Hyperliquidity: a Gathering Storm for Commodity Traders

How Digitalization is Changing Commodity Trading HYPERLIQUIDITY A GATHERING STORM FOR COMMODITY TRADERS

By Antti Belt and Eric Boudier

wide range of industries, from the recording industry are among the busi- A media to transportation, have been nesses that have already been disrupted by disrupted by digital forces. We believe that digitalization. In each case, many incum- commodity trading could be next in line. bents were in a state of denial until it was Traditional competitive advantages are too late. Such is the nature of disruption—it being challenged; traders are facing can often be hard for the businesses most increasing pressure as their role changes; immediately affected to recognize or accept and trading businesses are being forced to what is happening. For long-established rethink long-successful business models successful industries such as commodity and practices. trading, this can be especially difficult.

In this article, first of a series on the im- In commodity trading’s purest form, traders pact of digitalization on commodity make money by identifying and exploiting trading, we discuss how digitalization is pricing imperfections in the market related driving what we term hyperliquidity in com- to quality, time, and location. Historically, modity markets and how it, in turn, can traders’ most potent sources of competitive compound the effects of digital forces. In advantage in this pursuit have been access future articles, we will detail the hurdles to higher-quality market information, con- facing traders in this environment and de- trol of critical assets, and the possession of scribe how businesses can position them- superior trading capabilities, such as strong selves for success amid the challenges. trading systems, agile and entrepreneurial teams and individuals, and the ability to assess risk-reward tradeoffs adequately. Digitalization as a Disruptive Together, these levers have allowed traders Force to capture dynamic advantage.1 As the Publishing, accommodation and hospitality, reach and power of digitalization continue transportation and logistics, banking, and to expand, these sources of advantage are

For more on this topic, go to bcgperspectives.com coming under growing pressure in some data directly to trading systems. Cloud segments of commodity trading. To be sure, computing is eroding the traditional many commodities still possess characteris- advantage that trading firms have derived tics (for example, inherent heterogeneity) from their in-house IT systems and com- that will allow traditional traders to contin- puting power. Social media has introduced ue to make healthy returns in the short to an entirely new channel of information medium term. But whether such opportuni- and potential sources of value creation, ties will continue to exist as digitalization including sentiment analysis. Regulatory marches onward remains to be seen. changes are forcing greater transparency in the market, and more widespread use of Either way, traders will have their hands common technological standards is im- full. Numerous examples exist of how proving the ability to compare commodi- digital forces can marginalize human ties in some markets. capabilities. Consider the evolution of equity trading, for instance. Not long ago, a One way of gauging the effects of these stockbroker would take orders by phone factors on commodity markets is to look at from customers and place those orders on market efficiency. As the level of standard- the trading floor, known as the pit. Bro- ization and the transparency of informa- kers and market makers would shout orders tion rise, commodity markets approach to one another and make lucrative margins. increasingly high levels of liquidity and Today, the pit is a largely ceremonial place: competition, reflected in a faster pace of the real trade matching is done by ma- trading and reduced bid-ask spreads.2 chines in New Jersey. People like Charlie Hyperliquidity is the ultimate state of Sheen’s character in the movie Wall Street, commoditization, one in which a market’s stationed at a data screen in suspenders efficiency and transparency have reached and a tailored suit, are disappearing. their highest potential levels.3 A growing number of commodity markets are ap- In short, commodity traders cannot ignore proaching this state. the risk that they may soon confront the same technological challenges that have Hyperliquid markets have several upended numerous industries and laid defining traits: waste to many long-established ways of conducting business. •• Information is highly standardized and accessible, and trading is governed by relatively few standards. The Emergence of Hyperliquidity •• Market activity is handled almost Digital forces are both reducing the market entirely through an electronic platform inefficiencies that traders have long relied (one that handles mainly exchange- on and lowering the barriers for entry to traded futures or very liquid, platform- the commodity trading business. These traded, over-the-counter contracts) and forces are intertwined with a constant underpinned by an efficient infrastruc- stream of new developments in the market- ture based on algorithmic trading. place, shifts in technology, and ongoing regulatory changes. •• Decision making is increasingly controlled by algorithms fed by auto- The convergence of these factors makes mated data; human intervention is for a highly fluid environment that increas limited. ingly requires traders to move outside their comfort zone. Big data and predictive •• The bid-ask spread is tiny, typically algorithms expand the rigor of fundamen- just 1 to 3 basis points. Buyers or sellers tal analysis and make the generation of who come in with a large order, results more “real time” than ever. Infor- however, may not be able to secure mation specialists are providing structured such a bid-ask spread: competitors’

| Hyperliquidity 2

trading algorithms might detect the along the liquidity continuum. We slotted position and take steps to exploit it. each into one of five categories: low- For market participants, this places liquidity markets, transition markets, liq- a premium on smarter trade-order uid markets, highly liquid markets, and management. hyperliquid markets.4 (See the exhibit.)

•• Control over a commodity’s traded A number of these markets are moving volume is held not only by industrial quickly toward increased liquidity. These commodity players and merchant include markets of vastly different traders but also more and more by commodities, such as European power and hedge funds and a variety of pro liquefied natural gas, which currently have prietary traders and market makers very different dynamics and degrees of li- that possess algorithm-based trading quidity. At the same time, some highly liq- capabilities. uid commodity markets, such as the corn market, are moving relatively slowly to the •• Trading strategies are increasingly right on the liquidity continuum. based on speed, execution, and cross- asset trading. These strategies include European natural gas and iron ore are automatic arbitrage, high-frequency interesting examples of markets that, trading, and cross-asset (for example, while at very different stages, are moving gas-to-oil) arbitrage. strongly toward higher liquidity. Natural gas is a relatively standardized commodity We assessed 31 commodity markets, that was traditionally sold in Europe plus those for foreign exchange, equities, through long-term contracts linked to oil and government bonds, on the basis of prices. There was limited scope for market these characteristics to see where they fall expansion and increased liquidity, given

The Liquidity Continuum of Commodities Markets

LOW-LIQUIDITY TRANSITION LIQUID HIGHLY LIQUID HYPERLIQUID MARKETS MARKETS MARKETS MARKETS MARKETS

Physical oil Gold Financial oil Metallurgical Iron ore coal Aluminum Foreign exchange Wheat Natural gas Financial (EU) gas Thermal Steel coal CO2 certiﬁcates LPG Equities Power Corn (EU) Ammonia LNG Soybean Government Biodiesel Copper bonds Pulp Uranium DAP Palm oil Natural gas Sulfur (US)

Bioethanol Stainless-steel Cement Nickel tankers Biomass

Physical trade Physical trade based A developing financial Vibrant spot and An evolved execution based on long-term on a mix of spot and market and the financial markets and infrastructure, with the agreements long-term agreements emergence of financial the development of majority of volume market infrastructure adjacent markets controlled electronically

Included for reference purposes

Sources: Expert interviews; BCG analysis. Note: Arrows indicate strong movement toward higher liquidity. LNG = liquefied natural gas. LPG = liquefied petroleum gas. DAP = diammonium phosphate. EU = European Union.

| Hyperliquidity 3

pipelines’ volume and geographic limita- Price-reporting agencies have introduced tions. The deregulation of Europe’s gas smartphone apps that can facilitate more markets in the past decade, however, cou- accurate pricing of different qualities by pled with the current oversupply of natu- easing data collection; new electronic ral gas and the growing use of liquefied trading platforms (such as SonnenCommu- natural gas on the Continent, has created nity, the platform established by Germa- much more liquidity in the European mar- ny’s Sonnen for the trading of surplus ket. Simultaneously, the emergence of spot solar power) are easier to create than ever; pricing has attracted more players to the and new online platforms such as Platts market and greater pricing transparency. MVS, which provides data on iron ore, can As a result, liquidity in Europe’s trading help buyers and sellers better understand hubs, including the Netherlands’ Title the value of products relative to other Transfer Facility and the UK’s National grades or a standard. Balancing Point, has grown steadily. Con- tracts are now traded in digital platforms, Unprecedented types and quantities of and the ever-increasing need for short- data are now available. The typical evolu- term balancing of supply and demand has tion from a relatively illiquid market to a helped speed the market’s ongoing transi- highly liquid or hyperliquid one has been tion to hyperliquidity. sped up dramatically by these technologies. Metallurgical coal, for example, was a very Iron ore was a typical low-liquidity market illiquid market because of the wide variety until the emergence of a spot market for of coal quality and contracts, the relatively the commodity in 2010. Since then, liquidi- small number of producers, and coal’s com- ty has grown rapidly, enhanced by the re- plex valuation economics. However, the porting of iron-ore prices by publications emergence of electronic platforms such as such as Metal Bulletin and by the increased globalCOAL, with its standard coal-trading prominence attached to iron ore on China’s agreement, SCoTA, is causing metallurgical Dalian Commodity Exchange. We expect coal to become increasingly liquid. the liquidity of the iron ore market to continue to grow and note the commodity’s The trend toward hyperliquidity in com- now very tight bid-ask spread. modity markets is also being driven by a push from regulators and platform players for greater standardization and the Drivers of Hyperliquidity establishment of trade repositories, which What pushes a commodity market toward further increases transparency and makes hyperliquidity? We believe that there are the markets’ economics easier to quantify. three main forces: an increasing degree of standardization, greater transparency Greater Transparency of Information. of information, and the emergence of an Commodity traders seek to gain and advanced digital infrastructure. exploit information advantage—that is, access to superior information. Indeed, the An Increasing Degree of Standardization. absence of full information transparency Standardization fosters commoditization and availability is a precondition for and, ultimately, hyperliquidity by facilitat- traders’ traditional business model—and ing comparisons between and among goods the lack of transparency concerning on the basis of quality, time, and location. It individual commodities can be sizable. also helps facilitate more accurate valuation Consider physical oil, for example. A of goods. Physical oil, for example, has fragmented pool of suppliers and buyers, hundreds of qualities; power, by contrast, logistical bottlenecks, and transportation has uniform quality by its nature and hence limitations have long contributed to a is more prone to hyperliquidity.5 significant lack of information transpar ency. The International Energy Agency New digital technologies help drive notes that hundreds of thousands of standardization much more quickly. barrels of oil go unaccounted for every day.

| Hyperliquidity 4

Traders have long sought to take advan- works revolutionized over-the-counter tage of such phenomena. trading in equities; such platforms are now emerging in commodities markets. These Technology can significantly improve the platforms offer speedier, cheaper, and often transparency of information in commodity better execution of trades than incumbent markets, pushing them toward hyper systems. Innovations, such as blockchain liquidity. More and better data allow technology, offer solutions to age-old chal- market players to price quality and geo- lenges related to trade clearing and graphic differences more accurately. Spe- reporting. High-frequency trading, a cialist data providers gather information particular subset of algorithmic trading, has from sources such as satellite imagery, net- also prompted exchanges to develop work frequencies, and truck traffic; pool it algorithm-testing facilities to prevent together electronically; and supply it to predatory behavior. traders. Machines can run through this data in real time using algorithms and make rec- ommendations to traders, or even initiate n digitally driven hyperliquid markets, trades on their behalf, at speeds far exceed- Iinformation moves, and decisions are ing human capabilities. made, in a matter of milliseconds and the amount of data moved per day is measured Regulation, such as the Dodd-Frank Act, in terabytes or even petabytes. Traditional can also push markets toward higher trans- market inefficiencies are shrinking, and parency and liquidity. Regulators can only computer algorithms are more and more do so much, however, without the industry likely to outperform humans. This evolution itself pushing for greater transparency. of the trading environment has profound implications for commodity traders, present- The Emergence of an Advanced Digital ing both enormous challenges and substan- Infrastructure. To enable hyperliquidity, an tial opportunities. In the following articles extremely efficient digital infrastructure in this series, we will expand on those chal- that can handle an exponential increase in lenges and explain how hyperliquidity is the flow of information must be present or testing existing business models in all parts developing. Typically, this means creating of the commodity-trading value chain. efficient matching engines, which bring buyers and sellers together; incentivizing liquidity generation in new ways; and estab- Notes lishing direct market access to these match- 1. For discussions of how companies can create advantage, including dynamic advantage, in ing engines through an application pro- commoditizing markets, see “Escaping the Dog- gramming interface. The creation of such a house: Winning in Commoditized Markets,” BCG structure allows players to send quotes Perspectives, April 2015, and “The Art of Embracing Commoditization,” BCG Perspectives, July 2016. to the platform directly. It also enables the 2. Liquidity ultimately refers to market participants’ use of machine trading for either improved ability to secure fair prices. It is often measured execution of trades initiated by humans or by the volume of trades and the size of the the replacement of human traders difference between the best bid and ask prices, or the bid-ask spread. altogether. Nearly all major commodity 3. Commoditization occurs when the market exchanges are pursuing these mechanisms perceives products to be substitutable. It is to enhance market access. But many predominantly driven by the emergence of a exchanges are still struggling to determine standard design or technology in the marketplace, an increase in the transparency of pricing and the specific capabilities necessary to handle product features, or both. the rapidly growing number of transactions. 4. Markets for premium goods and services would be further to the left in the exhibit. Even in cases where an advanced digital in- 5. While oil has inherent heterogeneity, it is not immune to increasing liquidity. Digital forces are frastructure is already well established, new making it possible to quantify the value of differen- technologies keep pushing the boundar- ces in crude quality (known as “netback calculati- ies—and pushing markets closer to hyper ons”) instantly and precisely, exposing oil to some degree of additional commoditization pressure. liquidity. Electronic communication net-

| Hyperliquidity 5

About the Authors Antti Belt is a principal in the Helsinki office of The Boston Consulting Group and a core member of the firm’s Energy practice. You may contact him by e-mail at [email protected].

Eric Boudier is a senior partner and managing director in BCG’s Oslo office, the leader of the firm’s commodity trading and risk management sector, and a BCG Fellow. You may contact him by e-mail at [email protected].

Acknowledgments The authors would like to thank Esben Hegnsholt for his contributions to this article.

The Boston Consulting Group (BCG) is a global management consulting firm and the world’s leading advi- sor on business strategy. We partner with clients from the private, public, and not-for-profit sectors in all regions to identify their highest-value opportunities, address their most critical challenges, and transform their enterprises. Our customized approach combines deep insight into the dynamics of companies and markets with close collaboration at all levels of the client organization. This ensures that our clients achieve sustainable competitive advantage, build more capable organizations, and secure lasting results. Founded in 1963, BCG is a private company with 85 offices in 48 countries. For more information, please visit bcg.com.

| Hyperliquidity 6