In recent years, we have all gradually become familiar with the term blockchain, as the technology that allows networks rather than individuals to verify transactions has started to be successfully applied in financial services, pharmaceuticals, and other industries.
With customers demanding greater transparency, we are now seeing institutions looking at blockchain in a commodities context, to address issues such as traceability and ownership security. By effectively removing the need for a third party to independently verify transactions, blockchain technology has the potential to revolutionise the way commodities are bought and sold. With a number of high-profile cases of fraud in the market in recent years – typically the result of a failure to tightly control physical inventories – the ability to create a full audit trail for each and every participant in the movement of physical commodities clearly has widespread appeal.
In the last nine months of 2016, $1.4 billion was invested globally in blockchain startups, as technologists continued to explore how to capitalise on the opportunities it presents.
Over-the-counter commodity derivatives are a potential sweet-spot for blockchain. Banks have explored the use of smart contracts for interest rate and equity derivatives, and might now consider trying them out in OTC commodity derivatives, which are not yet subject to regulatory central clearing mandates. The lack of potential resistance from clearing houses, as well as the smaller size of the market overall, might make it easier to roll out smart contracts in OTC commodities than in other asset classes.
It has also been suggested that the blockchain concept may be a natural fit for the tracking of physical commodities along the supply chain, where transfers in ownership are often still recorded on paper and fraud remains a persistent risk. If title transfers were recorded electronically through a shared ledger, and verifiable by any participant along the supply chain, that could help build trust between physical market players and, ultimately, yield greater efficiencies.
Warehouse receipt financing – where there may be a number of duplicate and therefore confusing receipts created for a bank’s financing of a commodities deal – could also be de-risked by this type of technology.
The potential for blockchain to transform commodities trading is therefore enormous. It could lead to the elimination of inefficient, error-prone and costly back-office processes, such as confirmations, actualisation of volumes, and numerous forms of reconciliation. If all parties to a transaction had access to the same verified transaction record, available through a distributed database, the impact on the speed and costs of transacting would be immense.
In addition, credit risk could be reduced significantly, thanks to faster settlement times and lower collateral requirements. What’s more, improved availability and reliability of data, and improved auditability thanks to records being verified in real time, could minimise the need for human intervention across the entire deal life cycle. Blockchains even enable smart tendering, cutting out cumbersome negotiations and inter-party information exchanges.
With such huge potential for disruption, no business operating in the commodities space can afford to overlook this new technology. While there are potentially entire departments that you will not need to staff longer term, for now there is a clear need to invest in the talent that can help your business keep up with the pace of change. Now is the time to act, before you get left behind.
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