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Commodities: from pit to screen

Published in Automated Trader Magazine Issue 38 Autumn 2015

Commodities trading is undergoing radical change, driven in part by increasingly electronic markets and regulation. Peter Barker reports on how markets and traders are evolving.

Craig Pirrong, Professor of Finance, University of Houston

Craig Pirrong, Professor of Finance, University of Houston

What's happening in commodities markets, said Craig Pirrong, professor of Finance at the University of Houston, is that what used to be 'in the floor trader's head' is now being computerised. Moreover, increased electronic trading is a spur for greater liquidity, as well as a catalyst to change the way liquidity functions.

Ultimately, that means cheaper transactions. So hedgers and others are going to be able to execute orders at lower cost, a benefit to any market participant.

Meanwhile, market participants themselves are changing too. Castleton Commodities, which emerged from the energy subsidiary of the Louis Dreyfus Group, illustrates how trading firms might evolve.

What makes them distinctive, said Pirrong, is that they provide "a marriage of private equity capital in a private ownership model".

"The basic models that we have at the moment in terms of commodity trading are the private firms such as Trafigura, Vitol, Cargill. Then, you have publicly owned commodity trading firms like ADM (Archer-Daniels-Midland). Castleton is sort of a hybrid model," he said.

Commodity trading houses are adapting against a backdrop of the world's open outcry trading floors getting shut down one by one, with the last remaining ring in Europe belonging to the London Metal Exchange.

There is tremendous speculation that the ring will disappear. But it appears that the LME is making plans to include designs for it as the exchange moves to new headquarters.

"The ring is being invested in. When we move to our new premises, which will be the end of this year, or early next, we will have a new ring," said Paul MacGregor, head of sales at the LME. "We understand the value in terms of price discovery of all those prompt settlements in a very short period of time. The LME did a review in 2014 and the market wants to keep it."

Automated traders need apply

The LME's ring co-exists with its electronic platform, Select.

"We have seen growth in volumes on Select with no particular detriment to the ring, and when the ring is very, very busy during volatile periods, we do not necessarily see a detriment to Select either," he added.

Pirrong however, sees the ring as "important, but they keep it on more for tradition". And its continued use will come under renewed speculation with the news that JP Morgan plans to quit the ring.

Michael Camacho, head of commodities at JP Morgan said to the Financial Times that the move was prompted by shifting client preferences. "A very high percentage of our LME contract volumes are now traded electronically."

The primary base metals traded are: aluminium, copper, zinc, nickel, lead and tin. Minor metals contracts include cobalt and molybdenum.LME trading, in the ring and electronically, involves 40 general clearing members, including some of the big investment banks, brokerage houses, and some "very unique metal-specific members who really only offer access to the LME," said the LME's MacGregor.

"But the majors," he said, "are aluminium, copper and zinc, which is where we have focussed a lot of liquidity programmes that we are trying to introduce to the market place, and where we are trying to grow more liquidity on the Select platform.

The LME has developed a volume-based rebate programme, and MacGregor is reaching out to traders who find that profits are hard to make in other markets due to monetary conditions or market saturation.

"A lot of trading opportunities for market makers, automated traders in other market places, are more difficult now because of a zero interest rates environment and the fact that the equity markets - and in many cases equity index, equity derivatives markets - have also got to the point of saturation of proprietary and automated trading," he said.

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