Strategic Decisions for Commodity Exchanges in an Emerging Economy

Establishing an international commodity exchange in an emerging economy presents a strategic opportunity to stimulate economic growth, create or improve direct linkages to world markets, enhance trade efficiency by improving terms of trade, and integrate local markets into global markets. Achieving these outcomes, however, requires a clear understanding of the economic and institutional capacity of the commodity exchange host country.

The Importance of Payment Settlement Systems

Here we will focus on one simple but important practical consideration when establishing such a commodity exchange: the implementation of a payment settlement scheme. The currency choice, whether local or an international currency, can be a key determinant in the success of the commodity market. The type of currency and choice of currency to settle payments can significantly influence market participation, investor confidence, exposure to exchange rate volatility for market participants, and even affect inflation in some economic sectors of the emerging economy. Trades can be settled in fiat currencies or digital currencies, each of which entails their own set of pros and cons for the emerging market as well as the jurisdiction that issues the fiat currency.

Benefits of Stable Foreign Currency for Settlement Payments

Emerging markets stand to gain significantly by settling commodity trades in stable international currencies such as the euro, British pound, or US dollar. One of the most immediate benefits is the attraction of foreign investment. When settlements are conducted using a widely trusted and frequently used currency, foreign investors are more inclined to participate in the commodity exchange. Pegging settlements to such a fiat currency thus not only enhances investor confidence, but also reduces exchange rate uncertainty, making the exchange market more accessible and appealing to participants.

Using a stable fiat currency also shields both buyers and sellers from the volatility often associated with local currencies. These advantages are amplified when the chosen currency belongs to a major trading partner. In such instances, aligning settlement currency with trade flows facilitates easier benchmarking against global commodity prices and promotes transparent, competitive pricing, especially for commodities destined for global markets.

Moreover, settling in a major trading partner’s currency can mitigate exchange rate volatility, reduce price risk among exchange participants, and enhance the credibility and liquidity of the exchange. It also sends a strong signal of macroeconomic discipline and openness to global markets, key messages for international investors and institutions.

Potential Risks for Emerging Markets

While settling commodity transactions in a stable foreign currency offers clear benefits, such as reduced volatility and increased investor confidence, it also introduces significant trade-offs for emerging markets. Chief amongst these is the loss of monetary policy autonomy; local markets become subject to the monetary policies of foreign central banks, which can affect domestic conditions beyond local control. In emerging markets where inflation and currency devaluation are persistent risks, this diminished control can be particularly problematic. Moreover, by tying settlement payments to the currency of a major trading partner, the emerging market becomes vulnerable to that partner’s economic conditions and fiscal decisions, and limiting its ability to respond independently to ensuing domestic challenges.

Structural Vulnerabilities

More fundamentally, reliance on a foreign currency can mask underlying structural weaknesses, such as low productivity, fragile institutions, or poor fiscal discipline. These vulnerabilities, present in both emerging and advanced economies, may be obscured by the perceived stability of the foreign currency. As a result, critical reforms may be delayed, potentially undermining long-term economic development.

Additional risks include excessive borrowing, current account imbalances, and asset bubbles. The demand for foreign currency to settle transactions often leads businesses and governments to borrow in that currency. While manageable under stable exchange rates, any depreciation of the local currency increases the cost of servicing foreign debt, heightening default risk, a phenomenon known as currency mismatch. Additionally, access to foreign currency may be constrained by capital controls, increasing transaction costs and complexity. These factors can disadvantage domestic exchange participants by raising their operational costs, and perhaps limiting their ability to engage effectively on the commodity exchange.

Macroeconomic Effects

If the commodity exchange is a major economic institution, foreign currency settlement may distort trade competitiveness in some situations; i.e. a strong foreign currency makes exports more expensive and imports cheaper, potentially worsening the trade balance. Persistent current account deficits may follow, requiring financing through borrowing or foreign investment, both of which can be volatile and destabilizing. If the economy is heavily reliant on commodity exports, a reversal in capital flows may trigger a sharp correction, leading to financial instability.

Stay Nimble

Nevertheless, emerging markets can minimise risks through pragmatic strategies such as maintaining a flexible exchange rate regime for the local currency while anchoring commodity exchange settlements to a stable foreign currency. This dual framework allows for greater adaptability in responding to domestic economic conditions, while preserving the benefits of currency stability in trade and investment flows.

To support this model, governments can pursue reforms aimed at strengthening institutional capacity, improving fiscal transparency, and promoting financial inclusion. These efforts not only enhance resilience to external shocks but also create a more predictable environment for investors and exchange participants, both foreign and domestic.

Balancing Benefits and Risks

Settling commodity trades in a stable foreign currency can offer emerging markets substantial advantages. It enhances investor confidence, reduces exchange rate volatility, improves price transparency, and strengthens the credibility of the exchange, making it more attractive to global participants. These benefits can accelerate integration into international markets and support broader economic development. Nevertheless, to fully realise these gains, it is essential to manage the associated risks, particularly those affecting domestic stakeholders. Ensuring inclusive access, maintaining monetary flexibility, and supporting institutional reform are critical to building a successful and equitable exchange that serves both global and local interests.