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UTILIZATION OF BLOCKCHAIN IN COMMODITY TRADING (by Vladislav Pertsovich and Dr. Vladimir Udalov)

image credit: www.pexels.com

Introduced as a concept only about ten years ago, distributed ledger technology (DLT) – also commonly known as blockchain (1) – has left behind its cryptocurrency hype and enjoying a rapid rise to prominence in the industries beyond financial services including those involved in commodity trading. In this article we will shed the light on the factors that enabled blockchain for industrial application and consider pros and cons of blockchain use in trading as well as post-trade processes.

Blockchain is a way of decentralized digital communication, information validation and storing among multiple parties. Blockchain is designed to be tamper resistant and to create final, definitive and immutable ledger records. Moreover, it provides for very high level of redundancy and technical network availability and imposes single standard for information exchange to those who are on the same blockchain. These qualities are indeed highly desired disregarding of the specificity of application area. At the same time, blockchain modus operandi – continuous consensus building over data validation and its consequent replication in multiple locations – poses significant challenge with regard to its efficiency (ie speed and scalability) and flexibility (ie data volume and complexity). Consequently, in each individual case it should be further investigated at which cost (material and immaterial) one can benefit from the said qualities.

Picture 1. Distributed Ledger Technology on one graph.

 

BLOCKCHAIN TECHNOLOGY AT THE SERVICE OF INDUSTRY

Before we elaborate on potential application areas for blockchain in commodity trading, let us briefly consider some of the relevant recent developments which have enabled blockchain technology for industrial application:

  • “Privatization” of blockchain through initiating industrial consortia which in turn operate permissioned blockchains has diminished the risk of classified data leakage to the public. As the name says, information circulated on a permissioned blockchain is available to a limited number of authorized participants.
  • Evolution of consensus-building mechanisms: gradual shift from original Proof-of-Work to Proof-of-Authority, Proof-of-Stake, etc has helped to overcome the queue time challenge. In combination with limited number of validators of a permissioned blockchain and rules on what should be done in case of failure of a majority of validating nodes (cfr Tendermint PBFT-based consensus-building mechanism) this led to improved block time, latency time and finality of the block. 
  • Modular development approach has allowed for purpose-driven combination of various bricks constituting blockchain technology (cfr Hyperledger Fabric of IBM).
  • Development of middleware for blockchain. Going one step further, Ponton developed entire “plug-in” broadcast communication framework called WRMHL that allows docking of various industrial applications without modifying the underlying blockchain infrastructure. Moreover, Ponton built its framework the way it will be possible to replace the currently used blockchain core with a more advanced technology in future. Similar development shows Finboot with its MARCO middleware. Such developments allow for more customized frameworks with faster time-to-market and better reflecting requirements of individual use cases.

BLOCKCHAIN IN WHOLESALE COMMODITY TRADING

Activities around a trading transaction can be roughly split into two main blocks

  • origination and execution of a transaction,
  • the so-called post-trade activities.

TRANSACTION ORIGINATION AND EXECUTION

To originate a transaction, company pursuing trade needs to have a good overview of the market in terms of participants and supply-demand balance. Here, an easily accessible database with corresponding historical records that cannot be manipulated or erased would improve on the market information asymmetry. In order to become reliable source of supply-demand analysis a blockchain based trading platform should first gain sufficient liquidity. Since attempts of industrial application of blockchain technology in general are only a couple of years old, it is currently too early to say with confidence if blockchain-based commodity trading will ever succeed in attracting and sustaining critical mass of participants to generate trading activity and become liquid. In any case blockchain-based trading will have to compete over customers with centralized trading platforms like exchanges or broker screens.

For a transaction to take place, two counterparties need to agree upon its terms verbally or in written form. Most of the time, an intermediary would play a role in bringing two counterparties together (either as a broker or as a clearing entity) and would be rewarded for platform or risk mitigation services. Blockchain based trading would enjoy absence of the said middleman and his potentially manipulative influence on the process; thanks to its distributed nature it would definitely have higher technical availability of the network (fe in case of failure of one or several nodes); finally, since transaction data is stored multiple times in different locations, it will be stored in a much more redundant way. Provided settlement takes place on blockchain with the help of automatically executable Smart Contracts and in form of crypto-currency or tokens, settlement risk would be managed as efficient as it is currently managed by clearing house. At the same time, there would be no fee for clearing services anymore. The same would go for any other possible fees associated with cost-to-serve of a company-intermediary as there would be no such company.

This however means that participants to a blockchain would have to manage their network themselves (ie maintenance, user support, release, etc) or call for the so called Trusted Third Party (TTP) – a situation leading to inevitable centralization of decentralized ledger.

Irreversibility of the information stored on blockchain does not allow to recall an erroneously made deal, potentially leading with time to lots of unreliable information not suitable for market analysis purposes (see above).

A juggernaut like decentralized ledger is not able to cope with a centralized platform in terms of efficiency since transaction processing and verification depend on many and not one operator. Hence blockchain-based wholesale commodity trading with currently maximum several hundreds of transactions a second would not be able to serve organized spot or financial commodity markets where automated trading approach (cfr HFT) is flourishing. Forward markets or non-organized bilateral structured trading with much lower dynamics would be a better fit for decentralized wholesale trading. (2)

Truly global nature of public blockchains like Bitcoin or Ethereum is another quality that could potentially foster wholesale commodity trading on a decentralized ledger. However, current trend is building smaller permissioned blockchains. In this respect issue of interoperability needs to be addressed both for purely technical aspects and also in terms of making content of one permissioned blockchain available to participants of another blockchain without sacrificing on confidentiality of transactional data (cfr the Cosmos Network initiative). 

End of May 2019 a consortium of 44 European energy companies supported by Ponton went live with its Enerchain project, aiming at reducing cost of OTC trading on European power and gas markets. Apart from cost reduction, Enerchain’s value proposition is the possibility of trading with exotic products (sa load curve, certificates, flexibility etc) which can otherwise be traded only via e-mail or phone. Despite of industrial blockchain projects popping up all over the world, wholesale trading platform remains a relatively rare use case. Enerchain is probably the first project that went into production. It remains to be seen if it will be able to become as popular among traders as Trayport, GFI or enmacc.

POST-TRADE PROCESSES

Let us now turn to the second block of trading activities mentioned above. Upon signatures of the parties on paper (sale and purchase agreement) or automatic matching of the orders on the screen (broker or exchange), concluded transaction

  • needs to be confirmed by the back offices of the two parties;
  • (sometimes) needs to be reported to a regulator;
  • needs to be financed by the buyer via bank;
  • needs to be physically delivered by the seller, whereby this process is completely different in case of gridbound transport (power or pipeline natural gas) as compared to transport of wet or dry bulk (fe crude oil or softs);
  • needs to be financially settled upon delivery.

Although very different from each other, these activities have in common that each of them involves multiple counterparts and rely upon fragmented process steps.

While enhancing transparency and imposing clear standards to data flows, blockchain would reduce significantly chances of intentionally erroneous or withheld information and would allow to skip certain steps in the respective processes. Considering, for example, participation of the regulator to a blockchain, since transactional information is accessible from the outset and cannot be manipulated, process of regulatory reporting becomes obsolete. The same goes for trade reconciliation and capturing processes. A blockchain-based platform called VAKT targets exactly this, digitizing deal recap, confirmation, contract, logistics and invoicing of crude oil trading in the North Sea.

Various other initiatives have been launched in the past couple of years covering the post-trade activities mentioned above.

  • Some of them focus on trade financing and more specifically on streamlining KYC procedure, issue of Letter of Credit and Letter of Indemnity, allowing for high degree of standardization and hence reduction of processing cost with simultaneously enhanced processing speed (cfr KOMGO).
  • Other initiatives aim at securing title of goods and ownership of traded physical assets in custody (like Vaultchain in case of gold and silver).
  • Enhancing efficiency and risk reduction of handling physical inventory is also an issue in commodity markets. Implementation of blockchain here is combined with the use of IoT sensors and near-field communication (NFC) for the track-and-trace purposes (like Forcefield aims on the metals market).
  • In combination with IoT applications it should also be possible to trace the provenance of commodities and goods to identify if they were produced or harvested in a compliant and ethical way (cfr projects tracing origins of palm oil or coffee beans).
  • Finally, there is a number of initiatives dealing with container shipping of goods, more specifically processing of Bill of Lading and customs clearance. One of them – TradeLens launched jointly by Maersk and IBM in August 2018 – a platform of more than 100 participants including port and terminal operators, customs authorities and major shipping companies pursues digitalization and streamlining of usually very labour intensive and time-consuming paper work populating day-to-day operations.

Picture 2. Some examples of blockchain application in commodity trading

As mentioned above, development of blockchain-based applications for commodity trading is still very young to foresee for which of the use cases blockchain will prove to be a real value added. Blockchainization of post-trade processes seems to be somewhat more promising, also because the technology occupies in this case a previously virtually vacant market niche.

In the next article of this series we will elaborate on potential use cases for blockchain application across LNG trading value chain.

1 - Distributed Ledger Technology is highly heterogeneous, and blockchain is only one form of DLT. For the sake of simplicity, and since we do not talk in this article about such very different non-mainstream DLTs like IOTA or Hashgraph, a common term “blockchain” will be used further on.

2 - Peer-to-peer retail trading commonly associated with excess of decentralized small-scale energy generation (cfr prosumers) is not subject of this article.

Vladimir Udalov's picture

Thank Vladimir for the Post!

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