Commodities – The Super Cycle

Over the past few years, the commodity markets have experienced a worldwide boom which can only best be described as a super cycle. This growth has been directly powered by the emerging BRIC economies of Brazil, Russia, India and China along with the emergence of new players such as hedge funds and banks that are now aggressively trading commodities.

This has significantly reshaped the commodities markets which is now seen as a new asset class and an essential part of any investment portfolio.

Exchange Evolution
The recent increase in transaction volumes has changed the markets dramatically and has challenged the commodity exchanges to meet increased transaction volumes and in particular the need for continuous liquidity.

This has been further stressed by the arrival of new speculative participants, such as hedge funds, introducing increased volatility within the market place.

During times of sustained volatility, the clearing houses such as the London Metal Exchange had to increase initial margin calls by 500% from $5,000 to $25,000 per contract.

Larger firms can afford to trade, but smaller players have been squeezed to reduce the number of contracts they hold. This has directly reduced market interest, leading to greater volatility and further upward pressure on margins.

To support this evolution of the commodities landscape, it is my view there are a number of unique challenges that need to be overcome.

Managing Risk
Many market participants are using obsolete solutions or even spreadsheets to manage their risk which is unthinkable in today’s heavily regulated and faced paced market place.

In addition, many ‘non bank’ market participants lack the standard risk management tools such as being able to calculate Value at Risk (VaR)  across the complete portfolio along with being able to generate Basis point sensitivity to various underlying risk factors.

Furthermore, the ‘non bank’ players are lacking the standard scenario modelling tools available to Investment Banks to run historic scenarios or model future events and outcomes.

The challenge here is for all market players to develop comprehensive and robust solutions to manage risk in a real time environment.

Automation has been proven to bring transparency and risk reduction through reduced trading errors as well as introducing cost savings and efficiency gains.

A key challenge for the market relates to the post trade processing of large volumes of trades.  Historically, this has been a highly manual process that has been unable to scale due to the lack of standardization contracts, making STP difficult and in turn increasing risk and cost.

This can only be achieved by introducing standardization across the market place, defining standard contacts and introducing flexible and open multi asset architecture.

Another significant development in the industry is the arrival of arbitrage and speculative players.

Historically, commodity arbitrage used to focus on maturities but has now expanded to include a wide range of spread opportunities including electricity market price versus its production price (spark spread) or oil futures / gasoline and heating oil futures (crack spreads).

The development of new arbitrage and speculation requires market participants to develop a detailed understanding of correlation controls and a flexible management to analyze assets in real time to increase transparency of both market exposure and risk.

This can only be delivered by the introduction of robust real time trading tools. It is essential that the pure commodity players equip themselves with the real time order management, pricing and risk management tools that the banking community has come to know and expect.

Market Access
Effective market access in the commodities sector is highly dependent on technology. Market participants need to ensure that all the different market rules and traded products are included in a single portfolio and cross asset risks management system.

Specific commodity requirements include defining storage constraints, perishing or refining details, along with seasonality constraints and transportation losses etc. These details directly impact process and are an essential pre requisite when trading in a global commodities market spanning regulatory regimes and international boundaries.

Real Time Data
Access to real time data is an essential requirement. A connection must be available to all specialist data providers in all commodity markets. In addition, the software must be robust enough to handle extreme volumes of data both for pricing and risk analysis.

It is essential to provide the trader with flexible portfolio architecture to allow him to manage and view his position, PnL and risk factors at different aggregate levels and across multiple views.

In today’s fast changing global trading environment, the benefits of faster and more transparent processing is a must have.  The route to full automation is both desirable and necessary.

The commodity market place cannot continue to meet the volume and regulatory expectations without fundamentally embracing technology automation, real time trading tools along with robust risk management control.

To succeed, it needs to adapt quickly and be flexible. Only then, can the commodities market truly flourish as an efficient asset class in its own right.

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