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C. Statistics |
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Lifecycle
of a Trade
This page
provides lots of useful info on the Lifecycle of a Trade.
That term is
commonly used to describe all of the things, i.e., the events,
that happen to a trade from the beginning to the end of its ‘life’ in a
CTRM system.
Multiple
Types of Trades
There are
multiple different types of ‘Trades’ in the world of commodities. And they have different events along their
lifecycle. This provides sample
Lifecycles for a multiple types of Trades.
i.e., To explain ‘Lifecycle of a Trade’, we need to a particular
trade, e.g., a Commodity Swap and provide the Lifecycle Events for it, as they
will be different, for example, for the Events associated with a Commodity
Option.
When
to Start the ‘Lifecycle’
Pre-Trade
Decision Making/Decision Support
Prior to
entering in a trade into a CTRM system, there will be some decision made as to
whether or not to do the Trade at all.
There may be some Decision Support tool or software. The decision could be made for reasons
including:
a) Hedge. i.e., the firm already has some Market Risk,
and wants to reduce it via a trade done for the purposes of hedging, i.e.,
reducing exposure.
b)
Speculation. E.g., a
firm things the market, e.g., Crude Oil Price will go up so they ‘go
long’.
c) Market
Maker. i.e., a firm isn’t ‘initiating’
the trade… instead, a client of the firm wants to buy or sell something, and the
firm enters into the other side of that transaction after ‘making a market’ for
the client, typically by providing a ‘bid’ and an ‘ask’ price for the item.
For the
purposes of this page… we’ll consider the pre-trade decision, i.e., whether to
do the trade or not, as outside of the ‘Lifecycle’ or a trade… but feel free to
consider that included in the term if that suits your purposes better.
Risk
and Limits
Prior to executing
a trade, traders may be required to check one or more of the following
a) Credit
Limits. i.e., to check that, if they do
the trade, will they be exceeding a limit as set by the Credit department? Limits can be per counterparty, per commodity
or country or other consideration.
b) Market Risk
Limits. E.g., will doing that trade
cause a firm to exceed a daily VaR (Value-at-Risk) limit?
While those
items are important considerations, we’ll treat that in this page as outside
the ‘Trade Lifecycle’. i.e., we start
our discussion from the time the trade is entered into a CTRM system.
Trade
Types Included in this Page for Sample Lifecycle Review
We’ll provide
sample lifecycles for these types of trades:
1) Commodity Swap: This is a financially setting deal, i.e., no
actual physical delivery. And this is
OTC (over the counter), meaning done party-to-party and not on an exchange.
2) Commodity
Futures: Exchange-traded futures contract.
E.g., buying 10 Crude Oil futures contracts for December delivery, where
each futures contracts (commonly shorted to just the term ‘futures’) is for
1000 BBL (Barrels) of crude oil.
3) Physical
Transaction: Example is for an OTC trade
where there is an actual physical delivery of the Commodity, e.g., for Natural
Gas.
4) Commodity
Option: This is similar to a Commodity
Swap, except one side has the legal right to back out of the deal. Our example trade will be OTC, though there
are also exchange-traded Commodity Options
See also: CTRM Trade Type Taxonomy
See also: Trade Type Examples
Sample Trade
Lifecycle for a Commodity Swap
Example trade:
Trade done in June. For
pricing in December, a few months later.
Let’s say, one
party agrees to pay a fixed price of $40/BBL (Barrel) for Crude Oil for 20,000
BBL and the other side of the trade agrees to pay a price based on whatever the
NYMEX (New York Mercantile Exchange) publishes on the average of the December
prices.
This is known
as a ‘Fixed for Float’ trade or alternately a ‘Fixed Price versus Index’
trade. The ‘Fixed Price’ is the
$40/BBL. And the ‘Float’ part is the
to-be-provided price that will come in December. It is important that the ‘Index Price’ come
from an unbiased third party like an exchange.
See also: Trade Payment Formulas
1) Day 1:
1.1) Trade is
Entered
1.2) Since this is an OTC (over the counter) trade, there will be
some form of ‘Confirmation’ process with the Counterparty. That could be a ‘Paper Confirm’, e.g., a PDF
file sent via e-mail or something more automated.
1.3) Middle office Checkout. Typically there
will be some other group, other than the Traders (which are considered ‘Front
Office) to verify the details of the trade.
This would typically include marking the trade as being ‘ok’ in some
manner.
2) Days 1 and forward
During this
time, the trade is considered ‘Active’ or ‘Life’. Different CTRM systems have different terms
for this.
2.1) MTM (Mark to Market) and Risk calculations
are done at a minimum of once a day at the end of the day.
3) Setting the Price
3.1) As a key part of the Lifecycle of a Trade, at some point the
price of the ‘Float’ side of the swap will be fully known. In this case, our example trade is an averaging
swap, so the final, final price won’t be known until the last business day in
December.
3.2) At this
point, after the Float side price is known/finalized, the trade no longer has
market risk exposure at least in terms of exposure to Commodities price
movements. Since the payment dates for
Swap trade is typically some days afterwards, e.g., 5 business days is common,
there would still in most cases be a small amount of interest rate exposure.
See also: Applying Settlement Prices
4) Invoicing
4.1) Once the price is known for the Index Side, e.g., let’s say
that the average worked out to be $41/BBL, then an invoice would be generated
and send to the Counterparty. Invoices
are commonly monthly, based on the calendar month, though that varies.
4.2) A consideration for the invoice is what is called ‘Netting’
or ‘Payment Netting’. Typically for a
financially-settling Commodity Swap, only one side would pay. In this example, the netted amount is ($41
- $40) * 20,000 = $20,000.
Whether a
payment is Netted or not isn’t considered a part of
the ‘Trade Lifecycle’, so this is just as an additional note for the reader.
5) Last Payment
Date – Deal Lifecycle ‘Ends’
5.1) As noted above, the payment date is commonly 5 days after
the Index side payment is finalized, i.e., based on the prices coming in. After the payment is made, the deal is
considered at the end of its lifecycle. Note
that this is only the case for a financial Commodity Swap. Physical deals can be considered active even
after the last payment, as explained below.
5.2) Note that
this is a simplified example of a one month long deal. If a deal was, say, three month, or a year in
term, then there would be 3 payments or 12 as appropriate. In discussions of the ‘Lifecycle of a Trade’,
the common understanding is that the trade is not considered at the end of its
Lifecycle until the very last payment date it hit.
5.3) CTRM
systems generally do not have a module that some would call ‘Cash Applied’. That is, to check to see whether the full
payment was made or not. In other words,
just because the agreed-to payment date passed, that does not mean the
counterparty actually paid you what they owe.
That is a concern for firms and they do need a system or process to
handle that.
6) Still being included in Daily EOD
(end-of-day) runs
6.1) Even
after a deal has ended, i.e., the last payment date has past, often firms
continue to, for a limited time, continue to include a Trade in their end of
day reporting. At some point, though,
and this varies firm by firm, they will perform an additional step of marking
the trade in such a way as to indicate that it will no longer be included in
their EOD runs. At that point, the trade
is really, really at the end of its LifeCycle.
7) Purging old
trades
7.1) While this is not considered part of a Trade Lifecycle in
some sense of the phase, it is worth noting that at some point trades are often
purged from the production CTRM system.
For example, if there is a 7 year retention requirement for regulatory
reasons. E.g., trades older than 7 years
may be purged for legal reasons and/or to get better performance.
I am not
saying this is a ‘requirement’, just noting this is a common practice. It you really wanted to take the extreme view
for any definition of ‘Trade Lifecycle’, this is really the end, end.
Additional Items
1) When Trades
are executed, there is often a Broker and with that, associated Broker Fees. Broker fees are typically paid monthly, based
on the calendar month of when the trade is done, i.e., based on Trade Date of
the trade. This is often considered part
of the ‘Trade Lifecycle’.
Sample Trade
Lifecycle for a Commodity Future
In the
interest of having less duplicate text, I’ll just describe the differences for
a Commodity Future versus a Commodity Swap.
1) Because a
Futures Trade (short for ‘Commodity Futures Trades’) is done on the exchange,
there is no ‘Confirmation’ step like there is for OTC (Over the Counter). However, there would be a daily ‘Broker
Checkout’ to compare with what the exchange understands to be your traded
positions versus what is in your CTRM system.
2) For each
new Trade on the Exchange, there will be an ‘Initial Margin’.
See: Margining
3) For each
day, the Exchange will either give you some money back or, potentially, ask for
more money, based on how the market has moved.
That is known as ‘Variation Margin’.
4) If you buy
futures, e.g., 10 contracts (also called ’10 lots’), and then sell an equal
amount, i.e., Sell 10, then from the exchanges point of view, you are
completely done and you have no more risk.
By comparison,
if you have two opposite OTC trades, you would often still have Credit Risk,
even if they cancel each other out from a Market Risk point of view.
5) Some futures
contracts are Cash Settling if you hold them to expiration. i.e., you’ll just get or owe a certain
dollar amount.
6) Most
commodity futures contracts are physically settling, meaning you’ll actually
have to accept physical delivery of the commodity if you hold a futures
contract to maturity. That rarely
happens, and if it does, from a typically CTRM system, you might need to create
a new Physical Trade to account for it.
Sample Trade
Lifecycle for a Physical Commodity Trade
In the
interest of having less duplicate text, I’ll just describe the differences for
a Physical Commodity Trade versus our example Commodity Swap.
1) For the
physical trade, the seller would have to actually deliver the physical.
2) For
Physical Trades, there needs to be a reading of the meter or other approach to
determine what has actually been delivered.
E.g., if the traded volume of Natural Gas is 10,000 MMBTU, the actual
delivered amount might be just 9,998 MMTBU.
The payment made by the buyer would be for the actual amount, not the original
traded amount.
While this may
surprise some people, this applies even for things like gold. If you purchase 100 ounces and 100 ounces is
shipped, some small amount may flake off in transit, so you might get 99.950
ounces and the difference is substantial enough to track. i.e., the gold is weighted and payments are
adjusted accordingly.
3) The
payment, meaning the financial/cash payment, that could
be based on a fixed price, e.g., $2.50/MMBTU.
In this case, the invoice is just $2.50/MMBTU time the volume.
4) Alternately,
the cash payment might be based on an Index, as in the case of the ‘Float’ side
of the example Commodity Swap. i.e., the
buyer gets the Physical, and pays a to-be-determined amount, meaning that the price
is to-be-determined.
5) Even after
the last payment date, the deal lifecycle continues. There is something called a ‘PPA’, Prior
Period Adjustment. Though rare, updated meter
readings, ‘actuals’ can come in months after the physical delivery.
Sample Trade
Lifecycle for a Commodity Option
In the
interest of having less duplicate text, I’ll just describe the differences for
a Commodity Option versus our example Commodity Swap.
1) With
Commodity Options, the Buyer, i.e., the Purchaser of the option has the legal
right to back out of the deal. For our
Commodity Swap, example, one counterparty was paying a
fixed price of $40/BBL.
Assume that
same counterparty wanted to make that an Option instead of a Swap. We would describe that option as having a ‘Strike
Price’ of $40/BBL.
Naturally, the
other side of that trade would not just agree to let the other side out of
their agreement for nothing. In order to
justify the one side getting the right to not go through with the deal, the seller
of the option would require the buyer to pay some amount. That payment, made upfront, is called the ‘Option
Premium’.
Some Options
Terminology:
This is only
meant to be the briefest explanation, as is appropriate for the Trade Lifecycle
topic.
With a ‘Call’
option, the Buyer of the option would Pay the strike
price if they decide to go through with the deal.
With a ‘Put’
option, the Buyer of the option would Receive the
strike price if they decide to go through with the deal.
‘Exercising’
the option is the term for when the Buyer decides to go through with the
deal. i.e., remember only the option
Buyer gets to choose.
‘In the Money’: The option is profitable.
‘At the Money’: The option is breakeven.
‘Out of the
Money’: The option is not profitable.
Though none of those terms take into account the original Premium
payment.
2) Some
options are Cash Settling. For these,
you don’t really have an Option Exercise. Instead, the buyer will either get nothing at
the end, i.e., ‘option expires worthless’, or the buyer will get a payment from
the counterparty. Remember that the
buyer made the upfront initial Premium Payment.
3) When
options are Physically Settling, that is when it is important for the Buyer to
consider to Exercise the Option or not. If
an option is only a very small amount ‘In the Money’ it might make sense to not
exercise it. Why? Because the risks of
physical delivery and any extra expenses, such as transportation, may outweigh
the benefits of exercising it.
Notes
This is a
first-pass page, added in Oct 2020. For
now, I haven’t added any nice diagrams or flow charts. That would/will improve this page and I’ll
add those as time permits.
Acknowledgements
Thanks to Palvi Goyal who suggested via LinkedIn that that a page on
this topic be added.
Introduction to
CTRM
Click on this
link for a great introduction to CTRM software: Introduction to CTRM Software