A Reality Check for Blockchain in Commodity Trading

by | Sep 4, 2020 | Industry | 0 comments

Commodity trading is as old as human civilization itself, dating back to 4,500 BC. At that time, people exchanged livestock and other farm products until classical civilizations introduced a standardized unit of value on precious metals, such as gold and silver.

Commodity trading was an important business. Because of its scale and complexity, centralized exchanges, like the Amsterdam Stock Exchange in the 16th century and the Chicago Board of Trade in 1864, appeared to facilitate and control the trading process.

While the markets have advanced to become more refined and sophisticated, centralized financial exchanges still control a significant portion of commodities and derivatives trading. Exchange trading has some benefits, but the drawbacks outweigh them.

Because of this, many dealers sell their commodities directly to clients or other brokers in Over-the-Counter (OTC) markets. Exchanges and OTC markets comprise of two primary ways of organizing financial markets.

Exchange trading vs. OTC markets

Exchanges are regulated, offering the participants transparency of bid and ask prices for commodities, derivatives, and other securities across financial markets. Using an exchange implies playing on a level field, where anyone can buy or sell high, as long as they abide by the set rules and regulations.

On the other hand, OTC trading is a direct trade carried out outside a regulated entity, like an exchange. In OTC trading, dealers are allowed to start bidding wars and negotiate better selling prices among various buyers who are not aware of the prices given to others.

Since the deals are conducted offline, OTC prices are hidden from the public eye. Therefore, in OTC markets, it is difficulty for market participants to make benchmarks. Without price transparency, a market can quickly become illiquid once prices begin to fluctuate, and participants become fearful of losses. The IMF ranks this as a contributing element in the global financial crisis of 2008, underlying the extent to which the worldwide OTC markets are based on trust.

Counterparty risk

Exchanges are centralized platforms where buyers and sellers make transactions with exchanges instead of transacting directly with each other. To some extent, exchanges reduce counterparty risks. But, OTC market dealers are exposed directly to the risks that one cannot deliver the goods at the agreed time, or on the set conditions.

Transaction charges

Of course, exchange trading also has its shortcomings. One of the reasons whey OTC markets continue to thrive is because of the charges and friction associated with trade finance and settlements using centralized exchanges. The fee imposed by brokers makes smaller trades less profitable, forcing smaller dealers into OTC markets and favoring big institutions who can take advantage of the economies of scale.

Liquidity

In exchanges, large volumes are traded between different parties under standardized contract conditions. In OTC markets, smaller dealers can sell through brokers or look for buyers themselves. The outcome is that the more prominent players enjoy more liquidity in the market and typically have more price information to benchmark. Likewise, smaller players have much lower liquidity and limited market information.

What tokenization brings to the commodity market

Tokenization of commodities combines the benefits of OTC and OTC trading while eradicating their shortcomings.

Decentralizing the commodity exchange technology

Blockchain facilitates the issuance of digital tokens backed by units of real-world commodities. For instance, the Royal Mint in the UK uses blockchain virtual tokens to trade real gold, which is held in a central repository.

In the space of global commodities, these digital tokens could represent ownership of commodities and trade between brokers in various parts of the globe. Since every transaction is recorded on the blockchain, and only private key holders can authorize transactions, repetitions of commodity inspections and paperwork are eliminated.

Additionally, blockchain can imitate the transparency and security of centralized exchanges, while still keeping charges low and minimizing friction. Peer-to-Peer (P2P) markets on blockchain enable traders to sell directly to other traders or clients in an OTC arrangement. Third-party commissions are cut down, and settlements can be made virtually in real-time.

Smaller traders have an added advantage in using a decentralized exchange. Since asset-backed tokens (ABTs) enable fractional ownership of assets, smaller brokers could take part in fractional participation in more extensive, and potentially move lucrative deals.

Conclusion

Asset-backed tokens on a decentralized network bring real potential to the sector of trade finance to enhance transparency and offer the opportunity to trade without putting trust in a third party. Commodities markets are the oldest forms of trade finance, but their development has been more evolutionary rather than revolutionary.

ABTs and other tools of blockchain can alter the trading of commodities for good. For commodity traders, and the whole global economy, blockchain is set to bring unmatched value. Contact us today for investing, fundraising, and trading in asset-backed tokens.

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