In our globalized world, much of our food — as well as the animal feed and other inputs which become the food we eat — is produced far from where it is consumed. Before arriving on supermarket shelves it is traded on international markets and moves through global supply chains. Most countries aren’t self-sufficient and rely on imports for food. They depend on several breadbaskets — countries like the US, Brazil, Russia or Ukraine — that produce more crops than they consume domestically. When exports from these countries are disrupted, the problems quickly cascade — as evidenced by the global food crises of 2008 and 2011, and again today. However, agricultural commodity prices were already at record highs, well before the war in Ukraine severely exacerbated the situation.
Last year the United States went through the hottest summer ever measured, breaking the record set during the Dust Bowl of 1936. In the northern Great Plains, extreme heat combined with extreme drought brought swarms of grasshoppers, decimating the wheat crop. Wheat prices reached their highest level in years. Corn prices rose 45 percent. Meanwhile, Brazil, the largest exporter of soybean and coffee and second only to the US in corn, suffered its worst drought in 91 years. Then a surprise frost struck Brazil’s coffee belt in July, damaging the drought-stricken arabica trees as the buds that will become next year’s flowers fell off — creating 2 harvests failures in one season. The price of coffee today is double that of 2020. In Canada, the worst drought since 1961 doubled pea prices (alternative-meat has made peas more popular than ever).
Climate change is affecting agriculture worldwide, as increasing water-scarcity, rising temperatures and extreme weather events have diminished harvests in numerous countries. Across the globe, farmers will nevertheless need to grow more, because demand will continue to increase. By 2050 there will most likely be two billion people more on Earth and by the end of the century there will be another 1.5 billion. Average global crop yields — the amount of crops harvested per unit of land cultivated — are increasing too slowly to meet that need, while urbanization and underinvestment in agriculture make this situation worse.
It is important to understand the systemic risk of supply volatilities. China, for example, is by far the largest consumer of wheat in the world and only second to the United States in consumption of corn, yet it is almost self-sufficient in production of these crops. When their domestic reserves dwindle due to climate-induced harvest failures, it may force local buyers to import substantially more grain to meet demand, taking a significant chunk out of global supplies — in turn impacting prices and food security worldwide.
Traders perform a vital role in getting food from surplus to deficit regions
Intermediaries are crucial in absorbing such market volatility, as they swiftly move commodities around the world from surplus to deficit regions. Traders are present throughout the supply chain, not just shipping commodities from A to B, but also storing, processing (milling/crushing) and consuming them (for example in meat production). They bring enormous efficiencies to the market, allowing countries to move away from the ancient practice of hoarding grain. Without traders, global food security simply would not exist — especially under market conditions like we have today.
That doesn’t mean there is no room for improvement. The physical agricultural commodity trade has not fundamentally changed over the last 40 years and relies on processes that are even older. From the coffee you drank this morning, the wheat in your croissant, to the feed for the animals or palm oil (present in half of all packaged products in supermarkets, from pizza and chocolate, to deodorant, shampoo and toothpaste) — all of it is traded over the phone, executed by email, made binding with various hard copy contracts and involving many different intermediaries.
This results in high operational costs, complex execution and a lack of transparency with little market data to enhance decision-making. The UN estimates that more than 275 million emails are exchanged annually to process about 11,000 shipments of grain transported across the oceans. That is 25,000 emails per shipment between all parties involved! The market is entirely offline, although with more than $30 trillion dollars transacted physically and in over-the-counter derivatives, agricultural commodity trade is arguably one of the largest untapped e-commerce opportunities out there.
Most trading companies, however, do not just buy and sell physical commodities, they also leverage their knowledge and insights in the derivatives markets. In fact, proprietary trading is a significant part of revenue for the major trading companies. Usually a multiple of what is physically traded and this is reflected in the derivative markets, where the total volume in soybean futures contracts was around 27x greater than the volume harvested worldwide in 2020 (corn futures 12x larger, wheat 10x larger). The financialization of commodity futures markets plays a part here too, as hedge funds, pension funds and other financial investors also trade futures — although they have no interest in ever taking delivery of bulk corn or soybeans.
Commodity trading is all about fundamentals
The way the physical and derivative markets are connected is what makes agricultural commodity trading unique. In the end, the physical and futures contracts converge in a rational response to supply and demand. They reflect reality. Most other financial markets are not rational at all, with much more noise, non-fundamental volatility, and less convergence. Take equity markets, where celebrities nowadays sell shares in shell companies and social-media mobs can drive prices.
Commodity trading is all about fundamentals or changes to supply and demand (crop, weather, logistics, etc). Research is critical. Long before anyone in Silicon Valley talked about big data, commodity traders were aggregating data from thousands of farmers to get a real-time insight into the state of the markets. As data availability increased, algorithmic and high-frequency trading moved into commodity derivatives markets — especially after open outcry disappeared in the early 2000s. Arguably, algorithms are better equipped to find arbitrages and price agricultural commodity derivatives, due to the rational nature of these markets.
Many commodity trading companies saw this opportunity and investments in quantitative trading have been on the rise. Instead of relying on extensive traditional information networks to gain advantages from proprietary data, traders invest in sophisticated systems and dedicated teams to use predictive analytics to draw valuable proprietary insights from common data sources. They now combine quantitative approaches with strong fundamental research.
Our vision is that these trends will further drive liquidity and competition in the commodity markets — resulting in faster trading and reduced spreads. Hyperliquidity is the ultimate state of commoditization, where markets’ efficiency and transparency reach their highest potential levels. Three main forces push commodity markets towards hyperliquidity: an increasing degree of standardization, greater transparency and the emergence of an advanced digital infrastructure. The most liquid agricultural products (corn, soybeans and palm oil) are already highly standardized and the increasing availability of information has been pushing the industry towards digitalization for some time. The global pandemic has accelerated it. What is missing is the digital infrastructure and with climate risks to global food security mounting, this evolution will be key to building systemic resilience.
Digitizing the physical commodity trade enables a crucial upgrade of derivatives markets
That is why we are determined to bring the physical markets online. We’ve built an exchange environment for the global spot and forward trade in grains and oilseeds, currently in beta with all of the leading global commodity trading firms and key buyers participating. This enables trade by increasing efficiency, market participation and compliance, while reducing cost and errors. Besides the physical commodity market, we also digitize existing (brokered) over-the-counter ‘paper’ forward trade. This trade fills a major gap between the futures and physical markets — the most liquid futures market (Chicago Board of Trade or CBOT) offers mainly derivatives based on US products, which do not correlate with for example Russian wheat or Brazilian soybeans (while products meant to solve this issue, such as Black Sea futures, do not converge well). Unlike regulated exchanges however, we don’t offer central clearing. Thus we do not compete with traditional derivatives markets in terms of counterparty risk. Decentralized futures — or perpetual swaps to be precise — could change that.
In traditional derivatives markets, futures contracts are marked for delivery of the commodity in question. For example, corn should be delivered according to the contract when the futures contract expires. Therefore someone is physically holding the corn, which results in ‘carrying costs’ for the contract. Additionally, the price for corn may differ depending on how far apart the current time and the future settlement time for the contract is — this risk of variation between the price of a deliverable commodity and the price of the futures contract is called basis risk. Moreover, holding on to a futures contract also requires that you periodically roll over the contract into a new contract, before the contract’s expiry — creating more basis risk. As the gap widens, the contract’s carrying costs increase, the potential future price becomes more uncertain, and the potential price gap between the spot and futures markets grows larger. This leads to major issues when using futures to hedge physical commodity positions, which the majority of farmers, traders and end users do. The current dislocation in the Black Sea for example, has rendered the wheat futures markets all but useless for hedging purposes.
In 1992 Yale’s Robert Shiller therefore proposed perpetual swaps, with a method for generating asset-price indices through hedonic regression. Perpetuals are synthetic, which means they do not represent or securitize the underlying asset. Instead, it utilizes a periodic ‘funding’ schedule to tether its price to the spot price of the underlying asset. The perpetual is an attempt to take advantage of a futures contract — specifically, the non-delivery of the actual commodity — while mimicking the behavior of the spot market in order to reduce the price gap between the futures price and the price of the underlying commodity.
Only recently did perpetuals start trading broadly, in cryptocurrency markets ($195b daily vol). In May 2016 BitMEX first offered them and instantly became popular as it permits highly-leveraged trading at different time-horizons, without significant counterparty risk in the absence of regulated intermediaries. Due to its synthetic nature, you can trade much more volume than would be possible by the actual circulating liquidity of the underlying asset. The volume is essentially only limited by open interest.
So how does it work? As described, the instrument is tethered to an asset synthetically. Unlike a future, which is a contract to buy or sell an asset at a particular price in the future, perpetuals simply track the price of the asset using incentives based on price indexes. There is no need to actually fulfill the contract or hold the underlying asset. No need for a central clearing counterparty and algorithms will perform functions in the futures markets now entrusted to brokers, called futures commission merchants in futures markets. Like any futures contract, you can take a long/buy position, or a short/sell position. To price the instrument, the market displays an index from multiple exchanges, which is managed off-chain to prevent delays in updating and slippage (price changes between placing your order and execution). At certain intervals, say every eight hours, the prices of the longs and short are compared to the index price, and those on the right side of the trade pay the counterparty (called funding). This creates a powerful incentive to keep the price of the perpetual in sync with the spot price, as any difference would present an arbitrage opportunity for a trader.
Digitizing the physical agricultural commodity trade creates unique pricing benchmarks backed up by real trades, and presents a foundation for new financial instruments such as perpetuals. These will give retail investors an opportunity to participate in the agricultural commodity markets directly, while enabling institutional investors to take deep positions in specific markets, like short soybean Brazil or long milling wheat Indonesia. Traders will have more ways to capitalize on information advantages and the increase in liquidity would allow all industry participants — farmers, traders, millers, crushers and manufacturers alike — to reduce basis risk. This is exactly what you want when growing demand faces a dwindling supply; volatility can pay off nicely in trading, but it never does for the people that rely on imports for food.
More liquidity results in faster reactions from the market, guaranteeing that price movement happens in anticipation of the actual event, thereby solving the problem before it occurs. Financial investors thus help guarantee food security. 99% of futures are already traded without delivery of the underlying commodities. This liquid market helps farmers decide what to plant, while also offering them the opportunity to sell their crop whenever they want to sell and for the food manufacturers to buy ingredients when they need it (ultimately exchanging the futures for physical contracts). This efficiency allows countries to keep less inventory than they would otherwise have. We need to finetune that system, by creating a liquid digital spot and forward market, to which we can connect a decentralized futures market. Central clearing may become obsolete, but this evolution would be far from disruptive — the world needs more participants in agricultural markets. The higher the liquidity, the better these markets function and the better it is for everyone. We need tools to manage risk and commodity flows in a world where climate risks are ever increasing. We need to build the infrastructure for the future of food security.