How More Agri-Traders Can Improve Liquidity In Africa At The Exchange Entry Point

How More Agri-Traders Can Improve Liquidity In Africa At The Exchange Entry Point

Liquidity problems are undermining growth in Africa, where markets lack the active traders to boost liquidity and attract more capital.

Some development economists argue that more active traders in African markets create more volatility rather than reduce it, and open the doors for an African “whale” trader to short a currency — and country — into a downturn.

But those criticisms befuddle the presence of some risk as a legitimate argument to overprotect many African economies.

Liquidity is vital to further stimulate market activity in Africa, especially in the agriculture sector, where 70 percent of Africans make a living. Many African economies do not have agricultural commodity exchanges (or any active trading market) and effectively lack the liquidity and incentive to spur more cash inflow and investors into the sector.

Market liquidity in the African context

Liquidity is the one of the most important concepts in finance, although the definition is malleable in certain economic corners. At its core, liquidity means the ability to easily and quickly buy and sell an asset. That definition will make sense to those who buy and sell houses or trade lightly in stocks. But finance experts and practitioners generally emphasize various building blocks in creating market liquidity.

One building block is bid-ask spreads, which refers to the difference between the prices the buyer will pay and the seller will accept. In the African context, it is all too common to see how price information is “hidden on a piece of paper” in a farmer’s back pocket, as one investor described it. In other words, buyers and sellers trade on little-shared information.

The second building block is post-trade price impact — the price movement when you buy or sell an asset. Price shifts are natural, but buying a large sum of coffee beans in one market should not shock the exchange for a couple days.

The third building block is volume, or how many transactions are actually happening. Volume is present in some markets where local and foreign traders are active around the country’s most precious exports. One example is Ethiopian flowers — one of the country’s major exports.

The three building blocks, however, are generally not present across the board, particularly in some African agricultural markets.

Agricultural commodity exchanges

Commodity exchanges are important in establishing vibrant African food economies, specifically combatting challenges such as limited price discovery, high price volatility, and low participation from smallholder farmers.

Despite the clear benefits of building commodity exchanges in Africa, exchanges remain underdeveloped or are nonexistent. The Tanzanian Mercantile Exchange (TMX) began operating in Dar es Salaam in 2016. Trading is thin on the TMX and many other African exchanges. This is a sign of exchange immaturity, reflecting limitations in the system including high operating costs, limited contract enforcement, insufficient brokerage services, and changing (or unclear) legal frameworks.

Commodity trading and investment groups are helping to fill the gap. Trading groups play a central role in building up the agricultural market by shipping goods in and out of countries, particularly where exchanges are weak.

Locals in some countries are surprised to learn how much their country imports certain products, and how much they may overpay in the process. For example, some South African farmers discovered in 2016 that they could sell avocados for higher prices at the Mozambique border than they could get on the market if they exported avocadoes to China.

Introducing more traders to the system helps to combat such price distortion. Critics will cite rogue traders as a problem. For example, in the U.S. food market, debate has raged since 2008 around speculative trading. Financial researchers generally conclude that a flood of cash into the U.S. market between 2003 and 2008 was not well anticipated, and consequently not well regulated.

However, many African economies could use an infusion of cash into their agricultural markets at the exchange entry point, preferably at a more gradual rate than observed in the U.S. in 2003 to 2008. More market players will also raise market activity, hasten transactions in the space, and encourage legal frameworks to mature to match the demands of market participants and the greater global trade.

Energy trading as an example or argument for agri-trading

Oil and gas trading is a global business and has provided numerous economic and geopolitical benefits, depending on who you ask. Free movements of barrels and open competition on the market generally ensure customers globally can have access to more efficiency and less expensive choices.

Some African markets such as small Rwandan villages have seen off-grid solar energy prosper. But solar struggles to garner backing in some major cities in West Africa where independent power producers still depend on hydro or look forward to gas-to-power options. For example, liquefied natural gas (LNG) or floating LNG continues to control the conversation in markets such as Mozambique and Senegal, where gas prices are low and governments are committed to financially and politically backing large-scale power projects.

Low-cost oil producers specifically are winning in the global markets, such as producers in Texas’s Permian Basin. Many African producers are quickly learning to strengthen their production capabilities, particularly by lowering exploration and general operational costs. The prevalence of global trading in oil arguably has increased price convergence between the WTI and Brent oil index prices as well as encouraged operator advances. Profits are a major factor too.

Trading has also created great liquidity and quick transacting in these energy markets. Consider how fast prices respond to changes in policy in the U.S., Saudi Arabia or any other oil-producing country.

A similar bump in traders in the agricultural market could force food markets to grow efficiently, make more economically favorable choices (for example import versus grow), and address constraints in the value chain.

Considering the alternative scenario for a cash-starved sector, bringing in more traders may just stop some investors from shorting the sector in the long-term.

Kurt Davis Jr. is an investment banker focusing on the natural resources and energy sectors, with private equity experience in emerging economies. He earned a law degree in tax and commercial law at the University of Virginia’s School of Law and a master’s of business administration in finance, entrepreneurship and operations from the University of Chicago. He can be reached at kurt.davis.jr@gmail.com.