Processes
Origination
Commodity traders source raw materials from producers, may perform a first transformation, transport those, may store them temporarily and finally deliver them to end-users. Unlike integrated majors, which own and manage, partially or fullly, upstream, transformation and marketing of transformed products, traders do not control the full delivery chain. Their revenue is the differential between price paid upstream and selling price downstream. To realize it, a large range of services are being provided. Diversifying resourcing pools and maintaining good relations with upstream producers or primary transformers are of utmost importance, for various reasons:
-
Mitigating risk
Producers are very heterogeneous in terms of geography, corporate size, financial strength and culture. Climatological accidents, geopolitical conflicts or insolvencies can seriously impact prices or jeopardize ongoing operations. Not to get trapped when situations turn sour, it is absolutely necessary to build a network of alternative procurement options.
-
Reducing acquisition cost
Securing supply by diversifying agreements, is not only to bridge accidents, but as well to benefit from local procurement conditions, arbitrage geographically distinct price evolutions and position yourself favourably in terms of logistics. To remain competitive it requires a good understanding of the needs of the local producer, a reliable infrastructure and flawless execution.
-
Controlling quality
Producers are heterogeneous but productions even more. Crops depend on meteorological hazards, oil wells may become temporarily unavailable due to unforeseen maintenance, a mine cannot guarantee constant ore quality, etc. Customers however pay for well defined grades. To honour sales contracts, a trader must know where to source, how to upgrade (blending, transformation process), master logistics and understand well what it costs to meet customers specifications.
To secure a diversified and steady procurement flow, traders build tightly managed organizations. Sources are far and wide, operations complex and prone to surprises, risks important and finally profit margins relatively low. Several arrangements can be developed to stabilize sourcing flows.
-
Support to producers
Suppliers are often small operations. Transforming their production to a marketable product may require significant efforts. It may target the production itself (productivity, grading, economies of scale, safety, social and environmental standards), in countries with limited infrastructure its transport to export hubs or markets, and very often financial resources just to make it happen and improve competitiveness.
-
Logistics
Trucks or rail to bring the outcome from the field or mine to a market place or export hub, transformation, storage, overseas shipping, allocation to the most rewarding market. All of it requires mastering multiple know-hows, not only to move the materials, but as well to handle legislation, insurance, market skills, politics and risk management. This benefits upstream producers by disclosing new markets to them.
-
Funding
Trading companies may have access to capital markets which is harder to obtain for smaller, local producers. Financing of primary extraction or production may happen through various agreements:
- Pre-payments are loans granted by the buyer to the producer, guaranteed on and paid back later with the physical production they enabled.
- Offtake agreements are long term purchase contracts, whereby the buyer agree in advance to acquire part of the output of the producer over several years.
- Through joint ventures trading companies may become shareholder or participate substantially in important pluri-annual development projects.
-
Vertical integration
This is an evolution which is often observed, whereby a trading company not only fullfills a role as intermediary between initial producer and consumer, but becomes asset owner, either way, upstream and/or downstream.
Operations
Trading performs three major transformations. Each offers arbitrage opportunities, but is a business of its own. The right coordination between each business line coupled to a rigorous execution performed within each logistics, will determine the overall profitability. A trader has to honour his off-take agreements and supply contracts, but how is up to him. Depending on ever changing price differentials, he can redirect deliveries, source elsewhere, inject into or withdraw from storage. The more he controls the supply chain, the more combinations he has and versatile he can be. The more as well he improves price competitiveness and finally market efficiency. Most operations however are a scale business which become cost-effective only if large volume can be processed, if multiple supply sources can be combined and decisions are made swiftly to grasp opportunities as long as they exist. Those activities are capital intensive, so should be funded, and are executed in unpredictable conditions, prone to slippage and unexpected drawbacks, which requires adequate risk management.
-
Material processing, transformation of form.
Raw materials extracted from mining or harvested usually undergo a primary transformation prior to be marketed as 'commodities'. Depending on the product, the process will vary: grinding, concentrating, drying, blending, grading. This happens for various reasons: reduce weight, cut hazardous components, reduce perishability, meet regulatory requirement or simply satisfy customer demand. It can be motivated as well to increase profitability, e.g. by blending different origins to obtain synthetically the quality meeting all specifications at a more competitive price.
-
Transport, transformation in space.
Consumers are rarely vested next to a mine or farmland. Taking commodities from where they are produced and bringing them to where they are consumed is the most visible service provided by a trading company. It can be a long chain of processes. Speaking incoterms: Ex-Works to FOB, Free on Board to Cost Insurance Freight, CIF to Delivered at Place. Often multi-modal: pipeline, trucks, rail, inland barges and maritime vessels. The synergies which come with control of such midstream assets improve a lot the reliability, efficiency and profitability of the supply chain.
Overseas shipping is complex and freight prices volatile, trading firms hence pay a particular attention to maritime transport. They may own their own fleet or charter them from vessel owners, on time or voyage charter basis. Bunker fuel is a significant cost of each trip, its prices are volatile as well and requires proper hedging. All this expertise service their own trading desks, but to reduce transport cost, is proposed as well to third-party customers.
-
Storage, transformation over time.
In commodities supply and demand are usually inelastic. For the producer it is the sole income and investment in capacity may take multiple years to realize. For the consumer it is the main input of his entire refining or manufacturing business. Inventories help to bridge unforeseen supply accidents or unfavourable market imbalances. Controlling storage capacity gives a trader not only more security to honour his contractual committments, but offers him as well the opportunity to realize price arbitrages. Arbitrage opportunities are transient, hence flexibility and autonomy are key success factors.
Optimizing ownership in time happens on the price curve itself (storing at surplus, releasing at shortage) but as well by hedging physical positions with offsetting financial carry trades: swapping near and far deliveries, depending on the curve direction being contango or in backwardation. By trading the spread, operators contribute to reduce the price differential between forward and spot delivery. As for geography, arbitrage erodes the arbitrage opportunity and doing so improves market efficiency.
-
Trade execution.
- Pre deal analytics, Trade capture.
- Contract management, Confirmation, Matching.
- Scheduling, nomination, delivery.
- Fixing, netting and settlement.
- Finance, Accounting, Regulation.
Risk Management
Market Risk
- Position monitoring
- Scenarios
Credit Risk
- Credit exposure
- Collateral
- Margining
Compliance
In the aftermath of the 2008 financial crisis, financial authorities have enforced more stringent regulations on derivatives trading. One of the measures adopted by most regulators is the obligation to report derivative transactions and/or positions, whether OTC or exchange traded, to a central trade repository (CTR) or swap data repository (SWDR).
We detail hereafter the datamodel of how trades have to be recorded in the juridictions most relevant for Commodities trading and map those with our generic model.
Singapore - MAS
The Monetary Autorithy of Singapore (MAS) is the Central Bank of Singapore. As such it supervises and enforces regulations to safeguard financial stability, among which the Securities and Futures Act, in our case more precisely the regulation pertaining Reporting of Derivatives SFA2001-S668-2013, dated 31st October 2013.
Europe - ESMA
The European Securities and Markets Authority (ESMA) is in charge of rolling out the European Market Infrastructure Regulation (EMIR, Regulation (EU) 648/2012) for over the counter derivatives. The trade reporting technical standards set the outline of the records to be reported. A first version (Delegated Regulation (EU) 148/2013 dated 19th December 2012) has been superseded by a revised one (Delegated regulation (EU) 2017/104 dated 19th October 2016) as explicited in the validation rules which are detailed below.
United States - CFTC
In the United States, Commodities trading is regulated by the Commodities Trading and Futures Commision CFTC. As such it oversees implementation of the Dodd-Franck Act, which enforces reporting of derivatives activity by most market participants. The technical details are set forth in Title 17, Chapter 1, Part 45, Appendix 1.
Cross Jurisdictions
Mapping the Commopedia generic trade attributes to the corresponding attribute accross jurisdictions.
