180,000 980,000
US dollars transacted US$0.5 billion US$4.7 billion
US dollars transacted, cumulative through April 2014 US$14.0 billion
Another indicator of acceptance and success is that the New Zealand stock
exchange (NZX) offers derivative contracts based on the GDT trading platform, using
GDT’s clearing prices to settle against dairy futures contracts that NZX sells. In
2010, NZX launched the first of its three dairy futures contracts, Whole Milk Powder
(WMP) Futures. This was followed by the launch of Skim Milk Powder (SMP) and
Anhydrous Milk Fat (AMF) Futures and then WMP Options. NZX Dairy Futures have
since traded more than 50,000 lots with all futures contracts cash settled to prices
derived from GDT. Continued volume growth in NZX Dairy Derivatives supports risk
mitigation in the global dairy industry into the future. It’s unlikely a derivatives
marketplace would be successful without the GDT trading platform, a viable, trusted
marketplace for physical delivery.
4 Current sellers are Amul (India), Arla Foods (EU), DairyAmerica (US), Eurosérum (EU), Fonterra (New Zealand), Land O’Lakes (US), and Murray Goulburn (Australia). Fonterra was the initial seller in 2008. 5 AMF = anhydrous milk fat, BMP = butter milk powder, MPC70 = milk protein concentrate, RenCas = rennet casein, SMP = skim milk powder, WMP = whole milk powder.
13
In addition to efficiently transacting physical dairy products, the GDT trading platform
generates reliable, credible information about current and expected future market
conditions. Figure 3 below shows some of the market information that arises from
the GDT trading events. A vertical line in the chart represents a particular delivery
month in the calendar year. The color graph lines that cross a vertical line show how
the clearing prices for a given delivery month changed from one trading event month
to the next. For example, in Figure 3 clearing prices for delivery in January 2013
increased from GDT trading event to trading event as the trading events were held
closer in time to January 2013: prices from events held five months prior to January
2013 (see the orange line) were lower than prices held four months prior to January
(see the green line), and so forth.
Figure 3 — Example of Forward Price Curves from GDT Results
8. GDT organization and structure
As the GDT trading platform has grown, GlobalDairyTrade’s structure has evolved to
continue to ensure market participants are represented and have a voice in how
GlobalDairyTrade is administered. As shown in Table 2 below, GlobalDairyTrade
14
Holdings Ltd performs the administrative and management functions and promotes
the growth of GlobalDairyTrade. In its role as the independent Trading Manager,
CRA uses its trading platform technologies and experience in market designs to
manage each trading event and to continually enhance the platform.6 All sellers are
subject to the same rules and participation requirements, and all buyers (from more
than 90 countries) are subject to the same terms and participation requirements.
There is an independent GDT Advisory Board whose membership includes both
sellers and buyers. Finally, annual audits monitor GDT’s independence.
Table 2 — GDT Structure and Roles
GlobalDairyTrade Holdings Ltd
(GDT Ltd)
Independent Trading Manager
(CRA International) Sellers Buyers
Facilitates seller and buyer registration to participate
Performs administrative functions
Promotes growth of GDT
Annual audits monitor GDT’s independence
Subsidiary of Fonterra
Lead designer and developer of the trading platform
Conducts each trading event
Implements ongoing enhancements to the process and the trading platform
To become a seller:
Commit to offer at least 5,000 MT/year of product through GDT
Demonstrate to GDT Ltd that offering its product through the trading platform has a reasonable chance of commercial success
To become a buyer:
Provide the standard information requested
Demonstrate the intent to actively participate in trading events
To be eligible to bid for a seller’s product: need to be qualified by that seller
Independent GDT Advisory Board
Membership includes five sellers and five buyers selected using objective criteria based on a combination of those who trade the most and ensuring diversity of representation across product groups and geographies
GlobalDairyTrade Holdings Ltd and CRA participate as non-members
Reviews any proposed changes to the GDT market rules and operation of the trading platform
6 CRA’s Trading Manager team includes a multilingual Help Desk to assist participants during each trading event.
15
9. Conclusion
When first launched, the initial GDT trading events quickly established the platform
as the provider of reference prices and market information relied upon by the
industry. The innovative trading platform establishes reliable, credible prices and
market information through an efficient and transparent price discovery process.
The platform has become widely accepted by market participants. Sellers can be
confident their products are selling at market prices, and buyers know they will not
pay more than competitors for the same products. Moreover, the twice-monthly
trading events and six contract delivery periods within each event provide both
sellers and buyers the flexibility and opportunities to make better business decisions,
manage risk effectively, and improve their business operations and planning
capabilities.
The platform provides sellers easy access to a larger marketplace of buyers, opens
up opportunities to strengthen customer relationships, and enables the sellers to
structure their supply portfolio optimally. Likewise, the platform provides buyers
access to a large and increasing range of commodity products, the ability to decide
when and how much and from whom to buy, and the choice of how far forward to
secure product at a fixed, known price.
By lowering information and transactions costs and increasing liquidity in the
marketplace, the GDT trading platform has benefited both sellers and buyers,
enabling them to focus their efforts on value-added activities.
About the authors:
Brad Miller is head of the Auctions & Competitive Bidding consulting practice at CRA
International, Inc. Margarita Sapozhnikov is an Associate Principal in CRA’s
Auctions & Competitive Bidding consulting practice.
REALIZATION: ORGANIZATION-CURATOR:
www.globalagribusinessforum.com
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