Delivery notice

What Is a Delivery Notice?

A delivery notice is a formal document issued by the seller of a futures contract to a clearinghouse, indicating their intention to deliver the underlying physical commodity or financial instrument against the contract. This notice initiates the process of physical settlement in derivatives markets, transitioning a financial obligation into a transfer of actual assets. It is a crucial step within the broader category of commodity markets and financial derivatives, ensuring that contractual obligations are met.

History and Origin

The concept of a delivery notice is intrinsically linked to the evolution of futures markets, which trace their origins back to ancient Mesopotamia with early forms of forward contracts for agricultural products.⁴² In the United States, formalized futures trading began in the mid-19th century with the establishment of exchanges like the Chicago Board of Trade (CBOT) in 1848, which standardized the buying and selling of future deliveries for present prices.⁴¹ Initially, these markets were primarily for agricultural producers and merchants to hedge against price fluctuations, facilitating the physical exchange of goods.⁴⁰

As markets matured, the need for clear procedures for physical delivery became evident. The delivery notice, as a formal communication, developed to streamline this process, ensuring that both parties and the central clearinghouse were aware of the seller's intent to fulfill their obligation. The regulatory framework, particularly under the Commodity Futures Trading Commission (CFTC) in the U.S., has continuously evolved to govern these procedures, including detailed requirements for physical delivery contracts to maintain market integrity and prevent manipulation.³⁹,³⁸ For instance, in 2020, the CFTC provided further clarity on physical digital asset delivery, including a 28-day deadline for buyers to use their purchased digital asset.³⁷

Key Takeaways

• A delivery notice is a formal declaration by a futures contract seller to physically deliver the underlying asset.
• It is issued to the clearinghouse, which then assigns the obligation to a buyer.
• The delivery notice is essential for physical settlement in derivatives markets, ensuring the transfer of assets.
• The process involves specific rules and timelines set by exchanges and regulatory bodies.
• Not all futures contracts result in physical delivery, as many are closed out before maturity.

Interpreting the Delivery Notice

The delivery notice serves as a critical signal in the futures market, indicating that a seller of a futures contract intends to fulfill their obligation through physical delivery rather than cash settlement. When a clearing member provides a formal notice of intention to deliver to the clearinghouse, the clearinghouse then assigns this obligation to a holder of a long futures contract.³⁶

For the seller, issuing a delivery notice means they are prepared to transfer ownership of the underlying asset, such as a commodity warrant for metals, to the buyer. For the buyer, receiving an assignment to take delivery means they must be prepared to accept and pay for the physical asset. This process is highly structured, with specific rules governing the delivery period, accepted grade and quality of the commodity, and designated delivery locations.³⁵ The procedures ensure that the physical market and the futures market converge in pricing, providing confidence to investors.³⁴

Hypothetical Example

Imagine an investor, Sarah, holds a short position in a September crude oil futures contract, meaning she is obligated to sell 1,000 barrels of crude oil. As the expiration date approaches, Sarah decides to make physical delivery rather than closing out her position.

1. Issuing the Delivery Notice: On the first business day of the delivery month, Sarah's brokerage, acting on her behalf, issues a delivery notice to the exchange's clearinghouse. This notice states her intention to deliver 1,000 barrels of crude oil that meet the contract's specifications.
2. Clearinghouse Assignment: The clearinghouse, upon receiving Sarah's delivery notice, assigns the obligation to a long position holder. Let's say John, another investor, holds a long September crude oil futures contract. The clearinghouse assigns Sarah's delivery obligation to John.
3. Delivery Logistics: The delivery notice triggers the logistics of transferring the crude oil. Sarah, or her designated warehouse, will ensure the oil is at an approved delivery point. John will be notified of the delivery and will need to arrange for payment and acceptance of the crude oil. The settlement price for the delivery will be based on the exchange-determined price on the day the notice of intent was provided.³³
4. Transfer of Ownership: Once the payment is confirmed, ownership of the 1,000 barrels of crude oil is officially transferred from Sarah to John.

This process ensures that the contractual obligations of the futures market are met through the actual exchange of the physical commodity.

Practical Applications

Delivery notices are primarily found in futures markets where physical settlement is an option or a requirement. While a significant portion of futures contracts are offset before maturity through cash settlement, physical delivery remains crucial for certain commodities and financial instruments.³²

• Commodity Markets: In agricultural commodities (e.g., corn, wheat), energy (e.g., crude oil, natural gas), and metals (e.g., gold, silver), a delivery notice is used by producers, consumers, and traders who genuinely intend to buy or sell the physical asset. For example, a farmer might issue a delivery notice to fulfill their obligation to sell a certain quantity of grain, or a manufacturer might receive an assignment to take delivery of raw materials. Exchanges like CME Group provide detailed procedures for physical delivery across various commodities, including specific requirements for grade, quality, and location.³¹,³⁰
• Ensuring Price Convergence: The possibility of physical delivery, initiated by a delivery notice, helps ensure that the price of a futures contract converges with the spot price of the underlying asset as the contract approaches maturity. This convergence mechanism prevents significant disparities between the financial market and the physical market.²⁹
• Regulatory Compliance: Exchanges and regulatory bodies, such as the CFTC, have strict rules governing the delivery process. These rules dictate the timing of delivery notices, the types of warehouses or depositories that can be used, and the quality standards for the deliverable commodity.²⁸,²⁷ These regulations ensure market integrity and prevent market manipulation.
• Supply Chain Management: For industrial users and producers, delivery notices are an integral part of their supply chain and risk management strategies, allowing them to secure future supply or offload future production at predetermined prices.

Limitations and Criticisms

While the delivery notice and physical settlement process are vital for the integrity of futures markets, they also present certain limitations and potential challenges.

One primary limitation is the administrative burden associated with physical delivery. Unlike cash-settled futures, which simply involve a transfer of funds based on the final settlement price, physical delivery requires logistical coordination, including transportation, warehousing, and quality inspection. This complexity can deter some market participants, particularly speculators, who are primarily interested in price movements rather than taking or making physical possession of the commodity. Indeed, most derivatives contracts are closed out before their delivery date, with traders offsetting their positions.²⁶

Another potential issue is the risk of a failure to deliver (FTD). An FTD occurs when a party in a trading contract fails to meet their obligation, either by not having the underlying assets (seller) or not having sufficient funds to pay for them (buyer). While clearinghouses and exchange rules are designed to mitigate these risks, unforeseen circumstances, such as supply chain disruptions or technical problems, can lead to FTDs. For instance, failures to deliver increased during the 2008 financial crisis, highlighting the vulnerabilities in settlement processes., The Securities and Exchange Commission (SEC) publishes data on fails-to-deliver, acknowledging their occurrence in the market.²⁵,²⁴

Furthermore, the process can involve significant transaction costs, including storage fees, inspection charges, and transportation expenses, which can erode potential profits for those engaging in physical settlement. The limited liquidity often observed in physically settled contracts during the spot month, as traders who do not intend to convert to physical goods roll their positions, can also be a challenge.²³

Delivery Notice vs. Notice of Intention to Deliver

While often used interchangeably in casual conversation, "delivery notice" and "notice of intention to deliver" refer to distinct, albeit related, stages in the futures contract delivery process.

The notice of intention to deliver is the initial step taken by the short position holder, informing the clearinghouse that they plan to physically deliver the underlying asset. Following this, the clearinghouse then issues a delivery notice to a specific long position holder, assigning them the obligation to take delivery. Therefore, the delivery notice is a consequence of the notice of intention to deliver. Both are critical for facilitating the physical settlement of futures contracts.

FAQs

What happens if a buyer doesn't receive a delivery notice?

If a buyer holds a long futures contract but does not receive a delivery notice, it means they have not been assigned the obligation to take physical delivery. In most cases, these contracts will be cash-settled or closed out before maturity.

Can all futures contracts result in a delivery notice?

No, only futures contracts that are designed for physical delivery can result in a delivery notice. Many financial futures contracts, such as stock index futures or interest rate futures, are cash-settled and do not involve the physical transfer of an underlying asset.²²

Who issues the delivery notice?

The delivery notice is typically issued by the clearinghouse to the long position holder (the buyer) after the short position holder (the seller) has submitted their notice of intention to deliver.

Is physical delivery common in futures markets?

While physical delivery is a fundamental aspect of many commodity futures, it is not common for the vast majority of futures contracts to result in actual physical delivery. Most participants, especially speculators, close out their positions before the contract matures to avoid the complexities of physical settlement. However, the option of physical delivery is crucial for the efficient functioning and price discovery of these markets.

What is the role of the clearinghouse in the delivery process?

The clearinghouse plays a central role in the delivery process, acting as an intermediary between buyers and sellers. It guarantees the performance of both sides of the contract, manages the delivery notices, assigns delivery obligations, and facilitates the transfer of ownership and payment for physically delivered contracts. This role reduces counterparty risk.^{123456789101112131415161718}