The role of technology in commodity trading and risk management

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Managing commodity price fluctuations has become central to the business activities of many agricultural organizations in recent years. Volatility can affect a company’s bottom line, creating uncertainty that can impact funding, investment programs and shareholder income. As a result, agribusiness organizations have increasingly seen the need to take a more active approach to commodity price risk management in recent years. But what are the common strategies for this part of the market? How has the financial crisis and subsequent regulatory pressure affected the market? And what internal changes do agribusinesses have – and should they – put in place to improve exposure visibility and implement a robust price risk management program?

Changing markets
Agribusiness price risk management programs can include a range of strategies. Vertical integration, for example, allows an agricultural business to expand up or down the production chain and diversify the markets and regions in which it operates. Singaporean commodities company Olam International, for example, bought the cocoa processing business of Archer Daniels Midland for $1.3 billion in December 2014. Olam will now operate across the entire value chain. cocoa – from production to processing, including marketing, allowing for more efficient total management. margin management.

Other options available to a processor may include replacing more expensive products with cheaper ones, entering into long-term fixed price contracts, or developing exclusive long-term partnerships with growers. Kraft Foods, for example, signed a long-term supplier agreement with cocoa and chocolate manufacturer Barry Callebaut in 2010, making the Swiss company a major global supplier of industrial cocoa and chocolate to Kraft.

Although one of the most common strategies for managing commodity price fluctuations is the use of financial hedging tools, this method of managing price risk is not without its challenges. More recently, post-financial crisis regulations have impacted the supply and demand for these products. On the supply side, several major banks, including Deutsche Bank, Barclays and JP Morgan, have reduced their activities in the commodities market, reducing liquidity in certain segments of the market. Banks that remain as dealers have seen increased competition from hedge funds and commodity firms, which have expanded their commodity trading teams to fill the void.

On the demand side, many businesses and agribusinesses are subject to more regulations related to transaction reporting, counterparty risk and changing accounting standards, which have increased hedging costs. In addition to the new rules, agribusinesses currently face several other challenges when using financial tools to hedge against the current commodity price volatility.

Lack of visibility
The agricultural commodities sector is a diverse and complex ecosystem that requires major expertise to create significant financial positions to hedge. And it’s not always easy for organizations to get the necessary visibility into their exposure to the different types of risk in commodity markets.

A starch producer, for example, could sell to various industries such as human and animal nutrition, pharmaceutical/cosmetology and biochemical. Each open sales contract creates potential exposure to corn, power, sugar and freight prices, as well as different currencies and even interest rates, if financing is involved. The same producer has also usually purchased raw materials on the market or through long-term supply contracts which may vary in terms of volume/quality delivered and type of price paid.

As such, the producer must be able to map demand forecasts to actuals on the supply side and determine the net volume exposure to price risk for each risk factor and each price period. contract. The complexity of this challenge only increases when one considers that starch can be produced using a variety of inputs, including corn, wheat, potatoes, rice and tapioca. Moreover, some of these commodities may not even be traded in a liquid market and therefore risk managers have to use proxies, which creates additional basis risk.

Legacy computing complexities
Therefore, there is a very pressing need to extract, transform, and aggregate large amounts of data to properly monitor an organization’s actual commodity exposure. This is further complicated by the fact that after years of M&A activity, some agribusiness companies have layered many legacy IT platforms. Many organizations still operate in silos, allowing business units to develop their own solutions, rather than forming a central technology hub.

These layers can affect visibility when trying to manage exposure to major commodity markets. In an attempt to address this issue, some organizations have invested in a reporting layer connected to a risk warehouse to achieve better enterprise-wide technology integration. The integration layer brings together data from a myriad of internal systems, stores it in a massive risk warehouse, and then uses built-in business intelligence tools to make sense of the information. However, such a strategy can be a productivity trap. This often involves a lot of manual effort and hidden costs, and may not even provide the reporting frequency needed to ensure optimal responsiveness to market events.

Creation of a central hub
An additional complicating factor for many agribusiness organizations trying to manage commodity price risk is the fact that they often have business units around the world, all of which create commodity exposure. An international chocolatier, for example, may have several production units in different regions, each forecasting a certain level of demand for cocoa, dairy products, sugar and energy. As such, establishing a central trading desk that serves different business units of an organization can be a useful strategy to hedge against fluctuations in commodity prices.

These offices can be stand-alone P&L centers reporting to purchasing or treasury and serving local operating centers through transparent transfer pricing policies. A centralized trading desk receives data from each location into a back-end trading and risk management system that provides a holistic view of the organization’s overall commodity exposure. This allows risk managers to build a profitable enterprise-wide hedging strategy.

The advantage of having this global view is that the entire position of the organization can be taken by a central office which interacts with the market and executes the transaction. This should save time, money and resources. In certain situations, it also allows the organization to benefit from natural hedges when netting different positions in terms of currencies or certain commodity markets.

Robust technology platform
Organizations implementing this type of centralized trading strategy typically seek technology platforms with a range of tools, including multi-entity access, multi-currency functionality, and multi-GAAP software solutions. Today’s trading and risk management platforms provide a variety of tools to easily create, manage and mitigate firm-wide commodity positions. This can include: native unit conversions, with formulas linking end products to raw materials; family curves projecting illiquid products onto liquid market equivalents; spread correlation management; real-time prices; ratings against curves differentiated by physical and logistical characteristics, such as quality, location, and international trade terms; and the ability to manage multiple commodities and other asset classes, including foreign exchange and interest rates, on the same platform.

But organizations should only invest in a new platform if it is part of a real transformation program. While some organizations have the in-house expertise to create their own systems or extend their enterprise resource planning or treasury systems, many are turning to out-of-the-box trading and risk management solutions. . Hedging strategies usually involve the use of off-the-shelf products, and since off-the-shelf technology solutions exist to support these activities, why reinvent the wheel and develop something that already exists in the market?

Although linear derivatives and vanilla options are generally the most popular products in this sector, agribusiness players are also increasingly using more complex products such as accumulators. These more suitable products offer a way to build a position over time at enhanced price levels – sometimes at zero upfront cost but with more risk. Over a period of six or nine months, for example, the product accumulates cash or positions in futures contracts, depending on the evolution of market prices. This type of product offers great flexibility in terms of building a position and creating a profitable hedge, but must be carefully monitored using a robust trading and risk management platform.

Making price risk management a more integral business activity is crucial for companies facing changing markets and a more volatile price environment. When establishing a robust strategy to monitor and manage commodity price fluctuations, agribusiness organizations must have access to the necessary tools and be able to implement robust systems and processes to support operations. risk management. With the support of a centralized trading technology solution, enterprise-wide risk management can become more efficient, effective and successful.

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