Energy Markets Need an Urgent Debate on the Role of Algorithmic Trading in Volatility

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LONDON (ICIS) – Energy market players are set to spark a debate over the role of algorithmic trading as automated programs fuel rising volatility in recent months, market sources have said.

Gas traders interviewed by ICIS said trading had become “completely haphazard” with companies struggling to swap or match various products.

A source said volatility in the August natural gas contract rose 157% month-on-month as prices rose or fell from around €5.00/MWh to 10.00 €/MWh at very short intervals during some recent sessions.

“The other day I wanted to make an offer. In the time it took me to type it, the price had jumped €5.00/MWh,” he said.

“Traders don’t know what to do. It is chaos that breeds chaos,” he said.

Another trader agreed that volatility had increased significantly over the past few months and said it could be linked to the growing presence of algorithmic trading, a process of executing orders using automated, pre-programmed trading instructions.

However, he pointed out that the algorithms were just reacting to a flurry of market-relevant news that traders have been exposed to in recent months.

The first trader agreed that the algorithms were triggered by news, but added that regulators should take a closer look and intervene, given that the natural gas and electricity markets are physical markets and the extreme volatility will ultimately harm end consumers.

“Just to give you an example when maintaining [the] North stream 1 [pipeline]
we had less gas but the prices were around €160.00/MWh. Now we are better off, there is gas coming through Nord Stream 1, but the prices are €40.00/MWh higher. How do you explain that?”

The trader said exchanges should use the tools they have developed to stop markets when they heat up, allow them to cool down and restart them when traders have repositioned themselves.

ALGOS ARE NECESSARY

Markus Riess, managing director and co-founder of Germany-based strategy and management consultants Forss Partners, disagrees, however.

He notes that such moves could result in massive losses, which markets are keen to avoid.

Instead, he said, algo traders should be reactive to such events and control computers from the cockpit.

He insisted that algorithmic trading was badly needed to reflect the fact that markets are maturing and becoming more sophisticated.

“Algorithmic trading has provided a lot of liquidity to the equity market since 2002/2003 and we are currently seeing similar effects in the commodity market,” he said.

“Commodity markets are becoming 24/7 markets, not least because of renewable energy generation, which also triggers a lot more volatility. If you have a wind turbine, you have to react throughout the day or night.

“Algorithmic trading was picked up in electricity markets some time ago by many players and now we see a strong expansion in gas markets,” he added.

For Riess, algorithmic trading is the answer to the challenges of a market in full transformation. He added that computers were best placed to manage markets that would become increasingly dominated by renewable energy generation.

“Participating companies must be technically available to play this game. Markets are moving faster and more sophisticatedly and we are seeing a move towards a higher level of maturity, which is a positive development,” he said. added.

He said the volatility was linked to the level of insecurity in the market, as many companies worried about what was happening to gas supplies since Russia started the war in Ukraine in February.

“It’s true that since February we have had a lot of psychological uncertainty. People are nervous and unsure of what will happen to supply, which creates volatility,” he added.

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