Commodities Lectures Series - Block Chains vs. Investment Banks in physical commodities trading

Investment Banks have commodities units that make money in three major ways:

1. By helping corporations involved in the physical side of the commodities buisness to hedge their exposure to changing commodity prices through instruments such as exchange-traded futures, options and swaps to curb the cost of big run ups in the price of raw materials needed to purchase.
2. The second way was owning physical assets that dealt directly with raw materials - for example refineries and coal mines to running gasoline storage silos.
3. The third and most lucrative way is house trading or prop trading which is done in several ways - from a client flow trade that requires the Investment Bank to take positions the bank otherwise wouldn't have wanted. For example betting that natural gas prices would fall at a time when consensus was for it to go higher. Another form of prop trading is to use internal Bank's capital to take profitable positions. By early 2000s analysts estimate that prop trading accounted for at least a quarter of Goldman's pretax income.


BCG's strategic view on the role of Block Chain in Physical commodities trading illustrated how recording commodities transactions on a blockchain results in greater transparency and fairer prices. This would seriously impact the commodities prop trading of Investment Banks which rely on informal channels such as instant messaging to negotiate deals taking advantage of price information inefficiencies.

Real-time settlement provided by Block Chains could eliminate clearing risk with fraudulent or poor quality physical delivery of goods forcing Investment Banks acting as counterparties to release collateral earlier eliminating storage profits as was the case with aluminum storage with Goldman Sachs and The London Metal Exchange.

Block Chains can also disintermediate investment banks in commodity markets with low pricing complexity and low degree of diversity in pricing mechanisms such as Power. EnerChain, the world’s first trading tool for large-scale wholesale peer-to-peer energy trading over the blockchain developed by big European gas and power companies consortium achieves exactly this disintermediation through Block chain based trust, security and transparency between the market participants.

These Consortium permissioned blockchains governed by a group of commodtities participants has the most disruptive potential to align market participants towards real-time streamlining of matching, clearing and settlement of trades, asset exchange, standardization and wholesale peer-to-peer trading. In 2019, EnHelix Marketplace, a Block Chain based marketplace to streamline scheduling, nomination, and billing operations for midstream natural gas market participants including cargo brokers, and logistics companies was unveiled at the Gastech energy conference in Singapore. This HyperLedger based distributed ledger streamlines commodities trading with applications supporting every step of the process from pre-trade KYC, trade execution to post-trade risk management with smart contracts making these energy trades faster and more organized for market participants.Consortium blockchains are more decentralized thereby resulting in higher levels of security. That being said, setting up such consortiums around physical commodities trading can be a fraught process as it requires cooperation between all the participants and presents logistical challenges as well as potential antitrust risk.

Physical commodities may be entering a new supercycle from the beginning of 2022

The US Energy Information Administration reported in early January 2022, that while energy prices in the S&P Goldman Sachs Commodity Index (GSCI) ended 2021 59% higher, most other commodity indexes included in the GSCI increased by about 20%. Sharp price increases were largely driven by increased demand from the initial phase of global economic recovery from the COVID-19 pandemic. Goldman Sachs also seems very bullish on commodities even projecting a long supercycle for years to come.

The last time physical commodities were in a supercycle was in the 2000s when commodities were rocketing to their all time highs. This supercycle fizzled to an end at the end of that decade. In October 2012, Goldman Sach's Jeff Currie, then a commodities analyst, now the global head of commodities research observed at the London Metal Exchange meeting that the collective assets under management were the lowest they had been in a decade in commodities focused hedge-funds and the average commodity fund in 2012 was on track to lose close to 3%.

Goldman Sachs gets it wrong on their predictions for India growth

Last year Goldman Sachs predicted a 6.5% growth for India in 2013. This seems a bit far fetched considering that India's GDP growth in Q3 of 2012-13, at 4.5 per cent, was the weakest in the last 15 quarters (see graphic). Goldman Sachs was it at the prediction game again citing 5 reasons for gradual pickup in India's GDP growth including the upcoming general elections and expected fiscal stimulus; expected lower interest rates to stimulate economic activity; Policy, reform push to fast-track projects; Global economy acting as a tailwind; supposed green shoots emerging in activity data. Clearly the analysts at Goldman Sachs while certainly highly educated are naively out of touch with ground reality of the Indian political scene.



More recently, ratings agency Crisil on Monday April 15th cut its 2013-14 GDP growth forecast for India to 6% from 6.4% citing weak consumption demand, stubborn lending rates and the impact of policy delays on growth which is much closer to ground reality.