A holistic approach to Risk Management for Commodity trading companies

With only few Commodities presenting positive returns year to date, and with a growing regulatory outlook, the pressure and the pace of change in the Commodities market has never been so exceptional.

Managing Risk has never been so complex and regulated in the Commodities market: acting as tell-tails of the increased regulatory scrutiny and lower returns, some of the major banks have either withdrawn or significantly downsized their activities.

Risk management is about managing the uncertainty in business: this uncertainty can be broken down into five main components of Customer and Third Party Risk, Compliance Risk, Enterprise Risk, Financial Risk, and Corporate Governance and Controls.

Historically, Commodity trading companies (CTCs) focused mainly on Financial Risk, but the market has now generally recognized that these five components are highly interconnected and that it is important to strive for a holistic view of risk across the whole organization.

1.    Customer and Third Party Risk

It is paramount for CTCs to have a clear line of sight on who their counterparties really are, in order to understand if they can do business with them.

In addition to monitor their counterparties for Credit Risk – the ability of their clients to meet their financial obligations – CTCs are increasingly focusing on Reputational Risk as they cannot longer afford to do business with counterparties that are knowingly, or unknowingly, linked to sanctioned entities, been involved with money laundering, financial crime, et cetera.

Being associated with a heightened risk entity, either at individual or country level, will expose a CTC to the risk of regulatory censure. This in turn can lead to irreparable reputation damage that is often more devastating than an actual breach of compliance.

Ongoing background and integrity checks are a crucial feature of today’s fast paced, globalized business environment and can protect a CTC from reputational and financial ruin.

2.    Regulatory Compliance Risk

The commodities market is undertaking a big shift in regulatory requirements through the introduction of new regulations, and CTCs need to stay up to date with the ever changing regulatory landscape, understand how to react to these changes, assess what the impact will be on their business, and be able to supply evidence of compliance.

In the past few years, regulations affecting the commodity market have soared to a point that it is difficult for some medium and small CTCs to keep abreast of all changes. As a consequence, some commodity players are incurring the risk of being exposed to Regulatory Risk not by a conscientious decision to boost profits by not complying, but by failing to fully understand the implications and ramifications of the new regulations and sanctions.

In the case of MiFID II for instance, commodity companies need to be ready by early 2017 as this regulation will impose new important obligations on companies dealing in commodities, energy, shipping, and emissions.

Companies need to start planning now because as highlighted by Holman Fenwick Willan, a Law firm that specializes in Commodities, “some of the most significant changes in MiFID II are those which will require many more commodity market participants to become authorized, especially as a result of the curtailment of existing exemptions widely used by them”.

In the case of sanctions, regulators have already sent an unambiguous message that they will not tolerate infringements: BNP Paribas SA was recently sentenced to five years probation in connection with an $8.9 billion settlement resolving claims that it violated sanctions against Sudan, Cuba, and Iran.

The Commodities market will likely continue to experience unprecedented volumes of regulatory change and complexity, and with a shift towards heavy fines, the need for CTCs to stay compliant has never been greater. As a result, CTCs need to monitor the latest regulatory developments that specifically impact their organization in order to manage regulatory risk with confidence.

3.    Enterprise Risk

Borrowing the definition of Operational Risk from the Basel Committee, Enterprise Risk can be defined as the “risk of loss resulting from inadequate or failed internal processes, people and systems or from external events”.

In other words, CTCs are exposed to Enterprise Risk when a process that supports a given activity is inadequate (eg there are no clear accountability and decision frameworks), when a person doing the activity commits an oversight (eg manually referencing in Excel the wrong derivative contract causing wrong hedging exposures), when the system that facilitated the operation is flawed (eg IT systems vulnerable to cyber attacks), or when an external event disrupts the operations of the company (eg when epidemics affect the commodity supply chain).

Several steps can be taken to mitigate Enterprise Risk. For instance, CTCs can insure themselves against losses arising from external disruptions to their operations caused by natural disasters, or can implement strong internal auditing procedures to help mitigate losses arising from internal processes.

4.    Financial Risk

Financial Risk is the systematic risk of loss resulting from movements in market prices or liquidity.

Commodity prices can go through intense volatility due to supply and demand imbalances or market inefficiencies, and CTCs usually hedge their commodity exposure via derivative transactions. However, based on their risk appetite and on the hedging costs, CTCs might opt for a partial hedge, or not to hedge at all, in order to boost their returns.

Commodity price performance 1st Jan – 9th September 2015 (source: Thomson Reuters Eikon)

As Risk cannot be generally be eliminated completely, but it is instead transformed, a company hedging its commodity price exposure will transform its Price Risk into Basis Risk, the change of the price difference between the commodity being hedged and the derivative used to hedge.

These price differences exist “because the characteristics of the hedging instrument are seldom identical to the characteristics of the physical commodity being hedged” as Craig Pirrong summarizes in his Not Too Big To Fail paper.

 Also, as commodity derivatives contracts are usually denominated in US dollars, hedging can expose CTCs to Currency Risk if physical trading is done in another currency.

 To closely monitor their Financial Risk exposure and identify possible supply chain problems, big commodity trading firms often rely on Commodity and Energy Trading and Risk Management (C/ETRM) systems  that map all the positions in their complex portfolios to risk factors, and then use risk engines to calculate a variety of risk measures such as Value at Risk (VaR).

5.    Corporate Governance and Internal Controls

Global corporate governance guidelines and rules are becoming increasingly onerous, with the expectations of shareholders and investors adding pressure for greater transparency and control, especially as the Commodities market is attracting increasing scrutiny and calls for greater transparency by advocates and policy makers.

CTCs need to determine, build and manage a dynamic system of rules, practices, and processes, but this can prove being extremely challenging if they do not have a cohesive view across the whole organization.

To ensure adherence to Corporate Governance and Internal Controls, CTCs should update their control framework over time to reflect current requirements, and regularly train their employees on the laws, regulations and policies that apply to their job responsibilities.