Forward Freight Agreements
What are FFAs and how do they work?
FFAs are derivatives. Derivatives are risk management tools, the value of which is derived from the value of an underlying asset. In the shipping industry, the underlying asset is the freight rate for a specific physical trade route which receives a daily assessment on one of the Baltic Exchange Indices. While not all routes receive such an assessment, as demand for FFAs increases, the Baltic Exchange continually evaluates additional trade routes for inclusion in the indices. Freight derivatives serve as a means of hedging exposure to freight market risk by providing for the purchase and sale of a freight rate (the “contract rate”) along a named voyage route (the “contract route”) over a specified period of time (the “contract period”). Contracts are cash settled, and there is no physical delivery. On settlement, if the contract rate is less than the average of the rates for the contract route over the contract period (the “settlement rate”), as determined by reference to the relevant index, the seller of the FFA is required to pay the buyer an amount equal to the difference between the contract rate and the settlement rate multiplied by the number of days specified in the contract (the “settlement sum”). Conversely, if the contract rate is greater than the settlement rate the buyer is required to pay the seller the settlement sum.
The freight derivatives market began with the trading of voyage rates for certain “dry” cargo routes in the early 1990’s and later was expanded to include “wet” tanker routes. Until recently FFAs were used almost exclusively by participants in the shipping industry, such as shipowners and charterers, to hedge against fluctuations in freight rates. As the basic forms and means of trading FFAs have evolved, new participants such as investment banks and financial institutions have entered the market for the purpose of speculation. The conventional wisdom is that the paper market for FFAs will soon come to surpass the underlying physical market in terms of dollar value.
Types of FFAs: Swaps v. Futures
There are two categories of freight derivatives. One is privately-negotiated derivatives known as “over the counter” (“OTC”) derivatives or “swaps”. The other is standardized, exchange-traded derivatives known as “futures” or cleared contracts. One of the major differences between swaps and futures is the assumption of counterparty risk; that is, with OTC derivatives the risk of default by either party to the FFA is assumed by the other party to the agreement (the “counterparty”), whereas with exchange-traded derivatives the risk of default by either of the parties is assumed by a clearing house, and the parties to the agreement only assume exposure to default by the clearing house. The assumption of counterparty risk by a clearing house makes it almost certain that the holder of an in-the-money futures contract will be able to collect and has the potential to make this type of derivative more liquid than the OTC variety. This liquidity, combined with the ability to mask the true identities of the counterparties when trading on an exchange (as opposed to the transparency that comes with negotiating FFAs at arms-length, as is the case with swaps) generally makes futures more appealing to speculators. The liquidity of freight futures has been further enhanced by the entry of new clearing facilities to the marketplace. The International Maritime Exchange (“Imarex”) in Norway is the principal exchange dedicated to FFAs and uses the Norwegian Futures and Options Clearinghouse (“NOS”) to clear its transactions. Until recently, Imarex/NOS was the exclusive forum for clearing freight futures trades. However, in 2005, due to increasing demand from FFA traders, the New York Mercantile Exchange (NYMEX) and LCH.Clearnet also began clearing trades. Later in 2006, Forward Freight Agreement Brokers Association (“FFABA”) members Clarksons, Ifchor and Freight Investor Services plan to launch a multi-user screen based trading system which they have jointly developed as part of an effort to generate more FFA futures trading.
While swaps may lack the liquidity of their exchange-traded counterparts, the fact that they can be individually negotiated makes them a useful hedging tool for participants in the physical marketplace who are seeking to offset specific risks to which they find themselves exposed through contracts of affreightment and/or time charters. Parties to swap agreements generally use either the FFABA form contract or the International Swaps and Derivatives Association (“ISDA”) Master Agreement and Schedule. ISDA is a trade organization whose primary purpose is to encourage the prudent and efficient development of the privately-negotiated derivatives business. The ISDA prescribed form agreement for swap transactions includes a Master Agreement which sets forth the terms of the ongoing legal and credit relationships between the parties. Any amendments to the Master Agreement are set forth in an attached schedule. One of the major issues agreed to in the schedule is the choice of law provision, which typically provides that either New York law or English law govern the contract. From a legal perspective, the advantage of the ISDA form is that it has been used as the standard form of derivative contract for the great majority of traded commodities and, as such, it has been subject to judicial review and found to be enforceable in a number of international jurisdictions. As a result, the legal risk of uncertainty surrounding the interpretation of the terms of the ISDA Master Agreement is greatly reduced. This has not always been the case with the FFABA form agreement.
Before the 2005 amendments to the FFABA form, provisions setting forth events of default, termination and close-out netting rights were noticeably absent, and an aggrieved party litigating any such matter would have been forced to rely on English common law, which governs both the original and the revised FFABA contract, to show that its counterparty had violated the agreement. The FFABA has sought to bridge the gap between its form and the ISDA form by incorporating ISDA’s approach in listing specific and detailed events of default and in providing express termination and close-out netting provisions. While there is still no universally accepted form of OTC contract, the harmonization of the two most widely used forms and the movement towards a standard OTC contract with clearly definable rights and obligations should have the effect of enhancing the liquidity of swaps and bringing more participants into this segment of the marketplace.
The FFA market is still very much a work in progress. While there have undoubtedly been significant advancements in both the swaps and futures components of the market in terms of enhancing liquidity and reducing participants’ exposure to uncertainty and credit risk, these measures have as yet largely gone untested. The Firm will continue closely to monitor the freight derivatives market and keep clients informed of any developments.
Questions regarding this advisory may be addressed to Donald J. Kennedy (212-238-8707, email@example.com) or Richard T. Califano (212-238-8646, firstname.lastname@example.org).
The Baltic Exchange is an independent, London- based association of shipbrokers, shipowners, charterers, financial institutions, maritime lawyers, educators, insurers and related associations involved in the shipping industry.
The Baltic Tanker Indices consist of the Baltic Clean Tanker Index and the Baltic Dirty Tanker Index. The Baltic Dry Bulk Indices are the Baltic Dry Index, the Baltic Capesize Index, the Baltic Panamax Index and the Baltic Supramax Index.
While an FFA clearing house has yet to default, it is worth noting that such a default is not beyond the realm of possibility. In 2004, a member of the NOS in Oslo defaulted against the NOS by not being able to fulfill its obligations to pay the daily market settlement, i.e., the variation margin caused by the sharp increase in the market rates. The NOS, acting as a clearing house for the international market for FFAs, guaranteed the settlement of all member transactions delivered to NOS for clearing. In this case, the NOS closed the defaulting members position with the NOS and covered with their own funds the outstanding cash calls due to other members.
See, for example, Finance One Public Company Ltd. v. Lehman Brothers Special Financing, Inc., 414 F.3d F. 3d 325 (S.D.N.Y.) (2nd Cir. 2005) and The First National Bank of Chicago v. Ackerley Communications, Inc., 2001 U.S. Dist. Lexis 20895 (S.D.N.Y. 2001).
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