Binkabi has announced a partnership to create the world’s first blockchain-based commodity exchange.
Binkabi is the common technology and liquidity layers for commodity exchanges in emerging markets.
The need for commodity exchanges in emerging markets
Centralised commodities exchanges have a long history. Grain traders in Japan began experimenting with the idea in 1730, while the Chicago Board of Trade (“CBOT”) and the London Metal Exchange (“LME”) successfully launched their operations in 1864 and 1877, respectively.
Commodities exchanges play important roles in emerging economies. Of the world’s top 10 commodity exchanges, 6 are from emerging markets. This highlights the importance of commodity exchanges as highly efficient platforms for buyers and sellers to meet; primarily to manage their price risks better, but also to improve the marketing of their physical products. They have significant, well-documented benefits, making economies more inclusive, boosting the links between agriculture and finance, and making the commodity sector more efficient and competitive.
Challenges with setting up centralised exchanges
Many attempts to set up commodities exchanges in emerging markets have failed. In Africa alone, out of 28 exchange projects, only two are in operations. The most successful is Johannesburg in South Africa. The second is the Ethiopia Commodity Exchange. However, the scope is narrow (mainly coffee and sesame) and volumes are still relatively low after 7 years in operations.
There are many contributing factors to these failures but the most significant are the high cost of setting up and operating a centralised commodity exchange and the lack of liquidity especially during the ramp-up period.
It is estimated that a single country exchange would cost a minimum $25 million and in the case of Ethiopia, $50–100 million has been spent on the exchange.
Commodity exchanges have a long ramp-up period. As successful as Chinese exchanges, it took them 25 years to get to the present position (and China has become the world’s second largest economy). Trading volumes in China only took off since 2006 (see chart), some 15 years after the set-up of those exchanges.
This lack of liquidity during the long ramp-up period and the initial high costs of setting up centralised exchanges are among major reasons for unsuccessful attempts in developing markets.
Solution: Decentralised commodity exchanges
A consumer (Buyer/Commodity processor) posts an order (spot or forwards) of a commodity. The Binkabi Network returns with a most competitive offer. A smart contract then delivers the commodity token to the consumer and pays the producer an agreed amount of payment token, after deducting a transaction fee.
For physical delivery, the commodity-backed token is redeemed and the commodity is transformed in space (through shipping, ground transport) and/or in time (storage, warehouse). These logistics along with other financial providers such as peer-to-peer lending and insurance solutions all participate in the respective market places.
Under this model, the transaction would be:
- 100% on-chain and trust-less
- Direct, cheap and quick with high liquidity (can always buy or sell any commodity)
- Catering for both spot trading and hedging needs (forwards)
- Minimising possibilities for disputes
- Equal access for all participants
Decentralised commodity exchanges based on the trading of commodity-backed tokens can dramatically lower operating costs due to the nature of online trading, its security and blockchain’s native ability for clearing and settlement (one of the major costs for operating an exchange). Decentralised trading also switches the cost structure of setting up and operating an exchange from being largely fixed to being largely variable. Therefore, it is possible to cope with low volumes during the exchange ramp-up period.
More importantly, liquidity will significantly be improved due to:
- 24/7/365 trading — compared with, say, Ethiopia Commodity Exchange whereas trading of non-coffee commodities are only possible a few hours a week)
- Global order book — a coffee roaster can buy coffee from an Ethiopia exchange but equally could buy the commodities from Vietnam, Brazil or Colombia. What matters is common commodity quality standards so the buyer knows exactly what they are buying.
Commodity hedging on the blockchain
Producers in more developed markets have an ability to manage commodity price volatilities through hedging, often with forwards and futures.
Forwards are an agreement to buy or sell a certain quantity of commodity at a certain price in a certain future. The terms of the contract are privately negotiated. It helps users to lock in a price for the commodity. It has counterparty risk (risk of default by either or both parties to the contract) and therefore is often used among known/reputable parties.
Futures are similar to forwards, but are highly standardised in terms of quality, quantity, delivery and duration. Futures are traded on a centralised exchange that guarantees its performance. As such, futures are not subject to counterparty risks. In fact, obligations under a futures contract is with the exchange, through a process called novation. The exchange ensures that parties are able to perform through collateral requirement called margining. To open a futures contract, an initial margin is made. This contract is revalued on a daily basis using the current spot price. Any shortfalls are made up by variation margin through margin calls.
Trading futures on exchanges is an efficient process. It, however, requires large volumes as the fixed cost of setting up and operating an exchange is high. This is a major reason leading to unsuccessful attempts by many developing markets in setting up centralised commodity exchanges.
Forwards on blockchain can be done peer-to-peer, i.e., without an exchange, whilst overcoming the difficulties of traditional forwards contracts — i.e. counterparty risks. It can be done in two methods:
Method 1/User case
A rice producer wants to hedge price risk, he/she can enter into a forwards contract to sell rice at $500/ton in 3 months’ time. A smart contract regulates the agreement between the parties.
Each party also locks up an amount of collateral into a multisig smart contract. This is equivalent to the initial margin in a futures contract. Each day, the amount of collateral is recalculated and any shortfall is covered by a margin call (equivalent to variation margin). The daily spot price of the commodity is fed to the margin smart contract by an oracle.
At the end of the 3 month’s period, the spot price of a ton of rice is, say, $450 the producer will be paid: $500 — $450 = $50 per ton under the forwards contract.
He/she sells the rice on a spot market and gets $450 per ton. So the price he/she gets is $450 + $50 = $500/ton.
To ensure that the contract is adhered to, there is a guarantor who will step in in case either party is unable to make the margin calls.
Method 2/Use case
In order to avoid any contract performance issues, each party in the forwards contract could limit their loss to the amount of collateral put up at the beginning (equivalent to initial margin) of the contract.
Same as above but the loss under the forwards contract is limited to an amount, say $20/ton.
Under this method, each party deposits $20/ton in the collateral smart contract. At the end of the contract’s period following scenarios could happen:
- If $480 < spot price < 500 then producer’s payout = $500 — spot price
- If spot price < $480 then producer’s payout = $20/ton
- In this scenario if the spot price is $470 then the producer can sell the commodity in the open market at $470 /ton plus $20/ton under the hedge contract. It is still $10/ton short of his target of $500/ton but he is still better off than not entering a hedging contract.
- If $500 < spot price < $520 then producer’s payout (loss) = $500 — spot price
- If spot price > $520/ton then producer’s payout = $20/ton
- In this scenario, if spot price is, say, $530/ton then the producer can sell the commodity at $530/ton in the spot market but needs to pay $20/ton under the hedging contract.
There is no need for a third-party to act as a guarantor of this contract as the full extent of potential loss by either party has been escrowed in the collateral smart contract.
Implementation — Time to get REAL!
We will first focus on tokenizing commodity warehouse receipts in countries where a legal framework for creating and trading warehouse receipts is in place. In Africa, these countries include Nigeria, Ethiopia and Ghana. This will ensure that decentralised exchange projects can start quickly and on a sound footing.
Binkabi is the ‘protocol’ layer when it comes to business and technology architecture of commodity exchanges in emerging markets.
- Off-chain order books, on-chain settlement: order books will be maintained by licensed exchanges who will match orders before settlement takes place on-chain. Licensed exchanges are focusing on customer on-boarding — AML/KYC, regulatory compliance and business development. On-chain settlement which is the shared infrastructure is done via smart contracts developed by Binkabi.
- Common liquidity pool: The idea is that a new exchange can just plug in the common liquidity pool, increasing its chance of success. Over time, the same exchange will also add to the common liquidity pool with their own clients creating a global order book.
We have deliberately opted for the above business and technology architecture because:
- There are more to exchanges than just technology. One major requirement is licensing. In most countries they are licensed as a security exchange (so security exchange commissions need to be involved. With this comes all the on-boarding and on-going compliance responsibilities.
- To ease adoption — here we are talking about farmers — ‘blockchain’ complexities need to be hidden away. Farmers will primarily deal with the exchange through a wallet facility where their commodities (represented by tokens) will be available along with their bank account. It is possible to develop other types of financial services on the same wallet (think financial inclusion!)
So far, we have announced the partnership with TAK Group, a leading agriculture conglomerate in Nigeria, in respect of the world’s first blockchain-based commodity exchange. Other partnerships are in discussion and will be announced in due course. We are well on our way to become the common technology and liquidity layers for commodity exchanges in Africa.
