Pressure on CTRM/ETRM systems to find arbitrage

By Rebekah Tunstead | 18 July 2019

For years commodity traders and risk managers depended on legacy systems, spreadsheets and paper documentation. But with commodity markets becoming more complex and fast-paced, the race for efficiency and greater profit margins is becoming increasingly difficult as systems are having to evolve rapidly to stay competitive.

Commodity trading firms will have to start reviewing their business models as gross trading margins have decreased 20% since 2015, according to an Oliver Wyman report published in March. The need to monitor exposure, risk, and international logistics are key differentiating factors between firms in a high-volume, low-margin market.

In the commodities sector, trade wars, Brexit, and geopolitical events as well as possible changes in regulation are creating great uncertainty in the market. Technology has a challenge to assist firms to navigate through market volatility, risk, and complexity.

Commodity and energy trade risk management (CTRM/ETRM) systems are used by those in commodity markets to manage numerous segments of a trading firm’s front to back and risk activities.

The CTRM/ETRM space has seen consolidation over the past five years, with many vendors -Triple Point Technology, Openlink, Aspect Enterprise Solutions and Allegro - being acquired by ION Investment Group. 

Regulatory considerations

Since the financial crisis, an avalanche of regulation has increased the reliance on CTRM/ETRM systems – the European Market Infrastructure Regulation (Emir), the second Markets in Financial Instruments Directive (Mifid II) in Europe, and Dodd-Frank in the US. But changes to these regulations could soon take place.

On May 24, the European Securities and Markets Authority (Esma) launched a call on position limits and position management in commodity derivatives as part of a one year review into the Markets in Financial Instruments Directive (Mifid II).

“Esma notes in particular that according to Article 2(1)(30) of Mifid II, the definition of commodity derivatives includes securitized derivatives. However, the notions of spot month and other months, for which position limits are to be set under Article 57(3) of Mifid II are not relevant for securitized derivatives,” the paper stated.

“The concept of open interest does not apply either to those instruments in a straightforward manner and Esma had to find a meaningful approach to position limits in securitized derivatives in Article 15 pf RTS 21,” it continued.

On July 5, Esma published responses to the call for evidence which revealed a potential need for an update to the regulation.

The European Federation of Energy Traders (EFET) said in response to the paper that “the introduction of position limits has increased uncertainty in commodity derivative markets and occasionally discouraged market participants from entering into positions.”

“The lack of clear rules regarding calculation methodologies and the possibility of unexpected changes to the rules increases the risks for market participants and may reduce liquidity or move liquidity to non-EU trading venues,” the response continued.

In the US, the Commodity Futures Trading Commission (CFTC) has yet to complete rules on speculative position limits in agriculture, energy, and metals commodities. The regulator was charged by the US Congress under Dodd-Frank to establish certain position limits within six to nine months back in 2010.

On June 11, Commissioner Berkovitz told the FIA’s inaugural commodities symposium finalizing the rules is “one of the important pieces of unfinished business before us. I hope that we will complete it soon.”

“The question before the Commission is whether, based on our collective experience and knowledge about the markets we regulate, an exceedingly large speculative position has the potential to distort markets, impede price discovery, or facilitate manipulative schemes.  The Commission has asked and answered this question before.  The record before us demonstrates that the answer is “yes.”

As regulatory considerations around position limits both in the US and EU continue to be discussed having a CTRM/ETRM systems ready to deal with potential changes in regulation will be of increasing importance.

Emerging technologies

With this increasing complexity trading firms are looking to get more out of their CTRM/ETRM systems while limiting the impact on budgetary spending. The use of real-time data and analysis, cloud services, and artificial intelligence (AI) are key to advancing are fast becoming key to staying ahead of the competition.

There has been an increase in the adoption of artificial intelligence (AI) into CTRM systems with firms looking to implement the technology throughout the trading lifecycle, from pre-deal analytics to settlement. According to a report published by Ernest and Young (EY) in December 2018, 11% of vendor solutions said they had artificial capabilities.

The emergence of blockchain-enabled smart contracts is also gaining momentum. The ability to streamline reconciliation securely through an encrypted digital ledger is changing the traditional paper trail process. Replacing firms’ separate databases with a shared ledger of record, the technology has been described by EY as a game changer for the industry.

Also becoming of interest in the commodities and energy trading sector is the use of Robotic Process Automation (RPA). RPA is the use of robots which are introduced into existing software to perform repetitive and simple clerical activities. Although still in its infancy of adoption, RPA has a potential number of use cases such as: data submission, entry of compliance forms, and purchase order issuance, which is expected to reduce errors across the large volume of information proceed in commodity and energy trading operations.

In August 2018, a survey from FIS and the Commodity Technology Advisory reported that 75% of respondents said the cloud technology for commodities trading was seeing the greatest amount of investment and was the area most likely to see investment in the next 12-24 months.

In June 2018, ION said it had seen a 250% increase in cloud engagements across its CTRM/ETRM solutions. As with many other parts of finance cloud technology is growing in adoption as firms attempt to reduce costs while also limiting spend on infrastructure builds. Part of key considerations is the potential for scalability.

With rising amounts of data available and increased progress in the development of artificial intelligence and machine learning, new operational opportunities are beginning to present themselves. Crucial to the implementation of AI is efficient data storage and structuring and as algorithmic trading is beginning to take off in the commodities markets, a move from spreadsheets and legacy software to faster systems is required.

While an increase of data can come with numerous opportunities it also presents a challenge for firms to have processes in place to fully optimize the data. Although the commodity industry has begun to future embrace the benefit of technology adoption, the Oliver Wyman report identified a need by commodity trading firms’ quants and data scientist to work quickly to take advantage of short-lived information strategies. The report suggests main players will go back to their roots and look to gain a competitive advantage by developing operating models to support data analytics as an information advantage to increase profits.

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