Over the past few years, commodities markets have experienced a worldwide boom – particularly with the increase in demand from developing countries and the emergence of new financial players such as hedge funds and banks that have not previously traded in the market. These additions have re-shaped the commodities environment. Further, the appearance of a large number of financial players (Energy Hedge Fund Center has tracked over 500 hedge funds focused on energy and/or the environment) with no interest in the underlying assets has brought about a significant change in commodities trading habits.

Essentially, the commodities markets are now evolving in response to the pressure exerted by new incoming market participants who are boosting volumes and introducing new instruments. In such an ever-changing environment, market accessibility is crucial – and good IT choices help to meet the challenge while minimising risk.

1. Commodities market evolution under pressure from newcomers

Commodities exchanges have sought to adapt to the recent rise in transaction volumes through continuous support of liquidity, but the arrival of new speculative participants poses further challenges. Unlike traditional commodities traders or brokers, for most of the new players, commodities are just an asset class among others. In this respect, these traders risk limited amounts and take new positions rapidly and frequently, thus contributing to the overall increase in the number of transactions. In responding to this trend and competing to secure the largest market share, exchanges have undergone important changes. Recent merger activity among exchanges notwithstanding, one of the key developments is the reduction of standard size contracts (e.g. NYMEX miNYsm or CBOT mini-sized metals contracts), which have been adapted for new incomers such as hedge funds. Another major change is the employment of automation to support increased volumes and facilitate the arrival of new players with no back-office experience on the commodities market and no wish to invest in such. However, automation is far from being a complete and smooth process. Several competing protocols have emerged (FIX and XML, for example), making automation a continual challenge.

Current market dynamics have also had an impact on the range of instruments being traded. As well as attracting hedge funds in greater numbers, the periods of high volatility that the market has experienced recently have contributed to the development of derivatives products frequently used for hedging purposes. High volatility can be driven by geopolitical factors or natural disasters as well as more ‘workaday’ supply and demand factors. In times of higher risk, heavily energy-dependant corporates are using complex OTC instruments to cover their exposure on supply. A recent significant example is Air France-KLM which announced in the spring that it has secured 77% of its kerosene fuel needs for 2006-2007 at $50 a barrel. As this example illustrates, long-term swaps are increasingly being used to hedge against more volatile energy prices. But cross-asset baskets (mainly metal/energy) also offer good risk coverage and are often better solutions to exposures across markets. For firms looking to limit the risk and lower the price of the protection, cross-asset baskets are frequently proposed for long-term hedging requirements (up to 20 years) and include interest rate and foreign exchange components. In the near future, it is likely that commodities will be included increasingly in equity and credit structured baskets for hedging purposes against price inflation/volatility in the energy sector or any heavily energy-reliant industry.

Another significant trend in the industry is the multiplication of arbitrage and speculation derivatives. Commodities arbitrage used to focus on maturities but it has increased its scope to widen the range of market opportunities for investors who now use multiple arbitrage methods, including spreads, best of spreads, index, baskets, digital or Asian options etc. Two typical arbitrage strategies are electricity market price versus its production price (spark spread) or oil futures/gasoline and heating oil futures (crack spreads). The development of these new arbitrage and speculation derivatives means market participants must develop an understanding of correlation mechanisms and a flexible management and analysis of assets.

2. Changes strengthen the needs of market accessibility

The need to keep pace with change is forcing financial institutions – and especially the hedge funds which are pouring into this market – to maintain high standards of adaptability to be able to operate across several markets. In the commodities sector, effective market access is often a question of technology. Market participants need to ensure, for example, that all the different market rules and traded products are included in a single portfolio and risk management system, or can be easily added with regards to specific characteristics. Inherent commodities specificities are indeed multiple, including perishing or refining, seasonality calendar rules, storage constraints, transportation losses, and contract granularity. These specificities impact prices and as such their management of these parameters is the only safe path when trading on a worldwide market [see screenshot for an example of a typical commodities portfolio].

Access to real-time data sources across commodities markets is another essential requirement. Not only must a connection be readily available to all the specialist data providers operating in the commodities market (these have multiplied in recent years), but the software must be robust enough to handle the large volume of downloaded data. Additionally the software must also be usable across a variety of contexts and handle the specificities of the commodities data. It should, for example, cover all available contracts on the market, from the 5- or 10-minute contracts on the power market up to the different seasonality contracts for any type of commodity.

Finally it is important to allow the individual trader to have a flexible portfolio architecture allowing him to see his positions, P&L, limits and risks factors from a variety of different angles and aggregate these factors at the different levels.

3. Good IT choices help to meet the challenge while minimising the risk

To meet these market access challenges head-on, hedge funds need to ensure they have technology that is at once comprehensive and specialised. Not only do they require a portfolio and risk management system to be cross-commodity, but it should also be cross-asset, as most hedge funds combine commodities with other asset classes, like equity or credit [see outbox on cross-asset risk management]. For such funds, the most appropriate technology support comes in the form of an integrated system that offers full straight-through processing from front-to-back and across assets. The first benefit is full automation of operations with a front-to-back automated workflow and automated reconciliation of trades and positions with prime brokers. Second, an integrated solution will give hedge funds a global view on their activities and help them control their global risk exposure with parametric, historic and Monte Carlo Value at Risk and ensure mandatory requirements are met. Finally, it will help avoid the operational risk that can result from connecting disparate solutions. Combining several pieces of software together that specialise in a particular asset or functional area inevitably creates interfacing problems and an overall high investment of time, budget and effort for market participants that are traditionally unwilling or unable to spend on those three items. Supporting fewer systems means that staff at all levels are more familiar with system assumptions and output conventions.

In every industry, companies with innovative ideas and attractive products are penalised if they do not use the appropriate organisational and information technology tools. In the highly competitive hedge fund industry, tools that can adapt to market changes are even more crucial. Confronted with historic and well-equipped market players, hedge funds that are new to the commodities market should use all the tools at their disposal to maximise their trading expertise.
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Cross-asset risk management

Global multi-strategy funds that trade in the commodities market alongside a wide range of other strategies are faced with the challenge of assessing risk across asset classes. From a technology perspective, all such hedge fund managers should be looking to equip themselves with tools that display the following key characteristics:

1. A cross-asset perspective capable of consolidating all market exposure and able to match the pace of financial innovation in the market. This will help funds ensure that no instrument gets out of the risk control scope.

2. A consolidated view of all trading activity to enable full transparency across all levels of management – from fund manager to trader. Combined with a compliance tool, this transparency will ensure risk is being monitored and taken appropriately.

3. The use of multiple risk methodologies to provide a more complete approach to risk management. Although a historical methodology is interesting and useful, when employed in isolation it will provide biased information (the exploding volatility of the natural gas market is a recent example of this). Using other methodologies, including stress testing and Monte Carlo simulation, alongside the historical, will provide funds with a solid understanding of all exposure and potential scenarios.

4. Above all, to be fully reliable a proper risk management system should be provided by an external party and should be documented and validated by fund managers, investors, regulators and prime brokers. It should also produce comprehensive reports to provide investors with an accurate and transparent view of the risk.