Materials Risk

Last week 15 banks including ABN Amro, Macquarie and ING announced that they are to launch their first commodity trading platform for financing the trading of commodities using blockchain technology.

The platform (to be called Komgo) will operate out of Geneva and will start with two products. The first one will standardise and facilitate the know-your-customer process. The second product will be a digital letter of credit, allowing commodity houses or other platforms to submit digital trade data and documents to the Komgo customer banks of their choice.

Komgo will first be used for energy with the first trades being crude cargoes in the North Sea, the benchmark setting region for much of the world’s crude trading. From early next year, Komgo will widen to agriculture and metals and can then apparently scale itself up to new and emerging commodities.

The question is though is what problem are they trying to solve?

Blockchain remember is basically a way of sharing/communicating information, which can in turn be put to various uses in particular using consensus based systems that avoid the need for centralised systems and parties. For the most part it is just a bundle of pre-existing technologies brought together in a cryptocurrency context (in Komgo’s case using the Ethereum network).

The Komgo platform is viewed by the banks as a solution to trade and settlement inefficiencies, and to improving transparency and reducing the risk of fraud. In theory a shared database that updates in real-time and can process and settle transactions in minutes without the need for third-party verification. Instead of sharing a mountain of paperwork (what happens today) between a long list of parties, a trader will instead be able to use a digital letter of credit, which could speed up transactions considerably. Tamper-proof step-by-step verifications would reduce physical delivery risks, particularly those arising from fraud, by enabling participants to track inspections and certifications and so be sure of the commodity’s origin.

Any solution to a problem has its own costs and benefits of course. And any solution needs to be balanced against the costs and benefits of alternative ways of sharing and communicating information.

Lets start with the first product from Komgo – to standardise and facilitate the know-your-customer process. This basically means reducing the need for third party verification by trusted parties. But as Craig Pirrong of Streetwiseprofessor.com says this is basically a misnomer.

“Blockchain eliminating the need for trusted third parties which is (a) often untrue (in part because trusted parties may be required to enter information into a blockchain, and (b) is not necessarily a feature, because trusted third parties may be able to operate more efficiently than consensus based systems employed on a blockchain.”

And what about the digital letter of credit?

Well, different kinds of transactions are vulnerable to different kinds of information and opportunism problems. In trade finance there are multiple types of transactions meaning that customised blockchain approaches are likely to be necessary. Customisation of course makes it harder to exploit scale economies.

The sheer number of parties involved also makes it much more challenging. Trade finance requires a myriad of parties in a single transaction to communicate information among one another and so is inherently multilateral. This creates all sorts of challenges that are not properly spelled out. How can commercial rivals cooperate? How are the gains from cooperation divided? Who gets to see what information? Who makes the rules? How are they enforced?

Ironically, where the gains from cooperation are seemingly biggest (where there are large numbers of potential participants) is exactly where the problems of coordination, negotiation, and agreement are likely to be most daunting.

Bizarrely many of the members of Komgo (ABN Amro, ING and SG) are also founding members in a rival blockchain venture called Vakt. This second venture is also targeting physical oil trade financing in the first instance. Perhaps illustrating that despite the number of companies involved there is no clear consensus on how to move forward and so who will be dominant platform in the future.

All of this obscures what is probably the real underlying reason why the commodity trading firms and banks are so keen on moving in this direction – shifting market power from consumers to producers.

Transforming commodities into ingredients of course can shift market power from consumers to producers. Some commodities, such as coffee and cocoa, are already losing their commodity status and are differentiated by origin. End-consumers are already willing to pay more for gluten-free, or lactose-free, or organic, or non-genetically modified, or locally produced food. And the big brands are willing to pay more (hopefully) for specific food varieties that fit their particular recipes.

Many of the worlds largest commodity trading firms are restructuring amid dwindling profits. Wild swings in prices caused by political risk, the movement of other businesses into operations traditionally held by the big firms and the gradual loss of any informational edge in the markets has meant that commodity trading firms are increasingly under pressure.

Turning commodities into ingredients means you can charge a premium and exercise a lot more product and indeed price discrimination.

A decade on from the 2008 financial crisis and amidst the current crisis of confidence affecting many emerging markets its worth revisiting how markets of all sorts (not just commodity markets) are represented in the financial media. Recent research has identified the choice of words used in the financial media as being an important factor that can be both used to identify peaks and troughs, but may also influence investors expectations of future returns too.

The financial media, like individual investors and pundits, reflect a collective mood regarding the state of the market. In theory, the relationship between word choice and the markets should be linear. Taking equity markets as an example, the higher markets go, the more positive the language should become. Conversely, when markets fall, the language should grow more negative. This was the message from earlier research from the economist Robert Shiller, who explained in his book “Irrational Exuberance” that the media tend to exaggerate average days, hyping up stocks on very strong days, as much as they overdid the gloom in bad times.

A paper published in 2017 by Diego Garcia of the University of Colorado, entitled “The Kinks of Financial Journalism”, shows that, at least based on word choice, this relationship does hold, but only up to a point. As the title of his paper suggests, what Professor Garcia found was that market reporters tended to be asymmetric in the way they report market moves. The media are more negative about market falls than they are positive about market rises. As markets rise above a certain point or for a certain length of time, they reach a “kink” in which higher market highs made little or no difference to the positivity of journalists’ prose. However, as price falls grew worse, the language grew ever more negative.

The methodology involved searching through a database of financial market stories published by the New York Times and the Wall Street Journal between 1905 and 2005. The researchers assigned a score to the choice of words on a scale from positive to negative and then analysed how the positivity and negativity of coverage correlated with moves in the Dow Jones Industrial Average (DJIA). While the DJIA does not represent an average investor’s portfolio by any means, and is a measure of equity markets rather than commodities, it is reasonable to assume that the language of financial media reporting is similar across different asset classes including commodities. The caveat being that the price of commodities depends on the context, for while investors in oil companies may like higher oil prices, major energy importing nations will not since it could be a drag on economic growth.

As markets rise, investor confidence increases. Unknowingly, this higher confidence triggers perceptions of greater certainty and control among the media and investors alike. Cognitively, the brain is at greater and greater ease and rational thought takes a back seat. As a result, with things going well, we require little third party explanation or validation. Good times don’t need a story, let alone encouraging and positive language. There is little the financial media can or need add to the cognitive sensation that good has become better and the only way is up. For investors, the fact that the market was up and then up some more is itself self-affirming. Inherently investors want rising markets to be normal. In fact, ideally, rising markets should be so normal as to be altogether “un-newsworthy”. So, after a few days, there is remarkably little for the media to offer.

Falling markets, however, are a very different story. As markets fall, investor confidence decreases. Cognitive strain quickly develops and, as a result, narratives become vital as investors seek out reasons to be confident. Ironically, the media rarely offers that. As the media reflects the same falling mood and growing uncertainty as its followers, its own articles and stories become more negative as market prices decline. As peculiar as this may sound, by growing more and more negative the media is affirming that investors are correct in their feelings of uncertainty and being out of control. The lesson for investors and physical buyers and sellers in commodity markets is to recognise the change in the language used as a means for spotting euphoria and despair.

Another paper (“Mining the Web for the “Voice of the Herd” to Track Stock Market Bubbles”) by researchers from Trinity College and University College (both based in Dublin) also confirmed that language is important. They found that changes in the frequency distribution of English words can be helpful in identifying stockmarket bubbles. The researchers looked at thousands of articles from the Financial Times, the New York Times and the BBC that were published over a four-year period starting in 2006. They found that journalists’ language became less diverse when stockmarkets were rising, with certain common nouns and verbs like “rise”, “fall”, “close” and “gain” becoming more common still. The same does not apply when markets are falling: then, journalists’ language becomes less homogenous.

According to the Financial Times journalist John Authors, the financial media is exposed to asymmetrical incentives. The media are affected by “what might be a variation on what is known in the behavioural finance world as ‘loss aversion’.” The financial media, reflecting the fears of investors, are horrified at the prospect of losses and reflect this in their reporting. Authors also believes that there is a bias in favour of caution and negativity:

“For market journalists it means that we are far more scared of encouraging readers to buy and ushering them into a loss, than we are of urging them to be cautious, and thereby leading them to miss out on a gain. I hate the fact that I have been incorrectly bearish many times over the past eight years. But I am still deeply relieved that I was correctly bearish ahead of the disasters of 2008.”

The two-way connection between investors and the media creates a feedback loop whereby downward market movements may become exaggerated, amplifying the impact of the initial shock. This potentially opens up opportunities for investors who can spot when the media narrative has become too negative and so prices may not reflect the strength of the underlying fundamentals.

Although paying too close attention to financial media has its downsides (information overload for one),  it may also pay to listen to the voice of the herd, particularly the choice of words.

Also published on Medium here

Start with why. So says Simon Sinek, author of the book of the same name.

Why then should you read Materials Risk?

Well lets take a step back.

According to the investor Marc Faber investment manias are an essential part of the capitalist system. Without them we miss out on the potential upsides that can also have long lasting benefits for society and our economies. In the nineteenth century, for example, the canal and railroad booms in North America and Europe led to far lower transportation costs, from which our economies have greatly benefited ever since.

“My view is that capital spending booms like these, which inevitably lead to minor or major investment manias, are a necessary and integral part of the capitalistic system. They drive progress and development, lower production costs, and increase productivity, even if there is inevitably some pain in the bust that follows every boom.”

According to Faber the risk for investors, industries, economies and individual communities and families is, however, that the boom turns from a “real world” bubble that is relatively contained within a certain industry or region into a financial bubble. And here the impact can be much greater.

“…whereas every bubble will create some “white elephant” investments – investments that don’t make any economic sense under any circumstances – in financial economies’ bubbles, the quantity and aggregate size of “white elephant” investments is of such a colossal magnitude that the economic benefits arising from every investment boom can be more than offset by the money and wealth destruction that arise during the bust.”

The term “white elephants” is defined as “a burdensome possession; creating more trouble than it’s worth.” In the commodity world, they could equally be defined as holes in the ground, packed full of investors’ money, never to be seen again; grand projects built on a tower of sand that may have looked like the perfect thing to do at the time, but alas are now a burden.

Although I have some sympathy for Marc Faber’s argument that investment manias are an integral part of capitalism, I would prefer my money is not on the line when an investment turns sour. In writing my thoughts on this blog and publishing my books, I hope it is not your money either.

As an investor, you may not be totally dependent on the outlook for commodity prices. However, for many individuals, communities, and even whole countries their futures may turn decidedly bleak if commodity markets turn against them. And here misguided, short-sighted decisions by governments can make things much worse.

Empowering people to challenge consensus opinion and make better investment and business decisions. That’s why.