Why Blockchain Is The Future of Commodity Pricing

By December 3, 2019Bitcoin Business
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Commodity pricing hasn’t changed in three decades. Even for the most liquid, high-value and intensively traded commodities – oil, natural gas and gold – price setting is opaque.

Changes have been made to methodologies and regulation in commodity pricing, but selective reporting and fewer participants submitting trades have lowered confidence in the published prices. The current relationship-focused, self-submission-based system has made it difficult for regulators to police the market. If the market moves to an automated and consensus-based system, would the users of these pricing benchmarks have more faith in the price?

One technology offers the market the ability to reconsider how these critical benchmarks are determined. Enter blockchain. The technology enables all trades to be securely and accurately captured, and yet it is a team sport – competitors, partners and third parties can all win with blockchain.

To be sure, transparency is not always a net positive. The trader’s art is to exploit and capitalise on informational asymmetries, to gain an edge and hunt a profit. The difficulty in convincing competitors to collaborate and play fair cannot be underestimated.

Blockchain could facilitate the solution. The upsides to commodity traders are meaningful. Greater liquidity to intra-day trading markets. Moving from daily published prices to near real-time publishing. Creating new markets and trading opportunities with benchmarking capabilities not available today.

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Disrupting price setting? Blockchain may be the future for commodities pricing

This can be done. A newly created pricing body owned and governed by its members – a blockchain consortium, motivated by improving the accuracy and reliability of commodity prices.

Liquefied natural gas (LNG) pricing could be a test case. The LNG market is coalescing around a new spot market, using old pricing solutions based on selective trade reporting and human judgement. Blockchain could be the architect of this transformation from a nascent growth market into one transparent to all participants.

Commodity markets: primed for technological disruption

Blockchain at its core is not technically complex. Essentially, it combines distributed computing networks and cryptographic encryption, both existing technologies. This combination removes the need for a centralised authority within any system or network where parties interact. The true beauty in any blockchain is finding a native use case, a problem that cannot be solved without it. Digital currencies, such as BitCoin and Facebook’s Libra, are prime examples, as are the countless applications in peer-to-peer microgrid trading and supply chain that have emerged in 2019.

So why is blockchain a native solution for commodity pricing?

1. It removes the need for the large intermediators

The commodity pricing market today is dominated by a handful of large players acting as the market reporter between buyers and sellers, collecting selective trades and publishing prices once a day. That’s how Brent or WTI, Henry Hub or NBP prices are set, as are gold. Price reporters collect market chatter, intelligence and hearsay. The deployment of a blockchain solution would effectively remove the need for any centralised intermediary because activity is collated and anonymously published.

2. Players can avoid the prisoner’s dilemma and trust the competition

For anti-trust and competitive reasons, competitors cannot share pricing information with each other, but the demand for a benchmark price led to the creation of the price-reporting agencies (PRAs) and opaque benchmarks as we know them. Smart Contracts – a self-executing set of rules on a blockchain – would guarantee that all trading activity and competitors’ prices were being used in the formation of price. Traders don’t need to trust that their competitors are playing fairly, the blockchain does this. All participants can see, and trust, the same pricing information, with its anonymous audit trail from trade to price.

3. It guarantees the past cannot be changed

What is written onto a blockchain cannot be changed or deleted. This is critical for the efficient functioning of the energy markets – trillions of dollars of physical and derivatives contracts are settled using these referenced prices. Based on these, operators explore, and bankers lend – even though there are marked differences in the same commodity price published by the different PRAs on the same day. All players would know that no one party could maliciously or intentionally change the past.

4. It removes the need for human judgement

No more “editorial decisions” to change methodologies at will. No more PRA “boxing”, the practice of excluding participants from trading within certain timeframes. Instead, there is faster and more accurate pricing with transparency on trading activity intra-day, adding liquidity to the market.

5. Because the PRAs need to reform

Their business models need to evolve and modernise. Blockchain pricing can be automated, and counter-verified. An industry-agreed, consensus-based methodology can be codified and applied in real time, removing the need for reporters to collate information on one side of the trade. Adding to this, both the buyer’s and the seller’s proof of transaction can be verified instantly, something not possible today. At a stroke, this would eliminate the risk of spurious trades impacting price benchmarks.

An opportunity for the industry to collaborate

Following the 2012 Libor scandal in financial markets, eyes quickly turned to the PRAs, forcing them to defend their methodologies. The PRAs agreed to annual audits and strict staff training regimes in the wake of a review by the International Organization of Securities Commissions (IOSCO). But the criticisms and comparisons remain.

Short of a fully regulated market, which would be near-impossible to implement globally, a credible alternative to the status quo was not obvious to IOSCO. Seven years later, blockchain commodity pricing has emerged as that alternative.

If leaders within the C-suite want to avoid increased regulatory oversight and accusations of collusion and misbehaviour, peer-led collaboration is credible. It would mean an industry-led solution, with governance structures on how best to price their products – all before regulators step in and do it.

Does the market want more transparency on prices?

Full transparency sounds attractive – until it is your turn to be fully transparent. Traders have little desire to make their positions and commercial terms known in the market; this is how they make money, after all. A technological solution can find the balance between recording market activity and maintaining anonymity. Smoothing the many wrinkles in the present system takes away trading opportunities, leaving just intraday trading. But the trade-off is certainty and consistency, day after day.

There is a longstanding view that the PRAs have too much power and influence, with no independent party to challenge methodology changes on setting a price. Probably the biggest frustration has been the lack of clarity on how a price is really set. Is it based on actual trading activity? Or PRA extrapolation on yesterday’s price? Or even tea-leaf interpretation? The cost of alleviating these frustrations may be the market agreeing to anonymized transparency.

Adding liquidity, frequency and deeper analytic capabilities

Not only would such a solution add pricing liquidity with near real-time price publishing, but it would allow the PRAs and other data and analytics providers to develop new solutions for their customers. Information that has typically been reserved for the black books of the PRAs could liberate new benchmarking tools and offer instantaneous visibility of trading opportunities in different geographies.

Coupling these new pricing benchmarks with real-time inventories and live cargo tracking would easily open new trading channels not available today. Deeper and more meaningful insights would allow customers to make truly data-driven decisions.

One way to unlock LNG pricing

Our insight on LNG pricing, noted the rise in LNG being traded in the spot market. It’s now around 30%, with the participants moving towards the Japan Korea Marker that is openly targeting a more transparent price-setting process. This approach, however, still allows traders to submit false trades or indications to trade that cannot be verified by both parties.

Blockchain pricing could be the answer to unlocking LNG pricing. Many of the large project financiers of LNG are also investing and piloting blockchain solutions in trade finance and reconciliations. They were quick to see the benefits. Blockchain pricing can ensure that the 30% of LNG now trading in the spot market is not being incorrectly priced and traded.

Blockchain is often seen as a hammer looking for a nail. As with most nascent technologies coming to the forefront, the hype often creates a negative buzz. It is not the answer to all problems. But it does create unmatched value by decentralising a process or problem where trust cannot be guaranteed. In short, a perfect solution for commodity pricing.

The growth potential and pace of blockchain pricing is enormous. The Energy Transition, off-grid solutions and peer-to-peer trading will continue to disrupt global energy markets. Many of these new technologies are digitised by nature and capable of consuming vast amounts of real-time data for optimisation and decision making. There is no place in this new world for archaic, human subjectivity in setting a price.

Commodity pricing hasn’t changed in three decades. Even for the most liquid, high-value and intensively traded commodities – oil, natural gas and gold – […]

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