Latest Trends in Base Metal Commodities Trading
Over-the-counter (OTC) trading in the base metal markets, and the back office operations which support it, has historically been a manual trading and confirmation environment. Unlike its peers, who over the past decade have automated and taken on new, software enabled solutions to speed up and extend their markets, the OTC base metal market has held out, maintaining its traditional manual practices. This aversion to change has been accredited to a general desire by many in the industry to carry on with existing practices as they have worked so well for the market for so long. It would seem that the inexorable dominance of technology in trading has all but passed this market by.
However, the weight of argument has mounted on base metal traders and the market is finally facing up to the technological revolution, with pressures from sources both inside and outside the industry compelling OTC traders to overhaul how they handle post-trade processing. This pressure is timely – 2007 saw the 130th anniversary of the founding of the London Metal Exchange (LME), the key global exchange for the industry, with a declaration from the exchange that it wanted to double its trading volumes within the next five years. To achieve this, the LME has adopted a strategy which will see it grow organically, part of which includes a new onus on developing OTC trading.
In today’s fast changing and volatile global trading environment, the benefits of faster and more transparent post-trade processing are increasingly obvious both to traders and the regulatory authorities. For base metal traders, the route to automation is both a desirable and a necessary one – they simply cannot continue to meet volume and regulatory expectations without the advantages afforded by technology. Fundamental to this is also the fact that all parties in the industry want to ensure maintained integrity in their markets – and an efficient, robust environment in which OTC trading can continue to flourish is essential.
Like other markets, a key driver for change has been the massive growth in the number of OTC trades in recent years. According to data released by UK-based Markit Group in April 2008, monthly OTC trading volumes rose from an average of around 20,000 to more than 25,000 per dealer. The International Swaps and Derivatives Association (ISDA) also reported, in the same month, that the volume of monthly OTC volumes grew 38% on the same period in 2007. The popularity of OTC within base metal trading has mirrored this growth, with the traditional physical trading patterns, where suppliers, processors, stockists and users trade bilaterally rather than through exchanges, persisting.
Again, like their peers in other markets, the issues for base metal traders arise from the problems of post-trade processing of such large volumes of trades. The case for maintaining manual processing functions seems weak when faced with the efficiencies of automated solutions. ISDA published findings in May 2007 showing trade processing times in OTC equity markets levels has fallen to 21 days from around 50, but TowerGroup has pointed out that ‘arcane’ types of trading need to be targeted in order to better the processing times. With other markets embracing technologies, it is left to manually dominated environments like base metals to catch up and help raise the standard for the whole trading community. ISDA has highlighted the industry pressures on the base metal OTC market, with the logic of automation seeming much stronger as a result.
Indeed, automation has been proved to bring transparency and risk reduction through reduced propensity for trading errors, as well as cost savings, allowing the operations unit to do more with less. Given recent high-profile news of inaccuracies and anomalies in the trading world, solutions that minimise potential for error are to be welcomed, both from a practical stance and in terms of outside confidence in the market. The other classic benefit of automation, of course, is the improved connectivity which advanced IT networks bring – speeding up and increasing the levels of information throughout the system, as well as helping with clarity and ease of access to data relevant to the whole trading cycle. Additionally, standardised instrument formats can offer economies of scale, significantly speed the confirmation process and enable increased trading activity among the market participants.
As well as the efficiency benefits facing the base metal OTC community, regulatory pressure is also being brought to bear. Like other trading arenas in today’s difficult market place, the base metals trading market is under pressure to define how it does business, set operational guidelines and standards, and demonstrate compliance with those standards, both for industry efficiency and to ensure confidence in trading is maintained. The desire for top-down regulation, devised and implemented by a regulatory body, is weak with industry insiders, particularly on the bank side through asset managers and managers of hedge funds preferring the development and implementation of a self-regulatory system. This desire by the industry to police itself is borne out of a desire to maintain autonomy, to show that the industry has integrity and is sufficiently well-developed to look after itself.
On another level there are the cost implications of industry regulation by a third party. With self regulation the banks can define their parameters and develop systems that can be developed in line with existing practices. With outside enforced regulation there is no guarantee that compliance could be achieved without modification to existing practices and increased levels of bureaucracy. The adoption by the OTC base metals market of technologies is giving greatly advanced levels of clarity in how deals are struck and that best practice has been followed.
Notably the recent addition of base metals to the SWIFT MT 600 series messages in November 2008 has provided an opportunity for the market to automate post-trade confirmation processing, giving the double whammy benefit of minimal investment and maximum benefit for cost reduction, improved processing and reduced risk. This development ticks important boxes for regulators and industry insiders alike, and gives a good opportunity for a watershed in the industry – along with the LME’s anniversary campaign, the addition of base metals to SWIFT gives a good time-hook for raising the issue of automation and use the publicity to publicise the benefits and processes the industry is faced with. By raising the issue in this way, the whole trading community will have the chance to see and explore the direction base metal trading is to take in coming years and gives the opportunity for consensus and debate – a healthy situation for the industry to find itself in during a period of change.
Overall, these changes to the base metal market are in many ways no different to the patterns already seen in other financial arenas and there is an air of inevitability to OTC trading having to keep up with other trading environments. As noted, with trading volumes continuing to rise and the subsequent pressure this puts on back office processes, the case against automation is weak. Similarly, the volatile trading environment and the increasing tenacity of regulators plus the desire for best-practice in all trading environments require new solutions that will ensure all parties in the trading process are getting a fair deal.
Industry veterans might find the transition period a tricky one, but they should be enthusiastic about these changes. The base metal market has built up an enviable reputation in its long history and the opportunities for it to develop further into a truly 21st Century market are excellent. How those within the OTC community accept and adopt the opportunities open to them will dictate their own future, but rarely has a market had such an ideal chance to mould itself.