In the past year JP Morgan began offering clients a cocoa arb via its e-trading platform. Filippo Finelli, global head of commodities automated trading strategies (ATS), and Sandy Sehmi, commodities e commerce product head, discuss how this is part of their broader effort to bring more automation to commodities trading.
Profit & Loss: So tell us about the cocoa arb that you’ve been developing over the past year.
Filippo Finelli: The corporates who trade cocoa will often monitor the price of this risk component very actively throughout the day. But replicating the price and neutralising the risk can be very difficult for them because there’s many components to a single price.
First of all you have to look at the London cocoa price. The commodities market is futurised, meaning that there are monthly contracts available on the exchange which in turn means the liquidity is only on the front-end. The back-end requires more sophistication for a fair value price discovery.
To come up with a price, you need the London cocoa price for a liquid tenor. If you wanted to hedge further out, say to the middle of next year, you have to get there using the front month plus an adjustment. Then you have to do all the same for the New York leg. You also have to deal with the currency because one leg will be in USD and the other in GBP.
To provide the arb pricing in dollars or sterling you need the FX spot and the forward point. Suddenly you’re tracking six independent markets and it becomes a difficult thing to do.
P&L: And this is what you’ve solved for?
FF: Yes, we put all that together and we price everything in real-time. It has resulted in strong client interest as (a) it is very efficient for them to just trade this via our platform and (b) it’s possibly the tightest price available, because if you’re executing the legs independently, the sum of bid/offers they’re going to get will result into a wide price and the high correlation won’t be priced accurately.
Since this product is available from 9am until the close at 5pm, and it’s always streaming you can now leave resting orders, you can leave stops, you can link to other orders so it becomes a very powerful tool for helping firms to manage their risk.
P&L: What were the biggest technical challenges for you in developing this?
FF: There is a lot of market data that we have to process in real-time, which is a huge task but one we’re equipped to do. When we show a price to clients we don’t just show a price that is a mid, which could
be calculated from Excel, we always process full depth order books so that we can always provide a price for any size they want – they can see a different price for one lot, 15 lots, 50 lots or 100 lots – and that means we have to process a lot of market data, we have to be efficient in doing this and then on the FX side also always provide a price that is tight too, which we can accomplish by leveraging our internal capabilities.
P&L: So how do you see client demands changing in this area?
Sandy Sehmi: Our commodities business has a hugely varied client base in both the focus of the market participants and the size of them.
In this particular case we have an advantage because corporates’ main concern is having all the convenience to hedge their exposure easily in one place. What they want to be able to do is trade efficiently, they want to do something in one click instead of three and they want the least amount of post-trade noise as possible with regards to administration. Yes, they want to execute at a good price, but availability and efficiency are really the main things that they look for.
It’s also worth highlighting that, although a lot of our corporate clients will often be focused on a single asset class – for some of our more sophisticated clients the more products that we can offer them on the same platform the more powerful that is as a tool for them.
And coming back to the point about the diversity of our client base, it’s important to note that one of the ways that we access corporate flows is via our regional bank customers who help support their businesses, so then we also have to factor in the demands of these banks who are being driven by corporate end clients and yet who will have a slightly different set of requirements.
P&L: Is that part of the challenge then, taking something that is quite complex, like the cocoa arb, and making it simple to use for a wide range of customers?
FF: The philosophy behind this is really no different than the iPhone; you want to make something that is complex, powerful and needed and then make it as easy to use as possible. One theme that we’re seeing right now is that some investors are struggling with scale in today’s market conditions. In the commodities space, they often are not very used to an automated trading environment but this helps with their challenges and so the feedback we get is always very positive, they’re always keen to know what other parts of the business we can help them with.
SS: This point about simplicity is very critical to us. In the FX and precious metals world it’s pretty common to be trading electronically but in ags and energy, and to a lesser extent base metals, the corporate market participants aren’t used to an electronic platform, other than the most futurised businesses.
For many this is actually a new paradigm and so it’s absolutely critical that we don’t give these clients something that requires them to go through a complicated manual in order to use.
P&L: So then do you have to do a lot of educational work with clients?
SS: It varies massively between clients. Some of them just use a small subset of the functionality, they just want to click and trade or leave an order in. In ags there is a narrower range of products available on the platform, and so it’s mainly about choosing what currency and tenor you want, but in base metals we have a much bigger selection of products and so the education that’s needed is a little more complex.
P&L: And is the fact that they can do the currency piece through the platform with you a point that firms focus on?
SS: It depends on their location and exposure. For example, some US investors just want to see everything in US dollars because that’s the only exposure they have. By contrast, for some investors trading sugar it can be very helpful to use our platform to trade and then report in, say, Brazilian reals. That’s a real game changer for them, at that point they don’t simply want this platform, they need it.
For firms not used to electronic platforms, these trends are exciting. We’re used to adding pricing in a different currency for our clients, but this is new to many. And there’s an ancillary angle to this because we can offer this in a different currency and unit to what the product is normally traded in, so something normally in USD per pound we can instead do in AUD per metric tonne. Having this flexibility is a very powerful tool for our clients.