RISE OF AN INEFFICIENT MARKET

Has an opportunity arisen in commodity derivatives for those who are nimble???

If you listen to any number of market commentators in the commodity space right now, you’re probably well aware of the general malaise around bank commodity desks, with more reductions in size and capability likely to follow.

The space has faced numerous obstacles since the financial crises of 2008. Revenues have been hit hard with the slow-down in emerging markets (China in particular). Regulation has wielded its ugly, yet arguably necessary, head with the likes of the Volcker rule in 2014 and MIFID II now just around the corner (targeted implementation; Jan 3rd, 2018) – and equity markets have gone ‘gangbusters’, meaning less funds likely to be allocated to the commodity sector in the current market.

Goldman to review commodities after worse start in a decade – Bloomberg Article, July 2017

Why commodity Traders are Fleeing the Business – Shelley Goldberg

“Amid the mayhem, banks held tightly to their commodity desks in the belief that there was money to be made in this dynamic sector. The trend continued until the implementation of the Volcker rule, part of the Dodd-Frank Act, which went into effect April 2014 and disallowed short-term proprietary trading of securities, derivatives, commodity futures and options for banks’ own accounts. As a result, banks pared down their commodity desks, but maintained the business.”

All of this has led to a rather dramatic decline of both bums on seats, in terms of traders employed, but also a reduction of the size of capital that banks, institutions and market makers are willing to invest in the space.

There has been a systematic reduction in both risk-taking capabilities and liquidity from these institutions.

What Does It Mean…?

The result of the general decline in both numbers and positions held of bank traders, other institutions and market makers, is that we are now witnessing a split in volatility curves that would have hitherto been reined in.

There are now fewer traders out there left to re-balance the market by taking spread positions through forwards and options. The space is asserting Inefficiencies.

In many markets, short term liquidity and risk taking has been absorbed by algorithmic traders. However, with their short holding periods and time horizon they are ill-suited to trade anything beyond the short term. In metals, particularly, we see this in the increased dislocations of both forward curves and volatility surfaces.

Trading in longer time horizons and risk premia were traditionally part of the profit base that drove investment banks’ commodities units. As the banks have gradually removed themselves from this space, we have seen miss-pricing in products across the complex increase, and a corresponding opportunity for smaller and more nimble players has arisen.

Authors; 

Darius Tabatabai, Portfolio Manager

James Purdie, Head of Investor Relations

Disclaimer: Although this document has been issued by Arion Investment Management, it is important to note that the views of the author(s) may or may not represent that of the company. The document has been derived from sources believed to be current and accurate as at the date of release. The comments made are general in nature and do not take into account anyone’s personal needs, financial situation or requirements and past performance is not an indicator of future returns. Before acting upon anything associated with this document we would recommend seeking advice from your financial adviser.

About the company; Arion Investment Management Limited is a commodity focused investment management company, based in London. The company is authorised and regulated by the Financial Conduct Authority (registered no. 742037).