FSA Reviews Commodities Markets

by Robin Pilgrim, LawAndTax-News.com, London

28 March 2007

The UK's Financial Services Authority on Monday published a paper which examines the recent growth in investment in commodity markets.

The paper, entitled 'Growth in Commodity Investment: risks and challenges posed for commodity market participants', concludes that markets have changed significantly, bringing new issues which need to be understood and acted upon by participants.

Commenting on market changes, the FSA observed that the recent growth in commodity markets with record prices, high volatility, and the high returns to be gained have attracted a wave of new investors and firms into what was previously viewed as a specialist market. These new entrants include hedge funds, pension funds, high net worth individuals and even a small number of retail investors. The level of funds being invested is expected to grow and, unlike previous cycles, to remain.

Hector Sants, FSA Managing Director, Wholesale Business suggested that:

"The recent growth in the level of investment in commodity markets, the development of new products and a changing user base has combined to create a greatly changed environment in the commodities markets over the last few years. This has given rise to a number of risks and challenges for both established and newly arrived participants."

"The risks we have identified should not come as a surprise to those active in the market but serve to focus attention on the areas we consider to be of most impact and importance. Firms and exchanges need to consider how they have addressed these risks and continue to mitigate against them in the future."

Meanwhile, examining the risks and challenges for market participants inherent in the recent commodity market 'boom', the FSA identified these as including:

• Staffing/Compliance Resource – The pool of experienced staff with commodity market experience is limited by the small size originally of the market. Due to the growth in the market all regulated participants, including both firms and exchanges, face increased difficulties in recruiting appropriately skilled and experienced staff;
• System Capacity – Large volume increases pose challenges to trading system infrastructure especially following the switch by many exchanges to electronic trading. Exchanges must ensure they have sufficiently robust systems to handle the growth in trading volume and trading flows in terms of both processing and monitoring;
• Risk Management – Firms are facing increased volatility in some markets which raises risk of failure. Firms need to ensure they have appropriate risk management systems and procedures in place, including thorough testing and modelling of their algorithmic trading systems to ensure appropriate behaviour in any given set of circumstances. Those firms who invest in physical assets e.g. power stations will also need to consider the change in risk profile that this brings;
• New Users – New participants though familiar with other markets may not share the same level of knowledge or understanding as traditional participants. These new entrants may also introduce new trading techniques which traditional operators including exchanges need to be aware of;
• Market Abuse – While no more open to abuse than any other types of financial markets, firms need to ensure they have adequate systems and controls in place to prevent abuse taking place. As a result of the growth in activity on these markets the FSA will focus more attention on monitoring them.

Commenting with regard to the risks and challenges facing consumers, the FSA concluded:

"Although direct investment by retail investors is limited at present, financial firms are responding to growing consumer interest by developing products which will allow individuals to gain an element of exposure to commodity markets."

"These changes combined with a shortage of financial services professionals who understand the market could result in consumers buying products they don't fully understand. Indirect exposure of retail investors is also increasing through pension fund investment."

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