Commodity Trading: Backbone of the global economy

Comdex Official
Apr 25, 2019 · 6 min read
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Throughout history, shipping has been at the forefront of globalisation and trade advancement. Be it the exploration of new trade routes or the discovery of unexplored terrains, maritime transport has arguably been one of the biggest inventions of mankind. As time progressed, the transportation of humans progressed into the transportation of goods. Today, close to 90% of all goods are transported by sea with over 70% as containerized cargo.

As evidenced by the UN chief stating, “Maritime transport is the backbone of global trade and the global economy”, commodities are the backbone of the global economy of today.

Commodities affect everybody, be it a car owner who needs to fuel up his vehicle or a chef who needs to buy meat to serve in his restaurant. Behind every product we use and behind every service used, there is a big hand played by the commodities industry.

Commodity Trading

The trading of commodities is as old as time itself. In Sumer (modern-day Iraq), arguably the world’s oldest civilization, there are sources to indicate that citizens would use clay tokens sealed in clay vessels in exchange for goats. The clay writing tablets indicated the number of clay tokens inside each sealed vessel, and the merchant would deliver the specified number of goats. The clay tablets which included the amount, time, and date has a striking resemblance to today’s commodity futures contracts. We have similar examples throughout the world where commodities like seashells, pigs, cattle and other common items were traded. As time progressed, the commodity traders improved which eventually led to the trade of gold, silver and other metals.

Today, commodity trading is divided into four main categories depending on the type of commodity traded. They are:

  1. Energy Commodities — Crude Oil, Heating Oil, Gasoline Coal, Electricity etc.
  2. Metal Commodities — Aluminum, Copper, Gold, Silver, Platinum, Steel etc.
  3. Agriculture Commodities — Barley, Cocoa, Corn, Cotton, Wheat, Sugar etc.
  4. Livestock and Meat Commodities — Feeder Cattle, Live cattle, Pork Belly, Lean hogs etc.

Crypto commodities are the new entrants into this club where many commodity trading platforms offer crypto commodity trading as well.

While commodity trading is very similar to stock trading, the biggest difference is the type of asset that is traded. Commodity trading focuses on purchasing and trading commodities like the categories mentioned above as opposed to the company shares as in stock trading. Like stocks, commodities are traded on exchanges where investors work as a team to purchase or trade products in an attempt to generate profit from the fluctuation of market prices or because they need that particular product.

Size of the commodity market

The market size of the commodity market is extremely hard to ascertain as it would be hundreds of trillions of dollars in value. However, as an example, the crude oil commodities were worth $1.7 trillion per year. In combination, the commodity markets can easily be around $20 trillion a year.

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Image Source: https://www.visualcapitalist.com/size-oil-market/

From Origin to End Customer (The Value Cycle)

The journey of a commodity from origin to end customer has the involvement of commodity traders along the way. The purpose of the commodity traders is to move the raw materials necessary for daily life from their place of production or extraction to their place of consumption. This process has a lot of functions along the way, namely:

a. Sourcing
b. Purchase and Sale
c. Transport and Shipping
d. Storage & Processing
e. Inspection and certification

Supporting functions:

a. Trade Financing
b. Commodity Trading
c. Hedging and Risk Management

The commodity value chain is long and complex, involving many different actors throughout the world. Traders act as the organiser of this chain: sending commodities as efficiently as possible to where they are in highest demand, ensuring the best outcomes for consumers and producers.

The supporting functions of the trade lifecycle are extremely important as it ensures the availability of goods across geographies and it is the silent cog in the wheel.

Trade Financing

Investopedia defines Trade Financing as thus,

“Trade finance represents the financial instruments and products that are used by companies to facilitate international trade and commerce. Trade finance makes it possible and easier for importers and exporters to transact business through trade. Trade finance is an umbrella term meaning it covers many financial products that banks and companies utilize to make trade transactions feasible”

Trade financing mainly uses letters of credit (short-term bank credits whose collateral are the commodities transacted). Trade finance transactions occur between the banks of the buyer and the seller, not between the buyer and seller themselves.

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Traders are usually highly leveraged as a result of the low margin and high volume nature of the business and often rely on banks to provide the funding necessary to strike deals. Given the specifics of the various commodity markets and their different risk profiles, trade finance specialists and traders tend to work closely together. In many ways, providers of trade finance are amongst the trader’s most important stakeholders.

Commodity Trading

A commodity trader is an individual or business entity that focuses on investing in physical substances like oil, gold or grains and other crops. Most often these traders are dealing in raw materials used at the beginning of the production value chain, such as copper for construction or grains for animal feed. These traders take positions based on forecasted economic trends or arbitrage opportunities in the commodity markets.

Commodity traders engage in two types of trade:

  • Physical trading
  • Paper trading

Physical commodity traders engage in a number of actions as described in the value cycle while Paper traders only focus on managing the financial risks associated with trading commodities, typically through exchanges. Paper traders play a very important role in the smooth functioning of the markets as they bring significant liquidity to commodity markets and have a major impact on price variations by amplifying price movements.

Hedging and Risk Management

Producers and consumers of commodities use the futures markets to protect against adverse price moves. A producer of a commodity is at risk of prices moving lower. Conversely, a consumer of a commodity is at risk of prices moving higher. Therefore, hedging is the process of protecting against financial loss. Managing the financial risks associated with commodity trading is a key function within commodity trading firms. Traders hedge their exposure to risk by buying financial products (such as options).

References and Interesting Reads:

  1. https://visionproject.org/images/img_magazine/pdfs/international_shipping.pdf

2. http://www.forbesindia.com/printcontent/34515


About Comdex

A progressing industry needs a modern solution. Comdex is a platform aimed at revolutionising the fragmented commodity trade industry efficient, fast and transparent. The vision of Comdex is to revolutionize the rudimentary process of global commodity trade to minimize settlement times and maximize transparency, efficiency and immutability in trade discovery and trade financing at lightning speeds.

We discussed the importance of the global commodity industry today and in the subsequent blogs, we will highlight the pitfalls of the global commodity industry and how Comdex is solving each of these issues. Watch this space for more.

Find out more about what Comdex is doing to revolutionise the commodity trading industry at our official website.

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