Is blockchain the ingredient to shifting market power in commodity trading?

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.

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