Commodity market players must address risks, says FSA

The growth in investment in the commodity markets, the emergence of new products and the entry of new participants have given rise to various risks and challenges that need to be addressed by traders and exchanges, according to a new study published by the UK's Financial Services Authority.

The paper, Growth in Commodity Investment: Risks and Challenges posed for Commodity Market Participants, concludes that markets have changed significantly, bringing new issues that need to be understood and acted upon by participants.

The UK regulator says the recent growth in commodity markets, with record prices, high volatility and the high returns to be gained, have attracted a wave of new investors into what was previously viewed as a specialist market.

These new entrants include hedge funds, pension funds, high net worth individuals and even a small number of retail investors. The level of funds being invested is expected to grow and, unlike previous cycles, to remain.

Says Hector Sants, the FSA's managing director for wholesale business: 'The recent growth in the level of investment in commodity markets, the development of new products and a changing user base has combined to create a greatly changed environment in the commodities markets over the last few years. This has given rise to a number of risks and challenges for both established and newly arrived participants.

'The risks we have identified should not come as a surprise to those active in the market but serve to focus attention on the areas we consider to be of most impact and importance. Firms and exchanges need to consider how they have addressed these risks and continue to mitigate against them in the future.'

The FSA says the risks and challenges for market participants include the availability of staffing and compliance resources. The pool of experienced staff with commodity market experience is limited by the previous small size of the market, the study argues. Due to the growth in the market all regulated participants, including both firms and exchanges, face increased difficulties in recruiting appropriately skilled and experienced staff.

For exchanges, large increases in trading volumes pose challenges to trading system infrastructure, especially following the switch by many markets to electronic trading. The FSA says exchanges must ensure they have sufficiently robust systems to handle the growth in trading volume and trading flows in terms of both processing and monitoring.

With increased volatility in some markets raising risk of failure, the regulator says firms must ensure they have appropriate risk management systems and procedures in place, including thorough testing and modelling of their algorithmic trading systems to ensure appropriate behaviour in any given set of circumstances. Firms that invest in physical assets such as power stations will also need to consider the change in risk profile that this brings.

Although they may be familiar with other markets, new participants in the commodities field may not share the same level of knowledge or understanding as established players, the study argues. In addition, new entrants may also introduce innovative trading techniques that traditional operators including exchanges need to be aware of.

While commodities are no more open to abuse than any other types of financial markets, the FSA says firms need to ensure they have adequate systems and controls in place to prevent abuse taking place. As a result of the growth in activity on these markets, the regulator plans to focus more attention on monitoring them.

While direct investment by retail investors may be limited at present, financial firms are responding to growing consumer interest by developing products that will allow individuals to gain an element of exposure to commodity markets. The FSA cautions that these changes combined with a shortage of financial advisers who understand the market could result in consumers buying products they don't fully understand, and notes that indirect exposure of retail investors to commodities is also increasing through pension fund investment.

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