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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
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
4.1) 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.
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’.
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.
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.
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