Decentralized Finance in Commodities Markets

Aug 12, 2020

Decentralised Finance (DeFi) is a term used to refer to innovations in capital markets that rely on blockchains. Instead of using conventional financial rails such as banks or credit transfer APIs, DeFi based projects work entirely on blockchains without the requirement of central clearing houses or banking personnel checking transactions. This makes it possible for DeFi based ventures to be internet-scale, global ventures without having a presence in countries around the world.

The most prominent among this class of digital first, blockchain native ventures is MakerDAO. It has over a billion dollars in collateral in the form of digital assets such as Ethereum tied in it for lending — which is then used for trading or day-to-day purchases. Similarly, KyberDAO has enabled digital assets worth over a billion dollars to be traded. This growing, digital native infrastructure is empowering the next wave of financial applications to be built.

There is a catch though. The current generation of DeFi ventures are restricted to using digital assets when it comes to trading and lending. This means traditional instruments such as commodities swaps, futures or even lending against real life assets such as a house is not possible. This restricts the ability of the ecosystem to scale meaningfully enough to meet the needs of global financial markets today.

For a scale comparison, the total value locked in DeFi ventures today is around $5 billion. The size of the global commodities market in comparison is approximately $2.5 trillion. The race to plug off-chain assets such as physical goods to on-chain finance is at the crux of what will enable the next generation of DeFi applications. There are a number of networks that are working towards this through the approach of synthetic instruments.

Beyond blockchain based assets

Synthetic instruments on blockchain networks is one approach to representing real-life assets on these networks. How does that work? The equivalent of the asset’s value is tied up in a smart contract and another token is issued to represent that asset. Instruments like gold, foreign currencies and digital asset indices can be purchased on a project named Synthetix. The risk here is if the underlying asset (ie — the asset used as collateral) fluctuates greatly in value, the synthetic instrument can be liquidated. Another approach to doing this is what UMA Protocol is currently doing. Instead of tying up the value of the entire asset itself, a small fraction of the asset’s fluctuations are tied up in a smart contract. The parties involved in buying the asset are responsible for seeing if the new synthetic instrument is backed by sufficient collateral or not. The challenge here is that it requires constant monitoring of the asset’s price.

Commodities and real world assets as an avenue for DeFi

The traditional commodities market also has a number of problems — transparency, liquidity and the prevalence of margin calls in futures trading. Furthermore, outside of the traditional commodities covered by the major exchanges such as CME.

The commodities market — one that moves over $2.5 trillion worth of assets each year, sees its share of front running, price manipulation and loss of value in the form of margin calls routinely. Ethereum’s smart contract based “decentralised finance” ecosystem is the first step towards removing middle-men from complex financial products. However, limitations in how complex these contracts can be make it difficult to create the next generation of financial tools. Fetch.ai proposes a new financial ecosystem one suited for the digital economy. We lay a simple framework for how we envision it to be working.

Commodities trading on Mettalex

Fetch.ai solves this through the creation of what is referred to as position tokens. Position tokens are primarily used to track the difference in price of an asset. They do not require the entirety of collateral of an asset to be tied up in a smart contract, thereby allowing contracts of much larger sizes to be traded with lower collateral requirements. This is also different from the conventional leverage requirements in traditional markets as the possibility of a liquidation is not dependent on basis of the movement of prices until it hits a pre-set price band.

Fetch.ai based position tokens instead trade within a specific price-band that has been noticed to be common for the asset. In the case of steel futures on LME this is around $150 — between $225 and $375 (refer image). Position tokens are only valid within this price-band. In the event that the price goes beyond the upper or lower limits, the automated market-maker settles it immediately.

What does this mean? Assume an individual shorted an asset (that is, bet the price would go lower). And the price increased substantially instead. The position tokens will not be liquidated until the value of the short tokens goes down to $0. At which point, the short tokens will be settled against long-tokens to clear the positions and issue new tokens.

The upside and downside of these markets are restricted to the capital that is used to mint position tokens and do not provide leverage outside it — thereby reducing the possibility of a domino effect that comes from multiple leveraged products used within a restricted, derivatives based economy. These position tokens will not require an exchange for settlement but will rather be monitored and settled through Fetch’s automated market-making system. Individuals that provide idle assets to issue these position tokens are rewarded in governance tokens (the right to determine how the system functions) and transaction fees from trades done on the network.

Why does this matter?

Consider the example of a manufacturer that has exposure to steel prices for production in a traditional commodities market. In order to hedge against a substantial price hike, they could take a leveraged trade through an exchange. At 10 times leverage, they will need to tie up only 10% of the capital. This leveraged position will act as a hedge in manufacturing cost if the price of Steel went up substantially. However, in cases where the price collapses by about 10% or more and then recovers, the manufacturer risks losing the initial amount they took the leveraged position with in the event that the price of the asset recovers.

In contrast, position tokens are not liquidated as long as the price of the asset is within the bands specified by Mettalex. More importantly, democratising access to the commodities trading market for a more global crowd while incentivising them to do so with governance tokens that represent ownership in the system will give the users the right to decide how Fetch.ai handles these markets in the future.

Other innovations also enable new ways for the market to operate. On Mettalex, you a participant can create spreads and take exposure on a spread as the commodity passes between two states, e.g. between Copper Ore and Copper Cathode (raw material to finished good), this is a very useful tool for traders who are actually taking a raw material and moving it along a production process, with price risk built into that timeline. This instrument creation in traditional markets is very cumbersome, and hints at what digitisation means in the context of these markets.

A market ripe for disruption

With decentralised technology the cost of creating markets and onboarding stakeholders is reduced dramatically. We are bringing this to the traditional commodities market where the process of creating a new market is marred with roadblocks. We believe this new way of doing things is a game changer. Trillions of dollars of trading and new markets can be unlocked solving existing liquidity and access problems for a huge market, and building value for all stakeholders.

A market for the commodities of the future

Fetch.ai will be offering two-way contracts that empower the average individual to take on risk or offset them for assets that are not traded in conventional markets today.

Fetch.ai is focused on creating economic activity in new markets which do not exist yet, but will be enabled by decentralised markets empowered by multi-agent systems.

One place this is needed greatly today is for data-based asset such as pricing for hotels in a region or car rentals. This information does not have a ready repository third parties can plug into and use today. At the same time, businesses incur huge legal and operational costs due to the legal challenges of storing that data in a compliant enough fashion. Fetch.ai’s agents will make it possible to create a market for these assets in the future.

As commerce becomes more global, and barriers in trade are reduced with the web and faster air travel, the need to create benchmarks to compare regional service offerings becomes more predominant. Agent-based curation for travel will be possible only if price discovery is made possible. In order to kick-start this, we will also be creating a market for individuals to be able to contribute regional pricing data for commodities such as car rentals and hotel bookings among many others. This will help create an economy where our agents will be able to act upon price data that is fed in real time and create new economic opportunities for stakeholders within our network.

We anticipate this will create a substantially higher demand for tokens in our network. The financial world went from analogue to digital in the past twenty years. In the next two years, we hope to make it considerably more autonomous.