Blockchain in commodities trading

Blockchain in commodities trading

Somil Goyal and Irina Kirikova introduce blockchain and smart contracts, their potential applications and challenges for commodities trading.

Commodities trading industry has historically faced up to the challenges and used the opportunities afforded by technology innovations to restructure and grow. Over the past years, we saw the following waves of technology impact:

1. Internet supported globalisation of markets, improved price discovery and reduced costs
2. Commodity exchanges added liquidity to the markets
3. Risk management became an integral part of a commodity trading system
4. Algorithmic trading has substantially impacted certain markets

Now, blockchain and smart contracts have the potential to take the industry to the next level in line with the digital revolution that we observe in the wider economy.

What is blockchain?

Blockchain is a peer-to-peer network with no central authority. Some key features are as follows:

• Each node on the network could be a trader or a broker
• Any two nodes could together generate a “transaction request”, for example to confirm or reconcile a trade or schedule delivery of a sold commodity
• The request is encrypted to protect unauthorised viewing. Thus even in a peer-to-peer network, an unrelated third party is not able to see content of a transaction request
• All transactions with each particular node are recorded and could be tracked down
• All pending transactions are grouped together in a “block”
• The nodes validate this block by generating a “proof of work”, essentially executing a program to generate a hash which is difficult to produce but easy to verify. This confirms and records the validity of the block of transactions. From this point onwards, the transaction is performed.
• Each block uses proof of work from preceding blocks to form a “chain”, creating a “blockchain” with a “ledger” of all transactions executed, “distributed” across the network.

What’s new here: there is no reliance on any central authority, while security is maintained against unauthorised tampering or unilateral amendments.

What are smart contracts?

A smart contract is a digitally signed agreement between two or more nodes in a blockchain. Some key characteristics are:

• self-execution of the terms of contract when conditions are met, taking away the problem of counterparty trust;
• reduced incremental cost, faster execution and higher reliability; and
• reduced risks and costs from non-performance and settlement uncertainty (eg, credit or legal risks).

What’s new here: computer-driven verification and enforcement of contracts, rather than relying on expensive and time-consuming paperwork.

What are the possible applications?

As with most new and inherently disruptive technologies, it is human creativity and innovation that will drive successful applications. Some early objectives which are generating interest and gathering funding to development solutions include these areas

• “Trade reconciliation and confirmation” that reduce transactional costs and by keeping ‘the ledger’ distributed between counterparties
• “Trade settlements” that reduce operational risk of cash misallocation & optimise working capital
• “Price reporting” that allows to keep anonymity of counterparties and improves data verification
• “Physical commodity tracing” that allow to locate physical commodity & its owner at any point of time
• “Smart Commodity Trading” which allow traders to set-up platforms to develop liquidity, arrange funding, execute trade and hedges, as well as handle logistics in an automated, tamper-proof environment
• “Peer-to-peer energy trading” which allow owners of solar panels selling excess of generated power to the neighbourhood

Challenges

A range of challenges have to be overcome before these innovations will be mainstream in commodity trading industry.

Key issues

1. Security: the challenge spans protecting the whole network as well as protecting individual nodes from breaches.
2. Performance: to speed and computational power needed needs to be optimised to bring the cost of transaction on innovative networks lower than on the current trusted third party models.
3. Legal and regulatory: a range of issues arise e.g. comparing smart contracts versus legal documents, developing industry standards, accounting methods to record and audit distributed ledgers, etc.
4. User acceptance: common to every new technology, development of an effective new solution is only part of the challenge. These have to generate desire and confidence on part of the user to be used widely.

Currently we are running programmes matching solutions offered by Blockchain technology with issues faced by the commodity trading industry. The aim is to develop and roll out innovative industry solutions. We are keen on speaking in more details with any related parties to explore further opportunities available.