The Whats & Whys: Basis Price In Grain Markets and Decet’s Tezos Solution
In continuation from our previous article on a new type of decentralized commodities exchange built on Tezos, we will now get to the specifics as to what exactly we intend to provide for grain producers,what type of problem we are addressing, and why the “basis price” is a crucial economic factor in the production and distribution of grain.
Grain elevators (concrete cylinders which dot the countryside among the smaller towns and villages in the Midwestern United States), and the companies that own them, play an important role in this process. Elevators are both the local bellwether in agricultural markets and are the physical locations at which farmers can sell and deliver their products. Cash contracts between elevators and farmers are typically the first exchange of currency for grain in large scale agriculture. Grain elevators and their associated businesses provide the infrastructure to take delivery and store thousands of bushels of corn. These businesses then sell grain to exporters or domestic processors, thus playing a vital and stabilizing role in the global food economy.
Basis price has a very specific definition in grain markets. The basis price is the difference between the benchmark futures price of the grain being traded in a liquid market (CME Corn Futures, for example) and the price that the farmer will receive at the grain elevator where she/he chooses to sell their product. At its essence, the basis price is a liquidity metric. The higher the basis price, the more liquid the commodity is at that time. When demand is high, basis can be positive and the elevator will pay a premium to purchase the grain, as market forces influence and direct the price.
Basis is derived from the costs incurred by the grain elevators and exporters to transport and store the commodity. However, professional traders and firms are often unconcerned with the basis price as it rarely affects their margins. Basis contracts have yet to be standardized as a tradable instrument and therefore not transacted on a liquid exchange. Consequently, farmers and elevators haven’t had access to the same potential profits available to institutional traders. The basis price is still determined by human judgement and historical trends; two very unreliable mechanisms for accurate price discovery.
Supply and demand forces affect basis just as they do the price of grain contracts. In addition, the basis is hyper-local; an elevator near Champaign, Illinois might have a basis price of -$.20 but 40 miles away an elevator near Decatur could have a basis of -$.15. The basis is stronger at the Decatur location, but the farmer has to pay for the transportation costs, so a stronger basis at another elevator might not benefit the producer as the cost to move the grain would surpass the savings of the stronger basis at a different location.
Professional traders and commodities firms have the benefit (and ipso facto access to revenue streams currently unavailable to producers and elevator enterprises) of utilizing options on commodities contracts. Traders can use these instruments to not only mitigate risk but generate novel mechanisms of profit. Using “calls” (option to buy at a specific price) and “puts” (option to sell at a specific price), professional exchange traders and large institutional sized funds can hedge their positions as well as maximize returns on investments. These financial derivatives, as they are called, can be very beneficial to farmers and grain elevators in addition to the benefits they provide for the larger commodities and trading communities.
Decet intends to develop a Tezos powered exchange that maps physically deliverable commodities contracts (in this case contracts for basis price) onto a token (or another type of smart contract application) that can be traded on a digital exchange platform. These tokens will represent a basis price for 500 bushels of grain and an agreement between the farmers and grain elevators to deliver and receive grain at a specific basis price at a future date. The risk is no different than a traditional contract for grain delivery, except now, farmers will have a way to hedge against basis price fluctuations and the grain elevator operators can open the doors to new avenues of profit.
Businesses on the elevator side of the transactions can write (sell) puts to farmers/producers providing farmers more opportunities to hedge and thus ensure novel means of profit. Farmers can write covered calls within this exchange as well. Introducing liquid option contracts to producers and buyers will, in short order, yield benefits for all parties involved.
In the next article, I will discuss in more details the regulatory hurdles that must be cleared to have an approved Designated Contract Market. This involves the CFTC and conversations between Decet and the CFTC have already began. Blockchain will revolutionize the markets and contracts that the CFTC regulates, and they have been very receptive to the types of innovation Decet and Tezos will provide.
EDITORS NOTE: I would like to thank @__galene_ and Charlie Wiser (@cwiser ) for their insight, editorial acumen, and overall willingness to contribute substantive feedback. This would not have gotten any traction without your help.