Increased competition, the growing sophistication of customers and investors, and the demand for value-added products and services have forced many organizations to examine the existing business processes associated with their commodity-related operations, and to introduce more complex trading products and strategies in order to remain competitive. With this increase in complexity comes an increase in the associated risks.
We have identified eight red flags that could indicate increased risks for stakeholders:
- Opaque business models: Opaque business models can include transactions with unidentified parties, offshore entities and agents with an unclear purpose. In times of trade sanctions, anticorruption and anti money laundering laws, these business models may involve high legal and reputational risks. Trading margins that are unusually high may indicate opaque transactions that have not been executed on an arm’s length basis.
- High overhead costs: High overhead costs can create pressures on traders to generate profits and to take risk positions. For trading companies, it is important to keep the cost structure flexible in order to adjust in time of limited trading opportunities and to avoid entering into non-performing trades.
- Consideration of historical performance: It is important to know how strategies contributed to the entity’s results and whether the entity was profitable when adhering to its risk limits and trade strategies. A commodity trading entity with different trading strategies that consist of outright speculation and speculation on spreads or arbitraging positions must be able to explain the financial results of each strategy. Stakeholders should be worried when management cannot explain the root cause behind its results and has a history of low or negative financial performance.
- Limited experience of risk managers: Risk managers may feel pressure from traders to increase trading limits or to enter into certain specific transactions. Risk managers with limited experience and insufficient authority within the organization may not be able to withstand these pressures and can put the company at risk.
- Misalignment between interests of traders versus other stakeholders: Stakeholders need to be aware when there is a separation of ownership and management. When traders do not have an interest in the company, they may be insulated from downside risks while they are rewarded for upside risk, which can result in excessive risk taking.
- Overly complex trading products: In times when trading margins are under pressure, companies are looking for alternatives to improve margins. This can result in entering into deals of which the risk are not fully understood or in which the company has limited experience to execute.
- Poor trade execution: Successful trading companies differentiate themselves by efficient trade execution. Ultimately these companies are successful not by speculating on price movements but by managing efficiently the logistic process in order to get products from A to B. Indicators of poor trade execution include counterparty defaults, legal claims, high demurrage expenditures and inventory losses.
- Aggressive accounting practices: Companies that apply aggressive accounting practices may conceal the real underlying performance of the company. Stakeholders of trading companies should be aware of non-cash items recognized as profit as well as structures to derecognize assets and to improve the balance sheet.