ICE-NYX Merger to Boost Commodity Derivatives

Terry Flanagan

There will be a big increase in the European trading volume of commodity derivatives following the completion of IntercontinentalExchange’s merger with NYSE Euronext, according to Sungard.

Regulators have pushed for trades to move from over-the-counter onto exchanges where they will be more transparent and centrally cleared.

“The OTC market will never go away for small end users, but as you move up the pyramid mid-tier and large users will increasingly use exchange-traded products,” said Matthew Healy, senior vice president and general manager at Kiodex, the commodity risk management platform of Sungard’s capital markets business.

Healy expects the use of commodity derivatives will rise in Europe after the completion of ICE’s merger with NYSE Euronext. “We expect to see a huge uptick,” he told Markets Media.

In Europe power derivatives are growing the fastest according to Healy, while in Latin America agricultural products have the highest growth rate. Dairy and livestock derivatives are growing the fastest in the U.S. while in Asia it is metal derivatives.

Latin America is the fastest growing region for commodity derivatives due to exports of coffee, sugar,metals and energy. “Latin American banks have a huge opportunity which they are exploiting fairly quickly as international competitors face increased regulation,” said Healy.

Brazilian investment bank BTG Pactual said in its results call in August that its new commodities business will soon begin contributing to earnings. At the time Reuters reported that bank had spent $300m to hire staff to launch the business. In contrast JP Morgan Chase said in July that it would sell its physical commodities business as the Federal Reserve reviews a 2003 decision to allow banks to enter the raw materials market.

Another reason behind banks exiting commodities trading is the end of the decade-long “super cycle” of rising prices.

Healy admitted that growth of commodities trading had slowed from its peak and that hedge funds are changing their strategies. “Hedge funds want to diversify into other asset classes such as equities while still managing their risk on one system,” he said.

“Hedge funds are diversifying but they are not backing away from derivatives and also reviewing index products and fixed income,”Giancarlo Delia, client advisor at Kiodex added. Delia said investors are also changing their strategies as outsized profits from high-frequency trading have disappeared due to rising trading costs and increased regulatory scrutiny.

Sungard has identified six trends that it expects to shape commodities trading over the next 12-18 months:

1.  Low correlation across commodities is driving hedge fund managers to reevaluate their strategies with a micro approach, instead of riding the commodity super cycle.

2. Safe havens from collateral charges in the over-the-counter (OTC) marketplace will become scarce under new regulatory requirements, prompting a need for collateral management systems in both hedging and trading operations.

3. Movement of margin calculations from formula to value-at-risk (VaR) based systems will increase the importance of risk-modeling methodologies for the middle and back-office processes of market participants.

4. Replication of OTC trading conventions in exchange-cleared contracts, combined with increasing levels of globalization will require greater flexibility from trade capture and reporting systems.

5. The volume and complexity of data, including reference and market data, are increasing, driving the need for timely data management and interpretation.

6.  The growth of high-frequency trading in the commodities futures markets has simultaneously increased market depth and intraday execution risk, making it more important than ever to empower decision makers with real-time risk analytics and reporting.

“Corporates tell us they are trading with four different counterparties who each use a different method to calculate the collateral on their positions,” Healy said. “They come to us to try and match or understand the calculations so that they can challenge incorrect numbers and this has become a big trend.”

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