Key Takeaways
• Understand the various roles financial institutions play with commodities.
• Understand why some commodities are traded and others are not.

Introduction

In my last blog, I took a high-level view of the various commodity subdivisions and how they are used in the real world. I then touched upon the importance of price discovery within commodity markets and the role of the price reporting agencies. This blog will extend to help us understand the various financial institutions that participate in the commodities market, as well as the requirements necessary for a commodity to become traded.

The role of financial institutions with commodities

Amongst investment banks, there are many other types of financial institutions that play a role within the commodities markets, including: commodity trading houses, hedge funds, and real money accounts.

Investment Banks
Investment banks typically act across a variety of services with commodities. A 'full service' investment bank will exist to deal with financial derivatives, but also to act as a counterparty in the physical trade of the commodity. As a result, an investment bank can play a pivotal role in the delivery of commodities with their cash-rich position and ability to hedge risk at scale. Some examples of how they can be influence the physical commodity market include:
• Owning inventory for refiner participants to reduce their operational capital requirement.
• Purchasing storage facilities or pipelines to transport and store commodities between market participants.
• Provide financial support to supply chain participants.

Commodity Trading Houses (CTH)
A CTH originally existed as a middle-man between consumers and producers of commodities, earning a profit from buying and selling commodities at wholesale. CTH have since evolved to own parts of the supply chains. They therefore solve a similar problem that investment banks do with financing participants and facilitating supply chains to remain operational.

Hedge Funds
Hedge funds operate to serve a smaller pool of investors when compared to investment banks. They tend to use actively managed strategies with the goal of generating a profit in all market conditions. As a result, fees tend to be higher to the investor.

The smaller size and specific goal-driven business of a hedge fund will more often operate with the financial derivatives side of commodities, and will employ event-driven strategies to maximise returns on market-specific events that impact commodity prices.

Real Money Accounts
Some financial institutions do not have a similar capacity to borrow money to finance larger operations like an investment bank. Such accounts include those for insurance and pension funds as well as retail and private banks. They will therefore use commodity derivatives as an investment vehicle for purposes such as hedging risk and seeking diversification in their portfolios to match the goals (risk profile and return) of the fund.

Why not all commodities can be traded

Now that we understand the different types of institutions that can trade commodities and how their functions within the market can differ, let's take a look at the properties of a commodity that enable it to be traded on an exchange.

When we think about a commodity that is traded, it will typically sit in an exchange where buyers and sellers can efficiently receive a price for their desired product. Sometimes, where markets are insufficiently liquid, an investment bank can also step in and act as a market-maker: to be a buyer to the seller and seller to the buyer. Either way, a price for the commodity is transparent and accepted across all market participants of the exchange.

The challenge that commodities introduce to us align with their timelines for delivery and the abundance of grades and varieties that they can exist within. A single commodity (such as gold) can differ by shape, grade, source, transportation and percentage makeup. As a result, a 'spot price' might not exist for each individual commodity subtype, and instead is derived from a reference point price for the commodity instead.

Defining a reference point...

In this section, I am going to talk a little bit about the prices of commodities and the markets they trade in. Before I do that, let's go over a few definitions.
A spot price is the price of an asset, derivative, currency or any product at the current market rate, and for 'immediate' delivery. You can think of a spot price as the price you pay in your supermarket for any item on the shelf. You are paying £1 for a bag of bananas as they are immediately sold and owned by you after checkout.
A spot market, also known as a cash market or physical market, is where assets, derivatives and currencies are traded for immediate delivery. In the spot market, delivery is not going to be instantaneous, but is often made 2 business days later (T+2).
A spot transaction involves a trader buying or selling a product in the spot market for the immediate delivery (T+2).

The unique nature of commodities and their supply chain for extraction, refinement, transportation and delivery, means the spot market for commodities will not often reflect the spot delivery of 2 days time. Instead, the spot price will often reference a point on the futures curve of the commodity, with delivery reflective of that date.

The emergence of a commodity as a traded asset in an exchange is achieved through price discovery in the market. If market participants are able to receive transparency for what price the commodity is traded, they will then be able to confidently use it for their intended purposes.

A further factor to a commodity becoming traded exists with it's requirement to be frequently traded. This may begin to sound like a chicken-and-egg scenario where higher trade frequency of a commodity can come from it's global need (through necessity), but is also facilitated by transparency of it's fair price. As commodities are traded more frequently, the demand for price reporting agencies to provide market-wide price transparency increases, and thus a commodity can establish itself upon an exchange.

As previously mentioned, the heterogeneity of commodities do not place an expectation upon PRAs to provide all price definitions of a commodity. They instead provide specific prices for a commodity that act as a reference point to derive further prices from. For example, a price may be given for a grade of 80% gold, where a 70% grade will be traded at a price that is derived below that.

Following the establishment of a commodity into an exchange, we can see market participants benefit with improved transparency and liquidity of the commodity for trading. This can also lead to standardisation for it's trading in futures and commercial contracts. Lastly, the price confidence across market participants for the commodity will lead to its inclusion with different financial derivatives.

Summary

Financial institutions can play varying roles in the commodities market. While commodities can behave like other asset classes to a bank, by providing a source for speculation and to hedge risk, a bank can also play a vital role in the operational existence of a commodity. The unique physical presence of the commodity asset class mean they present opportunities for specialist financial institutions to play a role in it's creation.

Price reporting agencies will provide price transparency into spot markets for commodities once it's frequency of trading has been established. The PRAs provide price transparency for benchmark grades and variations of a commodity where subsequent prices can be extrapolated.