CRA Chapter 20140429 Final

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.

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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.  

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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.

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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.  

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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.

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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

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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.  

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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).

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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

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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.  

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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

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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.  

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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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