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Commodities: from pit to screen

Published in Automated Trader Magazine Issue 38 Autumn 2015

Commodities trading is undergoing radical change, driven in part by increasingly electronic markets and regulation. Peter Barker reports on how markets and traders are evolving.

Craig Pirrong, Professor of Finance, University of Houston

Craig Pirrong, Professor of Finance, University of Houston

What's happening in commodities markets, said Craig Pirrong, professor of Finance at the University of Houston, is that what used to be "in the floor trader's head" is now being computerised. Moreover, increased electronic trading is a spur for greater liquidity, as well as a catalyst to change the way liquidity functions.

Ultimately, that means cheaper transactions. So hedgers and others are going to be able to execute orders at lower cost, a benefit to any market participant.

Meanwhile, market participants themselves are changing too. Castleton Commodities, which emerged from the energy subsidiary of the Louis Dreyfus Group, illustrates how trading firms might evolve.

What makes them distinctive, said Pirrong, is that they provide "a marriage of private equity capital in a private ownership model".

"The basic models that we have at the moment in terms of commodity trading are the private firms such as Trafigura, Vitol, Cargill. Then, you have publicly owned commodity trading firms like ADM (Archer-Daniels-Midland). Castleton is sort of a hybrid model," he said.

Commodity trading houses are adapting against a backdrop of the world's open outcry trading floors getting shut down one by one, with the last remaining ring in Europe belonging to the London Metal Exchange.

There is tremendous speculation that the ring will disappear. But it appears that the LME is making plans to include designs for it as the exchange moves to new headquarters.

"The ring is being invested in. When we move to our new premises, which will be the end of this year, or early next, we will have a new ring," said Paul MacGregor, head of sales at the LME. "We understand the value in terms of price discovery of all those prompt settlements in a very short period of time. The LME did a review in 2014 and the market wants to keep it."

Automated traders need apply

The LME's ring co-exists with its electronic platform, Select.

"We have seen growth in volumes on Select with no particular detriment to the ring, and when the ring is very, very busy during volatile periods, we do not necessarily see a detriment to Select either," he added.

Pirrong however, sees the ring as "important, but they keep it on more for tradition". And its continued use will come under renewed speculation with the news that JP Morgan plans to quit the ring.

Michael Camacho, head of commodities at JP Morgan said to the Financial Times that the move was prompted by shifting client preferences: "A very high percentage of our LME contract volumes are now traded electronically."

Paul MacGregor, Head of Sales, London Metal Exchange

Paul MacGregor, Head of Sales, London Metal Exchange

LME trading, in the ring and electronically, involves 40 general clearing members, including some of the big investment banks, brokerage houses, and some "very unique metal-specific members who really only offer access to the LME," said the LME's MacGregor.

The primary base metals traded are: aluminium, copper, zinc, nickel, lead and tin. Minor metals contracts include cobalt and molybdenum.

"But the majors," he said, "are aluminium, copper and zinc, which is where we have focussed a lot of liquidity programmes that we are trying to introduce to the market place, and where we are trying to grow more liquidity on the Select platform.

The LME has developed a volume-based rebate programme, and MacGregor is reaching out to traders who find that profits are hard to make in other markets due to monetary conditions or market saturation.

"A lot of trading opportunities for market makers, automated traders in other market places, are more difficult now because of a zero interest rates environment and the fact that the equity markets - and in many cases equity index, equity derivatives markets - have also got to the point of saturation of proprietary and automated trading," he said.

Power brokers

In energy markets such as gas, power, carbon and coal, trading is mostly executed via interdealer brokers, and is a 'highly electronic market place', screen assisted for more than a decade, according to Alex McDonald, CEO of the London Energy Brokers' Association.

In Europe, OTC energy markets are traded on a hybrid system with voice brokers using a common aggregation software, such as Trayport.

"In the more liquid markets, such as the 'prompt markets' in NBP (National Balancing Point) gas, and the TTF (Title Transfer Facility) gas, virtually all trading is done via the screen assisted software. In the less liquid products...there needs to be a lot of human intervention when executing trades," said McDonald.

European energy markets are preparing for the next stage of REMIT (Regulation on Wholesale Energy Markets Integrity and Transparency), which has been preliminarily in force since the end of 2011, but will shortly witness detailed implementation. In early October, widespread reporting requirements will be introduced, as well as the imposition of much more prescriptive and firmer market abuse rules, said McDonald.

"To engage in trading, you have to disclose what your vested interest in it might be, and report promptly to a Registered Reporting Mechanism (RRM). The outcome will be market assurance and quality, but the impact of that is really in the reporting and in the post-trade, as opposed to radically shaking up the arrangement of liquidity," he said.

REMIT, he added, is providing energy markets with something that other markets don't have, namely, a "holistic" approach to product and a common set of reporting engines with utility product codes.

"In that sense it is the vanguard of all the things that financial regulation would like to achieve," he said. Compare that to MiFID II regulation, which will divide the market by product, participants, geography, and most notably between physical forward and derivatives markets.

Gas and power both trade as physical forward markets and have a very limited take-up of clearing. McDonald said the likely impact of the regulation would be to further fragment the market into types of users and products.

This will mean that contracts not physically settled will be classed as financial instruments and reported and regulated under EMIR (European Market Infrastructure Regulation), which affects derivatives, central counterparties and trade repositories and has a stated aim of improving transparency as well as reducing risk.

Under EMIR, the competent authorities will become financial regulators as opposed to the bulk of the markets, which are overseen by energy ministries.

"The juxtaposition," said McDonald, "seems to deny the transactions of packages and impact on the connectivity and liquidity between these two sets of markets, with their different products, supervisors and reporting routes."

Alex McDonald, CEO, London Energy Brokers’ Association

Alex McDonald, CEO, London Energy Brokers' Association

Next gen tech

One thing's for sure: new regulations and structures for the market will have a material impact on technology and data sets.

Questions have been raised over access and intellectual property for traded instruments, when the underlying is a common utility: can intellectual property be distributed and owned by market participants rather than market centres?

"Perhaps technology and the take-up of distributed ledgers could answer those questions because of sponsored access, because of speed to market, because once you get common identifiers you may be able to have more of a distributed product base," McDonald said.

It could very well be the "next generation of technology" that empowers both participants and supervisors, but also solves problems inherent to the "very expensive, current discordant and overlapping" set of regulations, and the concomitant intellectual property rights it produces, he added.

"Many of the current developed rules actually cement the silos into place because of the difficulties to defragment and interoperate. Therefore, participants cannot trade unless segmenting lots of cash collateral onto a centralised exchange and paying execution charges to get market access, data, post-trade processing and reporting," McDonald explained.

One of the lessons of any regulation is that the big get bigger and the small struggle for market access due to increased costs. The debate going forward will be whether a distributed model will trump a centralised model, and what the common objectives are and who sets them?

"As ever with networks and utilities, amongst which the financial and energy markets are no different, the questions are all about who is serving whom and for what outcomes," McDonald said.

Professor Craig Pirrong, however, said that the situation is comparable to other advances that shook up markets.

"That's one thing we saw in HFT, that is, essentially, HFT firms replaced the traditional kinds of firms that provided liquidity. And within that, we are going to see evolution," he said. "With anything that is technologically dynamic like this, we are likely to see new entrants, and if they have a technological edge or innovation, they are going to have an advantage or an opportunity."

APAC brief

Martin Lockstrom Chairman and CIO QuantCore

Martin Lockstrom Chairman and CIO QuantCore

China is a growing market, with distinct characteristics. Martin Lockstrom, founder of QuantCore Capital Management, runs a systematic trading shop based in Shanghai. He explains that there's a partnership with local asset managers.

"We sort of piggyback on their infrastructure because we don't have the asset management licence ourselves. We develop a trading system and then we can cooperate with various asset managers that operate the systems," he said.

Lockstrom added that there was regulatory change in China on almost a daily basis. "Because of the recent market meltdown over the last couple of months, the Chinese regulators are pretty much in a state of panic."

"Based on what we have seen so far, the more they are trying, the more the bloodshed."

China was on a path to liberalise markets, including opening up commodity futures markets to foreign firms.

"A lot of that has basically been undone in recent months simply because of the intervention they have been doing. They have really backtracked on the development path that they originally embarked upon," said Lockstrom.

He expected the long-term direction of liberalising markets to be resumed after some months as market conditions moderate.

For the LME, China is an important market, with membership including Chinese firms and organisations such as Bank of China, China Merchant Securities, broker GF Financial, ICBC and Standard Bank. Head of sales for LME Paul MacGregor said: "We have always had interest and trading volume coming directly from China. One of the reasons they have become members of the LME relatively recently is the demand of their customers in China to directly hedge on to the LME."

He also foresees India being a huge growth market, as well as Singapore and other Asian markets.

"Singapore has become a commodities hub. Japan is a mature market, it has an enormous steel industry that needs to hedge the inputs to steel (nickel and zinc). Australia has an enormous mining industry and very well-developed proprietary trading industry, and also managed money industry."

Africa and ags

Chris Sturgess, Director, Commodities, Johannesburg Stock Exchange

Chris Sturgess, Director, Commodities, Johannesburg Stock Exchange

The agricultural markets division of the Johannesburg Stock Exchange was founded 20 years ago.

From day one, the small derivatives exchange started off electronically, said Chris Sturgess, director of Commodity Derivatives at JSE. It enabled the exchange to connect member firms, particularly those accessing and then executing for clients from across the countryside.

"The electronic exchange provided a robust platform for farmers and millers to access the commodities market and to see transparent (prices)," said Sturgess. "Over the past 10 years direct market access is something that the majority of members provide clients in line with many international markets."

The most liquid and actively traded commodity is white maize, followed by yellow maize, soya beans, wheat and sunflower seed.

The JSE recently partnered with CME Group and Euronext to list a number of their products in the South African currency, the rand. These are cash settled contracts relying on their benchmarks.

"We had the technology, let's make it easier for the client base to access these international products using our local platform," he said. "With committed market makers who dynamically quote off the liquidity of a CME Group or Euronext market, these products start with instant liquidity."

By the end of the year, the JSE is introducing two cash settled beef contracts and a partner arrangement with ZAMACE, a spot commodity participant in Zambia for listing Zambian contracts in white maize, wheat and soya to be traded and settled in US dollars.

In terms of doing business in Africa, Sturgess said it was important to be aware of the available infrastructure, which is not always on a par with Europe or the US.

"We need to be mindful around bandwidth requirements and accessibility for electronic exchanges, but that said, Africa remains innovative and opportunities using mobile technology to enable trade and investments remain bountiful," he added.