Cash Settlement vs. Physical Delivery
In a contract that is physically delivered, the underlying physical market is inherently tied to the futures contract through the delivery mechanism. At contract expiration, any entity with remaining positions will be matched against an entity with an opposite position, and the process of physical delivery will begin. Eventually, the commodity will change hands between the maker of delivery and the taker of delivery – any entity still holding a position after the close on the first position day is eligible to be matched for delivery, and every entity with a position after expiration will need to deal with the delivery process.
On the other hand, cash-settled contracts are not physically tied to the underlying commodity. At expiry, a final settlement price is determined, and each entity is either owed money or pays money to settle their position. No one involved in the futures market is at risk of being compelled to make or take delivery of a physical product.
In the Exchange’s Agricultural markets, physically delivered products tend to have deeply liquid screen markets. They predominately trade via the central limit order book on CME Globex. For the most part, these contracts are liquid enough to establish reliable daily and final settlement prices solely from screen trading activity. Conversely, the Exchange’s cash-settled Agricultural contracts are traded almost exclusively as block trades; bilaterally negotiated and entered by a broker into CME ClearPort or CME Direct for clearing. While the screen is available, these markets historically have remained privately negotiated. For this reason, they tend to function differently than physically delivered contracts. These cash-settled contracts need additional partners, like brokers and price reporting agencies (PRAs), to obtain settlement prices.
Daily settlements
There are two types of settlement events for all futures contracts – the daily settlement and the final settlement. The daily settlement is used internally to facilitate the marked to market transfers of funds, calculate margins and establish daily price limits. It is used externally as a signal for the current price of a given commodity.
Historically, cash-settled Agricultural products were transacted bilaterally via brokers and submitted for clearing, while physically delivered products were traded on a liquid screen via the central limit order book (CLOB) on Globex. Therefore, the daily settlement for cash settled products was calculated using Exchange-approved market indications and broker contributions while the daily settlement for physically settled products was derived from a volume weighted average of trades on Globex during a given window of time before or at the daily market close.
The Southern Yellow Pine (SYP) futures contract will have a daily settlement procedure more akin to a traditional physically delivered contract like Lumber futures. Each contract month settles to its volume-weighted average price (VWAP) of all trades that occur between 14:59:30 and 15:00:00 Central time, rounded to the nearest tradable tick. If there are no trades during that settlement period, then the last trade is used to determine whether to settle to the bid or the ask during this period.
Final settlement and the role of price reporting agencies
The other important settlement price that should be noted is final settlement. Final settlement is the price used by both the buyer (long) and the seller (short) to ultimately terminate a contract. In physical delivery, it represents the invoice price at which the commodity will be sold and changed hands. In cash settlement, it is the price to which all financial obligations will be marked.
In most traditional Agricultural contracts, the final settlement price is derived in nearly the same way as daily settlement – a volume-weighted average price calculated during a short settlement period on the day of expiry. In cash-settled Agricultural contracts, a PRA or some other price reporting entity is necessary to determine final settlement. The role of the PRA is to combine data on underlying cash transactions, bids, and offers along with their knowledge of the market to come up with a price assessment – either daily or weekly – for a given commodity. The Exchange then employs calculations, which differ by commodity, to turn these assessments into final settlement prices.
For Southern Yellow Pine futures, the PRA providing daily assessments is Fastmarkets. The Exchange collects the “Kiln-dried Southern Yellow Pine (eastside) 2 2×4 rl fob mill, Daily Price” assessments each week day, and on the business day prior to the 16th calendar day of the contract month, all assessments that occurred during that month are averaged, resulting in the final settlement price. Below is a numerical example of this calculation from January 2025.
|
Date |
Assessment Price |
|---|---|
|
1/2/2025 |
$414.00 |
|
1/3/2025 |
$420.00 |
|
1/6/2025 |
$425.00 |
|
1/7/2025 |
$425.00 |
|
1/8/2025 |
$430.00 |
|
1/9/2025 |
$430.00 |
|
1/10/2025 |
$430.00 |
|
1/13/2025 |
$440.00 |
|
1/14/2025 |
$435.00 |
|
1/15/2025 |
$435.00 |
|
Average: |
$428.40 |
Price reporting agencies play a vital role in derivatives markets. Any PRA chosen to supply assessments that underlie a final settlement price must be thoroughly trusted by the industry. Final settlement prices determined by the Exchange using PRA data represent the final valuation of a commodity for the entire marketplace. If the assessments published by a PRA are not accurate and respected by the industry, then the final settlement price will likely be skewed and not reflective of true value for the commodity. The Exchange puts serious consideration into the PRAs that it works with; customer validations are continually conducted to assure PRAs retain the highest confidence within the industry, and all PRAs that partner with the Exchange are expected to operate in line with the principles of the International Organization of Securities Commissions (IOSCO).
Benefits of cash settlement
There are strengths and weaknesses with both physical delivery and cash settlement. Each commodity market is unique, and contracts should be developed to suit the specific needs of that given market. That said, there are several benefits afforded by cash settlement.
Cash-settled contracts are less complicated to design and can work for a broader array of market participants. Setting up a physical delivery mechanism requires significant time and investment by the Exchange. Often, that effort is the best fit for an industry and physical delivery makes sense. However, some markets already have active over-the-counter (OTC) trades being valued to reliable PRA assessments. This existing infrastructure, already accepted by market participants, can make a cash-settled contract more straightforward and timely to launch.
More importantly, traders can participate in the expiration of a contract without the consideration of any aspects of physical delivery. It facilitates speculation near contract expiration since liquidity providers need not be concerned with notice days and delivery timing. Additionally, any market participant within a commodity’s value chain can hedge their risk without concern over physical delivery. Cash settlement allows a greater number of entities to participate late into a contract’s life because the end result is purely a financial exchange rather than optionality on a physical commodity.
Participants can liquidate their position via taking an offsetting position, can execute an exchange for physical (EFP*) if they desire to buy or sell the physical commodity, or take their position to expiration without the threat of engaging in the delivery market.
*EFPs are subject to rule 538.
All examples in this report are hypothetical interpretations of situations and are used for explanation purposes only. The views in this report reflect solely those of the author and not necessarily those of CME Group or its affiliated institutions. This report and the information herein should not be considered investment advice or the results of actual market experience.
