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Arresting Entropy in Commodities Trading

Traders Magazine Online News, June 6, 2018

Mike Wilkins and Paul Dex

Entropy. A tendency towards disorder. For an observer of the commodities market, it may feel all too familiar.

The days of dealing with a clutch of standard contracts traded across a handful of exchanges with defined trading hours are gone. Commodities firms are now 24/7 global operations, firing orders around for a myriad permutation of contracts.

Change driven by market trends, regulations and local idiosyncrasies has seen commodities firms establish desks around the world, trading in different currencies, using different trading platforms often made up of a mishmash of software cobbled together. The technology estate is fragmented and consequently, so is the firmís view of risk and its own trading activity. That comes at a cost. Until now, itís a cost firms have largely resigned themselves to bearing, either because there wasnít an alternative, or the benefits of change werenít deemed worth the difficulty. That view is fading.

Paul Dex

The cost of disorder

Consider the scenario. In Chicago, a trader enters a position on the CME for wheat, traded in dollars and measured in bushels. His Parisian colleague does the same, but his contract is traded in Euros and measured in metric tonnes. Each trader hedges their position. The wheat is grown in different places and will have slightly different characteristics, but both are affected by the same fundamental market conditions. The two positions affect each other, and without a consolidated view, the head of trading canít confidently understand overall exposure. At the same time, two traders have made hedge trades, incurring broker commissions and exchange fees, when a single combined hedge trade would have sufficed.

This is a pattern repeated globally hour by hour, day after day. Wheat is just one example, but Brent versus WTI is another. It may sound simple to consolidate positions, but when relying on a sprawl of trading platforms and spreadsheets around the world, itís anything but. When traded contracts differ for similar underlying commodities, firms must also find a common approach to pricing risk and planning hedges. However, most firms could match a considerable percentage of their flow internally.

Those trading in products or via entities affected by MiFID II will also find that this approach helps them to adhere to the strict position limits now in force. By internalising flows, the organisation is less likely to breach limits, or have to make fewer sacrifices to keep within them.

Growing complexity

There are three compelling reasons to think again. First, the general regulatory push for a firmer understanding of compliance, risk and money management across trading firms. Dodd-Frank in the US and MiFID II in Europe push financial markets and participants to greater transparency and self-understanding. Second, the mounting business case across various commodity markets as the trading landscape changes. Third, innovative technology now exists to make a consolidated approach possible.

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