- A lack of liquidity in commodity markets is leading to large price swings in either direction.
- Specialty traders and market makers noticeably absent in commodity markets, making matters worse and exacerbating volatility.
As any seasoned cryptocurrency trader will know, the published price is only one side of the problem when it comes to volatile markets, execution is what matters.
And in recent days, commodity traders are finding that they can’t execute without roiling markets further.
Everything from geopolitical turmoil to excessive one-directional bets have made it harder to deal in some of the world’s most important commodities, prompting traders to take to the sidelines, rapidly draining liquidity and exacerbating price swings off lower volumes.
Prices of everything from oil to natural gas, wheat to metals have become alarmingly erratic as the spread between buyers and sellers starts to widen, with sharp rallies quickly followed by dramatic drops.
The London Metal Exchange’s one-week closure, after a Chinese nickel giant took massive one way bets on a fall in the price of nickel saw nickel’s price surge by 250%, faster than a meme stock, to cover those short positions, is just one example of markets gumming up.
Making matters even more challenging for traders, because some moves appear to defy fundamentals.
Despite supply looking the tightest in years and geopolitics and inflation acting as tailwinds for commodities, hedge funds are exiting long-term bullish bets, just as things look brightest for these positions.
Much of it has to do with market mechanics than anything else.
The reopening snags at the London Metal Exchange has seen otherwise “in the money” positions by traders who took bullish bets on nickel prior to last week’s closure now stand in a long queue of sellers who are seeing their profits evaporate with the price falls.
By last Thursday, almost US$3.3 billion of nickel was on offer at the limit-down price, but there wasn’t a single bid on the London Metal Exchange’s order book.
That lack of liquidity is worrisome for companies that need these contracts to hedge their feedstock price risks and which use nickel heavily, from stainless steel manufacturers to electric-vehicle batteries.
But it’s not just nickel that’s been affected.
Markets in everything from aluminum to wheat, natural gas to crude oil, have seen a sharp drop off in open interest (a measure of the total number of outstanding derivative contracts that have not been settled).
Typically, liquidity is provided by specialist traders, hedge funds and algorithmic quant shops, but the huge swings are seeing many of them beat a hasty retreat, sucking the oxygen out of these markets and leading to massive spreads.
Many of these market makers are configured to trading tight spreads and hedging their exposure risk accordingly to remain market neutral in markets that had been assumed to be deep and liquid.
The loss of liquidity hits doubly hard – market makers don’t dare to make money off the huge spreads now, because there’s no guarantee that they can hedge their positions, because there’s no liquidity.
Although market makers provide liquidity, they also somewhat ironically need liquidity to operate, which there just isn’t enough of right now and why commodity markets are seizing up and prices swinging wildly.
