Commodities Trading: Time to Let Go of Manual Legacies?

From 2019, Audi will no longer sell a new car with manual transmission in the United States. America has long preferred automatic, but it feels significant; like a turning point where the manual world for motorists begins to fade into obsolescence. Maybe in a few years well witness the final few petrolheads resist a change that has since become inevitable.

In commodities trading, thats where we are right now. Electronification and technological advancement in trading systems have put us on the brink of a world where manual is rightly a thing of the past. But were only on the brink – theres still a final jump to make yet.

Electric futures

Recent years have seen rapid electronification of a once stubbornly voice-driven market and the roar of barked orders in the options pits has dwindled to a murmur, while the futures pits have been silenced completely. Additionally, even as the last holdouts continue to defend their corner, electronification has enabled frontier markets around the world to open their own commodities exchanges with contracts based on regional nuances and catering to local players, creating a wider array of products to trade and developing a new set of benchmarks. One only needs to look at trading volumes of agricultural products in China and compare them to those traded in Chicago to see how volumes in these markets has exploded over the past decade.

Today, voice flows are ebbing even for the complex options which had resisted electronification for a long time. For example, five or six-legged natural gas options with different durations are being cleared on exchange that would never have been a few years ago. Brokers can create these custom strategies on exchange, where market makers see them, analyse them and instantly publish a two-sided market in response which brokers can then show back out to their clients. Traders are finding that, even if volumes will never be huge, there are venues and counterparties that can be relied on to take the trade, and communicating with those counterparties gets more automated and quicker. With orders being sent, filled, cleared and reconciled in a matter of moments theres little incentive to enter into an OTC trade when a futurized trade can be just as effective and significantly more efficient. As complex options join futures on-screen, a big part of the more manual, analogue commodities trading world slips away.

Manual gearboxes

But that moment has been coming a long time and everybody in the commodities market has watched as it has inched closer. Its not the only way the commodities world is letting go of manual though – equally important is whats happening under the bonnet.

Electronification of instruments has gone hand-in-hand with electronification of workflow too. However, there have remained gaps where manual processes have persisted. Fully transitioning to a post-manual world for commodities trading will mean eliminating these, front to back, top to bottom.

That means an order management system capable of dealing with the complicated contract descriptions that come with complex commodity contracts. It means handling different ways of pricing at the same time as providing connectivity to all relevant venues. Being able to trade Paris wheat, Black Sea wheat and Minneapolis wheat all on one platform may sound like common sense but the complexity involved has made historically uncommon practice.

It also means automatic and instantaneous post-trade reconciliation and margining. Creaking technology and processes have historically made these manually-intensive and time-consuming tasks, often left to end of day.

Some of these processes can be taken on by trading platforms offered by the exchanges themselves. But this isnt quite as automated as first appears. The platform affiliated to Exchange A might streamline reconciliation of trades placed with Exchange A, and Exchange Bs platform might do the same. But if an organisation is dealing with a cluster of exchanges and trading via a variety of brokers then this method leaves it with the unappetising task of then manually comparing across the different exchanges.

The problem here is a lack of an automated central view: different systems give different viewpoints but a single view of the truth still means manually collating and comparing. This creates inefficiencies across the board.

For example, risk analysis and hedge management suffer from a manual lag. Imagine that two traders working for the same organisation each had trades placed in related commodities with different exchanges. Without automated technology that maintains a view of both trades simultaneously and in relation to each other, you can run into problems. For a start, risk management becomes difficult when no single view of risk exists that accounts for the related trades. Each trader has probably hedged their exposure, but that itself is an issue – by netting off the trades against one another a smaller hedge trade could have been made, incurring lower funding costs and fewer commissions and fees.

Manual reconciliation across trading platforms simply doesnt work in a world where traders are under constant pressure to provide the best pricing possible while effectively managing risk.

Vertical integration

However, horizontal integration isnt the only way in which manual processes can hold organisations back. Increasingly important is deep, vertical integration with other technologies in the trading IT estate. Take commodity and energy trading risk management solutions (C/ETRM). These solutions look to maintain a consolidated view of the firms exposure to physical commodity risks across its portfolio, often involving transportation and storage concerns.

For example, if a firm owns a quantity of LNG on a tanker en route to a port, there may be risks relating to the availability of regasification facilities at the destination that cause difficulties or delays in sending the commodity on. This is a very different type of risk to those posed at the purely financial level and historically it was a fairly manually-intensive job to combine the two into a single view. Increasingly though, workflow management systems are integrating with such systems to provide a more accurate, consolidated view to inform ultimately better, more profitable trading decisions.

Its fair to say that oil and energy markets have led the way in departing from the old manual ways, to great effect. However, the benefits of doing so are commodity-agnostic. There isnt a market in the world that cant benefit from greater transparency, efficiency and a consolidated, real-time view of risk.

Its important to keep in mind differences between markets. For example, while ag markets must accommodate a farmer hedging his own exposure there isnt quite an equivalent user in oil. But if we can do so then a better world beckons for commodities traders, with technology at the heart of it. As Audi have shown us, despite what the hold-outs might say, there comes a point where there really is no reason to hold on to a manual world.

Mike Wilkins is Derivatives Product Marketing, Fidessa