Singapore commodity trading quarterly Q4 I 2016
Welcome Welcome to the first edition of EY Singapore commodity trading quarterly! We will be bringing you insights into current issues facing the commodity trading industry in Singapore, and key themes from our extensive thought leadership that are relevant to commodity traders. In 2016, prices have recovered in many commodity markets. Crude has recovered from a low of US$30 in Q1 to US$50 per barrel in Q3. Prices for coal and steel have both rallied, and agri-commodities have been mixed in 2016. The impact of the UK referendum on the global economy, or Brexit, is still unclear. Uncertainties that could affect Singapore commodity traders include whether the UK will continue to enjoy tariff-free trade with the EU, and the trade agreements that the UK will negotiate with other countries. There is also uncertainty at this stage about whether UK-based financial institutions will continue to be able to passport across the EU post-brexit, which could have knock-on effects on commodity traders relating to trade finance and hedging. Over in the US, with Donald Trump having won the US presidential election, the medium-term fundamental effects on the commodities markets are not yet clear. For commodity traders, volatility and uncertainty can result in trading opportunities. It also brings with it risks and challenges, in particular credit risk and contract performance risk on physical contracts, as well as market risk and rogue trader risk. In addition, various accounting changes are on the horizon, which will have an impact on how commodity traders report their financial results. These can have business implications beyond financial reporting.
Rogue trader risk: do you know your vulnerabilities? High volatility and market unpredictability raises the likelihood of unauthorized trading, or rogue trader risk, as trade volumes increase and traders seek larger returns (or to limit losses). There have been several high-profile rogue trading incidents at investment banks over the last few years, and an increasing number at commodity traders. While the fact-pattern for each one is unique, a common theme is that ineffective internal controls are a contributing factor in creating the conditions conducive for the unauthorized trading to take place. There are significant differences in the sophistication of internal controls over unauthorized trading across the commodities sectors. Larger multinationals tend to have a greater corporate focus on this risk compared to smaller local and regional traders. Significant levels of liquidity in oil and gas products provide more transparency, but also result in more opportunity for unauthorized trading to go undetected due to the high volumes traded. Less liquidity in physical markets such as coal, ores and some agricultural commodities can result in a high concentration of expertise among the traders, which can lead to a knowledge and experience gap between the traders and the control functions. This can create the conditions for the front office to engage in unauthorized trading. In all markets, traders are typically compensated to some degree by the profits they make. The trading role is high-pressure, and this can incentivize traders to cover up problems, attempt to make errors right by exceeding mandates, and increase their bonuses by reporting inflated profits. How we can help We assist our clients with current state gap analysis of internal controls over unauthorized trading. We also work alongside commodity traders to assist them to design, enhance and implement processes and controls that are commensurate with the scale and complexity of the business. In situations where unauthorized trading has already occurred, or is suspected, our teams help management determine the extent of the issue through deep-dive investigations, and assist clients to understand how the control environment can be improved to reduce risk of another unauthorized event occurring.
Credit risk: how can credit losses be mitigated or even predicted? Effective credit risk management enables traders, control functions and senior management to look through the same lens in terms of risk-reward decision-making. It allows for managed risktaking in order to generate trading profits, while mitigating the credit risk to levels that are acceptable to the organization. Having an excellent credit risk management function requires a healthy tension between their dual roles of policing the application of the company s risk appetite, and at the same time partnering with the business to provide input to commercial decision-making. Assessing counterparty credit risk is an art and not a science, in that it requires professional judgment, but various analytical methods can be used to assist decision-makers in making credit decisions that are commensurate with the entity s risk appetite. There have been numerous credit events over the last two years with commodity traders and their counterparties. Non-performance on contracts has been more common, due to counterparty financial difficulties and also with some fixed price forward sales having become less lucrative for producers in a rising price environment. This risk is particularly acute in markets with many small producers such as agri-commodities, where steep backwardation incentivizes producers to sell spot rather than honor fixed price forward sales. How we can help We help our clients improve their credit risk processes, controls and senior management reporting, through designing customized process flows and performing front-to-back gap analysis, and by working with key stakeholders in the business to better enable the credit risk management function to add commercial value. We also assist our clients with credit scoring using models that are developed by EY to estimate future credit losses.
Inventory financing for commodity traders Inventory financing has long been used by commodity traders as a way of funding physical inventory in order to release working capital while retaining price exposure to the commodity. One form of inventory finance is sale and repurchase agreements where a trader sells its inventory (typically to a bank) and simultaneously agrees to repurchase, or have an option to repurchase, at a future date at a pre-agreed price. The repurchase is at a higher price than the sale, and the difference is the cost of this financing. Commodity sale and repurchase transactions are currently assessed using the principle-based approach set out in FRS 18 (Revenue), which explains that judgment is required and that the guiding principle is whether the significant risks and rewards of the inventory have been transferred to the buyer at the point of sale. The benefit to commodity traders of financing working capital in this way is that the physical positions are accounted for on a consistent basis with the derivative contracts on the trading book, which by definition do not require the upfront cash payment that is necessary for physical inventory purchases. In effect, a physical inventory purchase combined with a simple sale and forward repurchase transaction is a synthetic long forward contract. This can provide additional margin for commodity traders. The new revenue recognition standard, FRS 115, is effective for accounting periods beginning on or after 1 January 2018 and may be applicable to some contracts entered into by commodity traders. FRS 115 contains more prescriptive rules about the accounting treatment for sale and repurchase agreements. In general, where the commodity trader is obliged or has the right (option) to repurchase the commodity at a higher price than the sale, the asset is not considered to be sold, and so no revenue is generated. The inventory would remain on the balance sheet, and a liability would be recorded for the amount borrowed from the counterparty. This could result in larger balance sheets for commodity traders when they adopt FRS 115, and could have knock-on implications for other borrowing facilities, in particular for those containing covenants related to gearing or other balance sheet ratios. As a result, commodity traders should analyze and consider the potential effects on their balance sheet now, in order to prepare for the adoption of FRS 115 in 2018. How we can help Accounting changes are complex and require proactive planning and analysis in order to implement smoothly. Our teams of accounting professionals work with clients to analyze the practical effects of accounting change on their businesses. We provide implementation assistance, technical guidance and project management capabilities to help our clients manage the changes in financial reporting and the wider business implications.
Select thought leadership Managing commodity volatility How can commodity traders and others hedge their price risk exposures? Click here Navigating volatility: do you change your business or the way your business works? How can mining and metals companies maintain strong balance sheets and profitability? Click here Risk culture: much ado about something Financial Institutions will see a sea change in the way they approach risk governance. Click here Contact us Winston Ngan Partner, Financial Services Assurance Ernst & Young LLP Tel: +65 6309 6918 E-mail: winston.ngan@sg.ey.com Adam Gerrard Senior Manager, Financial Services Assurance Ernst & Young LLP Tel: +65 6309 6957 E-mail: adam.gerrard@sg.ey.com
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