Call an ETRM software vendor these days and they will tell you that despite the financial crisis, there are plenty of Requests for Proposals being issued at the moment. Further, they will tell you that the key driver behind these activity levels is risk management.

Risk Management was identified by the respondents to our Commodities study¹ earlier this year as the primary critical business issue facing them as traders and executives a trading firms. In fact, it ranked an average score of 4.38 (on a scale of 1 to 5 where 5 was critical). Drilling down deeper into the responses to the study, the emphasis on risk management under current market conditions was even more emphasized by some of the other important business issues mentioned by the respondents which included:

• General Market Liquidity
• Understanding the Factors Behind Price Formation
• Rising Credit and Collateral Requirements
• Portfolio Management
• Reporting
• Credit Scoring
• Errors & Omissions
• Lack of Audit Trails
• Lack of Integration

This led us to produce a number of white papers around the theme of risk management and the idea of "holistic " risk management—including "Seeking total risk management solutions in today's commodity markets" and "Breaking down the barriers to holistic risk management."

Today, risk management must incorporate much more than just market risk. It must include a focus on liquidity risks, operational risks, regulatory risks and credit risk and, if involved in physical trading, it must also involve a focus on deliverability and other areas of exposure. This is what we have termed "holistic" risk management and it is this broader interpretation of risk management that is indeed the driver behind the activities in the ETRM software market today.

Areas of Concern

CommodityPoint has discussed several major areas of concern in the risk management area so far this year in several IssueAlert articles. Let's review them again:

1. The Need for a Broader View of Risk—most ETRM software solutions have adequate coverage of market risk but how well do they cover other areas of risk such as credit risk? Many pay lip service only to other aspects of risk management and require that users build or deploy off-system work arounds to cover credit risk, regulatory risk and so. Certainly, ETRM solutions vary in their coverage of risk management depending upon their pedigree and some provide better coverage of physical risks than others, some better credit risk management and so on.
2. Risk Analytics—as commodity markets have evolved and changed, particularly over the last 18-months or so, volatilities have often been very high. The algorithms used by many risk tools are somewhat dated and may no longer be ideal for current market conditions. Some methods assume that input parameters are within certain ranges including for example volatility and may now be highly suspect. Further, many utilize historical price movement s o predict future price movements and yet commodity prices and price trends have broken with history recently and in a supply constrained world are increasingly likely to do so. ComodityPoint has recommended a move towards more stochastic risk assessment methods and more stress testing and scenario building to compensate.
3. Lack of Integration—It's no secret that many trading companies operate utilizing software which is aging and or has to be supplemented by spreadsheets or other pieces of software. Further, the integration levels between these software components is poor. Under such circumstances, workflow cannot be properly implemented—if at all—and the infrastructure is fraught with areas of potential risk such as errors, omissions and fraud. Under today's market conditions, the issues experienced with poorly integrated software is magnified as they are increasingly stressed. In a nutshell, the software is increasingly an additional risk factor to consider.

4. Reporting—It's quite easy to get data into most ETRM solutions but often it's a little more difficult to get information back out again. While some vendors have made considerable advancements in this area, the need for real-time views into the operation and for tracking of key performance indicators often cannot be met compounding an already difficult situation.

There are, of course, other areas of risk but for CommodityPoint, these appear to us to be the key ones.

Changing Needs Will Drive Innovation

The changing nature of commodity markets and the increasing exposure that traders face are driving innovation on the part of both the vendors and the users. More market oversight and regulation is increasing the pressure on executive management to ensure that their trading operations are run to a set of comprehensive risk guidelines. That innovation can be seen in the existence of new ventures offering a different approach to managing risk and in the upgraded offerings being announced by existing vendors. Much more innovation will come in the areas of business intelligence, architectures, risk metrics and more.

Despite that, what is required is a more comprehensive understanding of some of the issues. What types of risk metrics and tools are deployed today? for example. CommodtyPoint have responded to this need for data and analysis by teaming up with UK-based consulting firm, seminel, to undertake a comprehensive follow up to the Commodities Study focused on risk management. Kindly sponsored by Abacus Solutions, Amphora, SAS RiskAdvisory and SolArc, this study is now underway and we would like your firm to participate. To do so, please complete our questionnaire available here. You will receive the management summary when completed and we will cover the results in an IssueAlert article at that time.

¹Changes in Commodity Markets: Impacts on Traders and Software, CommodityPoint, 2009