What pushes a commodity market toward hyperliquidity? We believe that there are three main forces: an increasing degree of standardization, greater transparency of information, and the emergence of an advanced digital infrastructure.
An Increasing Degree of Standardization. Standardization fosters commoditization and, ultimately, hyperliquidity by facilitating comparisons between and among goods on the basis of quality, time, and location. It also helps facilitate more accurate valuation of goods. Physical oil, for example, has hundreds of qualities; power, by contrast, has uniform quality by its nature and hence is more prone to hyperliquidity.
New digital technologies help drive standardization much more quickly. Price-reporting agencies have introduced smartphone apps that can facilitate more accurate pricing of different qualities by easing data collection; new electronic trading platforms (such as SonnenCommunity, the platform established by Germany’s Sonnen for the trading of surplus solar power) are easier to create than ever; and new online platforms such as Platts MVS, which provides data on iron ore, can help buyers and sellers better understand the value of products relative to other grades or a standard.
Unprecedented types and quantities of data are now available. The typical evolution from a relatively illiquid market to a highly liquid or hyperliquid one has been sped up dramatically by these technologies. Metallurgical coal, for example, was a very illiquid market because of the wide variety of coal quality and contracts, the relatively small number of producers, and coal’s complex valuation economics. However, the emergence of electronic platforms such as globalCOAL, with its standard coal-trading agreement, SCoTA, is causing metallurgical coal to become increasingly liquid.
The trend toward hyperliquidity in commodity markets is also being driven by a push from regulators and platform players for greater standardization and the establishment of trade repositories, which further increases transparency and makes the markets’ economics easier to quantify.
Greater Transparency of Information. Commodity traders seek to gain and exploit information advantage—that is, access to superior information. Indeed, the absence of full information transparency and availability is a precondition for traders’ traditional business model—and the lack of transparency concerning individual commodities can be sizable. Consider physical oil, for example. A fragmented pool of suppliers and buyers, logistical bottlenecks, and transportation limitations have long contributed to a significant lack of information transparency. The International Energy Agency notes that hundreds of thousands of barrels of oil go unaccounted for every day. Traders have long sought to take advantage of such phenomena.
Technology can significantly improve the transparency of information in commodity markets, pushing them toward hyperliquidity. More and better data allow market players to price quality and geographic differences more accurately. Specialist data providers gather information from sources such as satellite imagery, network frequencies, and truck traffic; pool it together electronically; and supply it to traders. Machines can run through this data in real time using algorithms and make recommendations to traders, or even initiate trades on their behalf, at speeds far exceeding human capabilities.
Regulation, such as the Dodd-Frank Act, can also push markets toward higher transparency and liquidity. Regulators can only do so much, however, without the industry itself pushing for greater transparency.
The Emergence of an Advanced Digital Infrastructure. To enable hyperliquidity, an extremely efficient digital infra structure that can handle an exponential increase in the flow of information must be present or developing. Typically, this means creating efficient matching engines, which bring buyers and sellers together; incentivizing liquidity generation in new ways; and establishing direct market access to these matching engines through an application programming interface. The creation of such a structure allows players to send quotes to the platform directly. It also enables the use of machine trading for either improved execution of trades initiated by humans or the replacement of human traders altogether. Nearly all major commodity exchanges are pursuing these mechanisms to enhance market access. But many exchanges are still struggling to determine the specific capabilities necessary to handle the rapidly growing number of transactions.
Even in cases where an advanced digital infrastructure is already well established, new technologies keep pushing the boundaries—and pushing markets closer to hyperliquidity. Electronic communication networks revolutionized over-the-counter trading in equities; such platforms are now emerging in commodities markets. These platforms offer speedier, cheaper, and often better execution of trades than incumbent systems. Innovations, such as blockchain technology, offer solutions to age-old challenges related to trade clearing and reporting. High-frequency trading, a particular subset of algorithmic trading, has also prompted exchanges to develop algorithm-testing facilities to prevent predatory behavior.
In digitally driven hyperliquid markets, information moves, and decisions are made, in a matter of milliseconds and the amount of data moved per day is measured in terabytes or even petabytes. Traditional market inefficiencies are shrinking, and computer algorithms are more and more likely to outperform humans. This evolution of the trading environment has profound implications for commodity traders, presenting both enormous challenges and substantial opportunities. In the following articles in this series, we will expand on those challenges and explain how hyperliquidity is testing existing business models in all parts of the commodity-trading value chain.
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While oil has inherent heterogeneity, it is not immune to increasing liquidity. Digital forces are making it possible to quantify the value of differences in crude quality (known as “netback calculations”) instantly and precisely, exposing oil to some degree of additional commoditization pressure.