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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: Risk management is about managing the uncertainty in business: 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.
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. 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 as this regulation will impose new important obligations on companies dealing in commodities, energy, shipping, and emissions.
In the case of sanctions, regulators have already sent an unambiguous message that they will not tolerate infringements: 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. 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. 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.
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. 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.
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.
Thomson Reuters Risk Management Solutions bring together trusted regulatory, customer and pricing data, intuitive software and expert insight and services. Provides easy access to trusted news, data, and analytics, all filtered by relevance to your exact needs.
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Thomson Reuters Solutions Thomson Reuters Risk Management Solutions bring together trusted regulatory, customer and pricing data, intuitive software and expert insight and services Provides easy access to trusted news, data, and analytics, all filtered by relevance to your exact needs.