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The trouble with transparency

 

An increasing focus on moving opaque OTC business into a more transparent approach has started to impact the commodities world. For example, in India, a long troubled market, the relatively new regulator SEBI has started addressing the complex historic situation there around physical markets. The government body that regulates the physical aspects of commodity markets (e.g. warehousing) has defined a series of increasingly tight rules around what constitutes good practice, with a view to eliminating the worst of the historic practices. The reason to do this is obvious; without trust or transparency, markets are inefficient, open to abuse and effectively hold back the real economy of a nation.

The overall regulatory drive to reduce risk around the globe and the drive to get OTC business onto exchanges or central platforms (if only for central clearing) is working its way throughout the commodity markets. The intention here is to enhance transparency.

However, there’s the problem.

Most financial participants in commodities say that trust and transparency are good things to have. The trouble is that everybody wants 2-way trust but not everybody wants 2-way transparency.

More than any other asset class, opaqueness offers knowledgeable physical market participants the ability to take advantage of their knowledge. Physical commodities’ locations, quantities, status, quality and availability are all critical factors in determining price. Without this information, pricing is vulnerable to gaming and possible manipulation.

Transparency is critical to effective functioning of commodity markets. Without transparency, small markets players are not encouraged to enter markets and compete with the incumbents; fine for the incumbents, but not much good for the market as a whole. By unintentionally restricting entry to markets, expansion is limited, liquidity curtailed and market stagnation becomes a real possibility.

Price discovery is an example of this. Traditional benchmarks have been set with market participants agreeing on prices. Now the pressure is on to create better price discovery mechanisms, for instance the global trend towards physically delivered commodity futures contracts.

As the fintech bandwagon continues to enable disruption, we have already seen other industries and markets being disrupted (or eliminated) by new models and concepts. Just look at the growth of retail peer-to-peer lending platforms over the last few years. Total P2P lending is estimated to be worth approximately £2.7bn in the UK in 2015. Much of this lending was historically provided by traditional lenders – now its lost to them.

Similar disruptions are yet to hit the commodities sector, but when they do (as they surely will), it would be reasonable to expect that new business models will be centred on much greater transparency than traditional practices, many of which are still inefficient and based on legacy paper-based processes which reinforce the opacity. Indeed, regulators are already clearing the path for such disruption to take hold.

A new status quo will undoubtedly arise and offer innovative approaches, and a key feature of these will be new levels of transparency. Venues, platforms and services where transparency is provided will become the norm as businesses with a stake in the physical economy move away from opaque and inefficient processes to more transparent and equitable facilities (i.e. “levelling the playing field”); the classic disruptor scenario.

At Kynetix, our view is that now is the time for the current commodity market venues and participants to embrace trust and transparency and ensure that their competitive position is not risked by the new disruptors when they arrive.

For more information read our whitepaper “Improving Confidence in the Commodities Markets”