Managing Commodity Risk in the Face of Extreme Volatility

Supply chain disruptions and geopolitical unrest have led to turmoil in the commodities markets recently. Prices and volatility have spiked, forcing initial margins higher at CCPs and squeezing both collateral and liquidity. This type of environment is a nightmare for commodity trading firms, and many are seeing their technology stacks and risk controls being put to the test.  

To illustrate, energy prices have been extremely volatile in the last couple of years. Lockdowns during the COVID-19 pandemic sapped demand for oil and natural gas, causing prices to plummet in 2020. Next, the global economic recovery induced by widespread vaccinations along with extreme cold weather and supply chain disruptions – not to mention the long-term shift away from fossil fuels to renewables – resulted in skyrocketing prices in 2021. 

Press reports have pointed out that energy traders have been forced to search for workarounds to avoid paying hefty initial margins associated with these large price swings. For example, there’s been a marked increase in open interest in European style box spreads on WTI. This delta-neutral options strategy, which involves buying a bull call vertical spread and bear put vertical spread with the same strike prices, is effectively a means of borrowing money. We saw a similar dynamic in nickel. The price of the metal plummeted in 2020 during the pandemic and then rose steadily through 2021 to reach a seven-year high. 

At the end of each business day, firms must put up funds to cover the CCP’s initial margin on their trades. Traditionally, firms kept a capital reserve in case they got a margin call, but that resulted in an opportunity cost because those funds couldn’t be invested overnight.

Imagine having a real-time risk management system, such as Nasdaq Risk Platform, that can replicate the initial margin on your trades. With improved visibility, you can more effectively evaluate the risk of executing a trade in the first place and strategically determine where and how best to optimize your trading strategy. With additional insights, you can see whether it makes sense to execute on one venue versus another and calculate the incremental initial margin if you were to add to your position. In addition, you know exactly how much capital you are required to keep aside for initial margin to meet your obligations at the CCP and exactly how much you can invest overnight.

Outside of capital optimization, real-time monitoring of trading activity and stress testing prior to volatile market conditions is critical to the future-proofing and resiliency of your organization. With the ability to stress test your portfolio, you can more effectively preempt future margin calls and run various event scenarios to proactively determine what liquidity is required in each circumstance. By creating this additional visibility, firms are able to reduce their overall risk and more effectively manage your capital.

About Nasdaq Risk Platform

Nasdaq Risk Platform is delivered as a cloud-based SaaS solution, which reduces operational complexity. Clients can be onboarded quickly, allowing them to concentrate on their business instead of allocating resources to implementation, maintenance and software updating processes. Nasdaq Risk Platform enables firms to lower their overall total cost of ownership, reducing overall capital expenditures.

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Commodities

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