Managing Director & Partner
Digital forces are changing the way commodities are bought and sold in the marketplace. And this trend is transforming the commodity-trading value chain and redefining sources of competitive advantage, redistributing as much as $70 billion in trading value in the process.
In this third in a series of articles on the impact of digitalization on commodity trading, we explore the forces that are altering the power balance among the industry’s titans: brokers and banks, merchant traders, industrial commodity companies, exchanges and trading venues, and service providers. We also identify steps that these players can take in response to the challenges they face and discuss emerging sources of competitive advantage.
Commodity traders make profits by monetizing market imperfections, including those related to quality, time, and location. The value of a given trade is determined by the size of the imperfections minus the trader’s “friction costs” of infrastructure, handling, and other operating expenses. On the basis of our analysis of world commodity flows and typical trader margins and operating expenses, we put the industry’s potential annual value pool today at $70 billion.
As the various commodity markets move toward hyperliquidity (the state in which a market’s efficiency and transparency are at their highest possible levels), the pie shrinks. But the prize remains substantial. Who will win the new fight for market share? (See Exhibit 1.)
In recent years, the industry’s profits have been shared among five major groups of players: brokers and banks, merchant traders, industrial commodity companies, exchanges and trading venues, and various service providers. The profit proportions have been determined by the groups’ respective abilities to leverage the industry’s traditional sources of competitive advantage: access to information, control of (or access to) assets, and trading capabilities.
As digitalization advances, however, and as more commodity markets (European gas and power markets, for example) approach hyperliquidity, the sources of competitive advantage are changing. (See Exhibit 2.) Information is becoming more vast in scale and scope and, simultaneously, more widely available. Thanks to asset securitization and the decentralization of production assets, such as power plants, various players are finding it easier to gain access to, and control of, assets. Trading capabilities, traditionally based largely on human skills, are evolving rapidly and are increasingly characterized by algorithm-based decision making, which uses advanced analytics. And the technology underpinning these new trading capabilities is becoming more widely available.
The upshot is that incumbents’ established business models are becoming less and less relevant.
Compounding the challenge for these companies, new competitors, most notably service providers, are entering the arena. The newcomers further alter the competitive terrain and could materially change the industry’s balance of power.
Each of the five groups of players faces its own challenges and opportunities. Within each group, some firms could weather the storm and thrive; others could see their businesses fundamentally disrupted.
Brokers and Banks. The traditional business model employed by brokers and banks, which focuses on providing market access and liquidity to clients and on using information to the company’s advantage, is at the frontline of disruptive change. Brokers, such as Clarksons and Global Coal, are typically independent and offer liquidity and financing to customers by connecting buyers and sellers; these companies do not, themselves, take positions in the market. Banks that operate commodity desks, such as Goldman Sachs and JPMorgan Chase, provide market access and financing. In markets that are more liquid (crude oil, for example), they often offer risk management services.
Digital forces will put growing pressure on these businesses by ushering in several significant challenges:
We already see the effects of these challenges. Multiple commodity trading desks at these businesses have closed in recent years, and the closings seem likely to continue unless banks and brokers rethink their value proposition. To remain in the commodity business, banks and brokers will probably need to add services and other value-creating elements to their offerings. They could, for example, support algorithm-based trading, consult on hedging strategies, or offer structured products through digital platforms.
Merchant Traders. Merchant traders such as Vitol, Trafigura, and Cargill operate as optimizers of commodity flows between suppliers and end customers. They create value through their ability to access critical assets, blend or disaggregate products or product elements, collect proprietary information, manage financing, and connect market players through their global reach.
Merchant traders have been quite agile in adapting to changing market environments in the past. Their traditional competencies and edge in information created a winning recipe. As digitalization marches onward, however, we see a number of challenges for them:
To negotiate the new environment, merchant traders will need to continue their history of agility and adaptation. This time, however, the changes they face are likely to come much more quickly, putting a premium on flexibility and speed.
Merchant traders will need to find ways to create proprietary information flows—for example, by partnering with suppliers and inserting information-gathering sensors in suppliers’ value chains. They will also need to make greater use of algorithm-based analytics and the trading of securitized assets. This will necessitate cross-commodity analytical platforms, which many merchant traders do not have. Merchant traders must also place greater emphasis on risk management, which becomes increasingly important as the market accelerates and the correlations between asset classes (between equities and commodities, for example) change.
Merchant traders should not discount the threat that digitalization poses. In many markets, logistical bottlenecks and inherent differences in commodities’ physical qualities and credit risk profiles make the incursion of digitalization seem a distant possibility. But signs of digitalization are already apparent in some of the most illiquid markets. Digitalization can fundamentally change merchant trading’s business model, both by aiding traders and, eventually, by replacing large segments of human-based analytics and trading. Merchant traders must recognize this possibility and prepare to respond with new competencies.
Industrial Commodity Companies. Industrial commodity companies, such as mining players BHP Billiton and Anglo American, oil companies Total, Shell, and BP, and utilities Vattenfall and Uniper, are cornerstones of the global industrial landscape. They operate in all parts of commodity value chains, from upstream production to transformation and distribution. Some of them have also built significant trading and marketing arms. These companies are thus fully exposed to the forces affecting the commodity-trading landscape.
As digitalization makes markets more efficient, these companies will benefit from fairer price formation and increased transparency. Many industrial commodity players that have built value chain optimization and trading arms, however, will come under increasing pressure from digital technologies. The challenge is likely to play out across a number of dimensions:
To maintain their profitability in the face of these forces, industrial players will need to assess their position in the trading value chain. Which parts of the chain should they own themselves or with a partner, and which parts should they outsource? These companies will also need to become even more digitally integrated—by digitalizing their information flows and steering processes, for example, to enable their physical assets and supply chain to adapt in real time to changes in the market, including changes in commodity prices.
Exchanges and Trading Venues. Commodity exchanges and trading venues operate platforms that allow players to trade securities. Exchanges such as the Intercontinental Exchange and the Chicago Mercantile Exchange handle trades that are governed by standardized contracts. The exchanges match trades automatically, often using limit-order techniques. Participants don’t know who is on the other side of their transactions, and the trades are cleared, which eliminates counterparty risk. The platforms offered by generic trading venues, such as Trayport, handle trades that are governed by less standardized, over-the-counter (OTC) contracts.
Driven by digitalization, the volume of electronically traded commodities is steadily increasing, and this trend will likely lead to a number of changes for exchanges and trading venues:
To cope with these changes, commodity exchanges and trading venues need to find ways to adjust their commercial model to create additional revenues and attract liquidity. Possibilities include services such as co-location (that is, placement of a company’s computers that contain its trading algorithms next to an exchange’s matching engine to enable faster trading) and direct, ultra-quick feeding of price data, and new business models, such as the “rebate” systems that trading platforms have introduced to boost liquidity in the trading of equities. Platforms and exchanges will also need to invest in IT architecture that can keep up with the demands that arise from greater volume and rising performance standards.
Service Providers. Historically, most commodity trading firms maintained their own in-house value chains, so they owned the customer interface, data, systems, traders, and back-office functions. However, as discussed in our previous article, such end-to-end ownership of the trading value chain has become less common. Specialist service providers, such as Quandl, Contix, and Likron, are changing the value chain’s economics—and capturing a growing share of the prize.
These newcomers offer specialized data, algorithmic expertise, processing capacity, and other types of digitally enhanced services. Their offerings have the potential to further enhance the trading value chain’s efficiency, profitability, and costs—and to further undermine the economic logic of a single trading firm’s owning and operating its own end-to-end value chain. The newcomers also pose challenges to established service providers.
Although most of these new service providers are still expanding and exploring their operating space, it is clear that their growth prospects are sizable. Growth potential stems from several digitally driven factors that are affecting incumbents (namely, brokers and banks, merchant traders, industrial commodity companies, and exchanges and trading venues):
Traditional service providers will still find opportunities in this rapidly evolving environment. But they need to reassess their value proposition in the face of the new challengers and continue to expand their use of digital technologies if they hope to keep pace.
As digitalization redefines the commodity-trading value chain and puts cracks in existing ways of doing business, the requirements for success are changing. To win in this environment, competitors need to retool and reshape themselves across all three traditional sources of advantage:
The commodity-trading arena finds itself at a crossroads. For most players, making the changes necessary to remain competitive will be a tall order, but the task is ultimately achievable—and critical to success. In the next and final article in this series, we will expand on the capabilities various players need and discuss the opportunities they have to strategically reposition themselves.
For the first two articles in this series, see “Hyperliquidity: A Gathering Storm for Commodity Traders,” BCG article, November 2016, and “Attack of the Algorithms: Value Chain Disruption in Commodity Trading,” BCG article, January 2017.