With a wave of globalization and liberalization sweeping across the world, there has been a manifold increase in the volume of international trade and business. Subsequently, rapid and unpredictable variations in financial asset prices, exchange rates, and interest rates are exposing the commodity markets to a significant financial risk.
Today, in the highly uncertain business scenario, there is a stronger plea for attention to financial risk management than ever before. Furthermore, the emergence of additional risks upon expanding business in new geographies and establishing trade relations with overseas buyers and supplies is forcing traders to alter their funding and investment strategies.
Why Financial Risks Management Matters in the Future of Commodity Trading?
What sets profit-making traders apart from the masses? It isn’t necessarily the focus on efficiency and system performance, but rather an understanding of financial risk and its management.
Commodity trading risk management (CTRM), in general, and financial risk management, in particular, are the core competence for trading firms. They use efficient risk management systems to link revenues to costs and enhance operations in volatile markets.
With the accelerating speed of technological innovations, a wide variety of CTRM system providers are offering a larger palette of different types of financial solutions. Moreover, the changed business environment in 2020 has made it a launching pad for traders to become digital-centric, virtual, and agile – and to do it all at lightning speed.
There is no one-size-fits-all approach, as trading organizations vary significantly in their objectives and rationales for financial supply chain management. However, advanced technologies are leading these organizations out of the crisis to grab market share and gain a distinct competitive advantage over their competitors.
Hedging – Technology as an Enabler
A holistic hedging strategy and framework is widely recognized among commodity buyers and sellers to mitigate the risks of price fluctuations. However, there are numerous examples of trading firms making costly decisions, due to lack of integration between different units of their business. This often leads to an opposite increase of the net exposure rather than a desired reduction.
As business grows in complexities and the use of spreadsheets becomes impractical, advances in technology are making it easier to combine exposures and related hedges to a single monitoring department. A growing number of financial risk management service providers are turning to Artificial Intelligence (AI) and deep learning to improve efficiency in the accounting and investor relations functions.
In recent times, AI has been reinventing the way in which hedge funds drive successful returns. CTRM and hedge fund accounting software based on machine learning and AI algorithms can learn from a mass collection of data and tackle financial decision-making tasks.
Additionally, machine learning can aid in short-term price predictions of commodities based on voluminous data sets. Moreover, involvement of academics such as the Oxford Man Institute of Quantitative Finance for research on the application of AI and related advances in finance is set to open new operational possibilities.
Centralized System to Blur Line Between Financial and Physical Trading
For years, trading business organizations have been layering many legacy IT platforms on top of one another. They operate in silos, allowing each unit to develop their own solution, rather than forming a centralized system.
Strong geographical footprint which creates exposure to commodities remains a complicating factor for businesses to manage commodity price risk. A significant increase in complexity and multiplicity of financial instruments and transactional choices have been compelling commodity firms to expand their skill sets to new horizons.
Centralization of commodity trading operations, in particular, is emerging as a success factor. Companies that implement centralized trading technology solutions to improve finance and business risk management stand to reap substantial benefits.
Today, establishing a centralized system that serves different business units is considered a useful strategy when hedging against commodity price fluctuations and mitigating enterprise-wide commodity positions. Deployment of IoT sensors and near-field communication chips in physical trade inventories – common collateral for loans – is highly likely to be a reconciliation between trading and financing.
Organizations are further looking out for technology platforms with a variety of tools such as multi-currency functionality, and multi-entity access, and multi-GAAP software solutions. Consequently, financial risk management platforms are helping commodity trading companies to maintain acceptable levels of financial performance. In addition, these platforms provide the ability to manage asset classes such as foreign exchange and interest rates on the same platform.
Blockchain Gains Momentum in Financial Supply Chain Management
Blockchain technology continues to be viewed as the key piece of future industrial infrastructure, capturing the attention of governments and key investors. The technology is said to be highly resilient, as it creates trust with its tamper-proof, decentralized, and distributed digital record of transactions.
In commodity trading business, blockchain is set to make every payment and supply chain transaction more manageable, transparent, and easily authenticated. Moreover, in 2019, a report from the Capgemini Research Institute revealed that an increasing number of companies are incorporating blockchain into their supply chain financing efforts – 87% at early experimental or proof-of-concept stage. However, it is imperative to note that the technology remains difficult to apprehend and its deployment on a large scale is limited to only 3% of the organizations.
Financial risk management will continue to be an absolute priority for trading firms. In today’s more competitive landscape, commodity trading firms rely increasingly on strategic assets over arbitrage-led transactions to lower the overall cost of delivery and storage costs.
The digitalized era brings to fore new challenges for trading firms. Greater access to necessary tools and implementation of robust systems and processes will remain important to support financial risk management activities in commodity trading business.