Commodities trading is as old as human civilization itself, dating back to 4,500 BC. At that time, trades were based on livestock and crop harvests, until classical civilizations agreed on a standardized unit of value on precious metals like gold and silver. Commodity trading was an essential business, as a result of its scale and complexity, centralized exchanges appeared to facilitate and manage the trading process, such as the Amsterdam Stock Exchange in the 16th century, and the Chicago Board of Trade in 1864.
Although the markets have evolved to become more sophisticated and complex, these centralized financial exchanges still control a large proportion of commodities and derivatives trading. Trading via an exchange offers benefits, but it also has some drawbacks. For this reason, many dealers sell commodities directly to customers or other dealers in over-the-counter (OTC) markets. Thus, exchanges and over-the-counter consist of the two basic ways to organize financial markets. However, both of them have advantages and disadvantages. Now, this gap can be bridged by blockchain technology.
Exchange Trading vs. OTC Markets
Exchanges are regulated, providing traders and investors transparency of bid and ask prices for commodities, derivatives and other securities across financial markets. Using an exchange means playing on a level field, where anyone can buy low or sell high, providing they follow the rules of the game.
OTC trading is a direct trade, not performed using an exchange. In an OTC market, dealers are free to start bidding wars and negotiate higher sell prices between different buyers who don’t know the prices offered to others. As deals are done offline, the prices are not public. Thus in OTC market, it is hard for market participants to make benchmarks. Without price transparency, a market can quickly become illiquid once prices start to fluctuate and dealers become fearful of losses. The IMF counts this as a contributing factor in the global financial crisis of 2008, underlining the extent to which the global OTC markets rely on trust.
Exchanges are centralized places where buyers and sellers make transactions with exchanges instead of with each other directly. To a certain extent, exchanges reduce counterparty risks. However, OTC market participants are exposed to the risks that one cannot deliver the goods at the agreed time or on the agreed terms.
Of course, exchange trading also comes with drawbacks. One of the reasons that OTC trading continues to exist is because of the fees and friction associated with trade finance and settlements using centralized exchanges. The fees charged by brokers make smaller trades less viable, forcing smaller dealers into OTC trades and favoring larger institutions who can leverage economies of scale.
Furthermore, physical global commodities trading comes with specific friction points. Imports and exports are subject to rigorous documentation requirements, much of which is still paper-based. Physically settled trades mean that commodities have to be moved around different locations, requiring physical inspection each time they change hands.
In exchanges, large volumes are traded between various parties under contract terms that are generally standardized. In OTC markets, smaller suppliers can sell through brokers or find buyers themselves. The result is that the bigger players have more liquidity in the market and usually have more price information to benchmark. On the other hand, smaller players have much lower liquidity and limited market information.
What Tokenization Brings to Global Commodities Trading
In a previous article, we outlined how tokenization of assets can change the way we do business in general. Tokenization in global commodities trading combines the benefits of exchange and OTC trading, while eliminating the disadvantages of both.
Decentralizing Commodities Exchange Technology
Blockchain can generate digital tokens backed by units of real-world commodities. The Royal Mint in the UK is already using blockchain digital tokens for trading real gold which is held in a central repository.
In the world of global commodities trading, these digital tokens could be used to assign ownership of commodities and trade between dealers in different parts of the world. As all information is recorded on the blockchain, and only private key holders can authorize transactions, a lot of the repetitions of goods inspections and paperwork can be eliminated. With blockchain, a transaction can be secured through an atomic swap and paper documentation can be replaced by blockchain records. This brings the combined efficiencies of reducing costs and saving time.
Blockchain can also replicate the transparency and security of a centralized exchange, while still keeping fees low and reducing friction. Peer-to-peer (P2P) marketplaces on blockchain allow a dealer to sell directly to other dealers or customers in an OTC arrangement. Unlike a centralized exchange, no brokers or other middlemen are needed in a P2P trade. Therefore, third-party commissions are greatly reduced, and settlements can be made virtually in real-time.
These marketplaces can also be set up to display the bid and ask prices to all participants, thereby creating transparency in OTC trades akin to using centralized exchanges. Because blockchain is a decentralized technology without the stringent requirement of listing, smaller dealers can benefit from the transparency.
Smaller dealers have an additional advantage in using a decentralized blockchain exchange platform. Because asset-backed tokens offer the opportunity for fractional ownership, smaller dealers could enjoy fractional participation in larger, and potentially more lucrative deals. Smaller dealers could therefore join forces to make bigger trades, increasing their individual potential for liquidity and bringing greater liquidity to the overall market.
Automating Settlements with Smart Contracts
Smart contracts on the blockchain can also automate the settlement process in commodities trades. This applies whether the commodities being traded are cash or physically settled, or if derivatives such as futures or forward contracts are used.
Smart contracts allow for full automation of tokenized cash-settled derivatives, as the settlement funds can be held in escrow until the contract’s end date, then released automatically. Even in a physically settled trade, participants can use blockchain-based key signatures to confirm the delivery of goods. Furthermore, all parties involved in the movement of the commodity can track the whereabouts of the assets in real-time. The traditional letter of credits and services from banks are no longer needed, saving significant costs and reducing friction through the implementation of atomic swaps on blockchain.
Asset-backed tokens on a blockchain offer real potential in the world of trade finance, to increase transparency and provide the possibility for trading without putting trust on an intermediary. Smart contracts have the potential to reduce counterparty risk, thereby providing more liquidity and reducing costs in a commodity or derivatives trade. Asset-backed tokens can also enable anyone to participate in a large volume trade through fractional ownership.
Commodities markets are the oldest forms of trade finance, but their development has been more evolutionary than revolutionary, at least until now. Asset-backed tokens and other features of blockchain have the potential to completely transform global commodities trading. For commodities dealers and customers, as well as the broader global economy, blockchain is poised to deliver unprecedented value.
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As a prominent blockchain infrastructure provider, CoreLedger is making blockchain technology simple for businesses to use. With CoreLedger’s offerings, clients can readily tokenize their offerings with fast-to-implement resources that will allow them to modernize their services. Thanks to our in-house developed software solutions and experienced blockchain specialists, CoreLedger is ready to help you make your next move with blockchain technology.