A multitrillion-dollar industry is getting turned on its head

Key Points
  • Commodity trading is on the cusp of digital disruption — something that has largely eluded the multitrillion-dollar industry for years.
  • Trading firms and the banks that finance them want to reduce risk in document fraud.
  • Blockchain is one of the technologies that commodity firms want to leverage on to improve tracking.
RJ Sangosti | The Denver Post |  Getty Images

A multitrillion-dollar industry is finally undergoing a digital makeover as commodity traders enlist technology to solve longstanding problems in their world.

From crude oil to soybeans, cocoa, cotton and chemicals, the physical commodities trade involves the buying and selling of raw materials that are used in daily life as fuel, food or ingredients for finished products. About $10 trillion worth of commodities are produced and consumed yearly, according to an estimate from the government of Singapore, a trading hub for many such goods.

Despite the size of the industry, much of the global business is still run traditionally — and on paper — particularly in the trading of non-industrial, agricultural products. Hordes of middlemen and observers have weighed on the industry's profits, all capitalizing on the principal question: How do you ensure that the cargo you receive was exactly the one you ordered?

"Trading is all about manual documentation. They have no trust between counter-parties, so they hire middlemen, intermediaries to check if the documentation is right. It's actually [like] the old times — they courier the documents and everything, even in today's world,” said Srinivas Koneru, the founder of Arkratos, a technology company working on the problem.

That arduous transportation process not only cuts into economic efficiency, but also creates multiple opportunities for fraud at each point of contact.

Years after many major industries have gone largely digital, new technologies to tackle the problem are beginning to gain traction in the commodities world. Blockchain technology, for instance, has thus far proven to be a secure and unchangeable record keeping tool that has the potential to help track cargo.

What is Blockchain?
What is Blockchain?

As the process now stands, commodity transactions require a host of important papers. That includes shipping documents that are transported throughout lengthy supply chains, involving multiple parties and different territories.

Those documents are stamped manually and emailed back and forth. Invoices are scanned manually and attached to emails.

As cargo changes hands and ships, it goes through individuals, vessels, companies and countries — all of which need to adhere to different regulations, systems and formats of documentation. That makes it difficult for fraudulent alterations to be detected. In other words, it is entirely possible for almost any document to be intercepted and changed at each stage between the original supplier and end consumer.

“The way that they process documents hasn’t changed in about 20 years. It’s fairly manual,” said Randy Wilson, a commodity trading and risk management leader at Deloitte in the U.K.

Wilson was speaking in May at a press briefing about the oil and gas industry, but traders across the wide spectrum of commodities report similar issues.

There are middlemen and companies that can verify the authenticity of goods and papers at any stage, but that makes the process more costly and time consuming. For instance, any discrepancy needs to be crosschecked over the phone followed by documents being resent through either email or courier.

Those providers of verification services, which include surveyors, will be the first in line to be disrupted in a technology revolution tackling the issue.

Beating fraud

The extensive verification process is particularly important in the business of financing global trade.

Trade financiers “need to figure out which trades are authentic,” said Cheam Hing Lee, CEO of Rhodium Resources, a commodities trading firm in Singapore founded by Arkratos' Koneru.

In fact, there has been a rise in falsified documents in the last five to 10 years, Deloitte's Wilson said.

Cheam cited the example of fraud in bills of lading. That document is issued by a transport operator to acknowledge receipt of cargo for shipment, and it's signed to ensure authenticity. High-tech photocopiers and scanners can now duplicate the original bill of lading and add fake information, said Cheam, who has spent more than 25 years in commodity trade financing with major banks and commodity giant Cargill.

“Today, the photocopier machine is able to photocopy [something that] looks exactly like the original, including the blue and black ink being signed, [or] the yellow ink or green ink. Once you have that, then you have an avenue of fraud,” Cheam told CNBC.

Even watermarks can be convincingly duplicated, he added.

Fraudsters can use the fake documents to make it appear they have many more shipments of a commodity than they actually do. They can then obtain loans from banks, using their nonexistent supply as collateral.

While some companies are using artificial intelligence to identify fake documentation, the technology is still lacking, said Cheam.

Another fraudulent practice is called "invoice spoofing," and it involves intercepting invoices and changing the bank account details for where payments should be sent. Deloitte’s Wilson said the incidence of that practice has gone up “strongly” in the last few years.

All that just means heightened risk for a number of parties, including the eventual buyer who placed the order and the financial institutions providing loans.

A notorious example of such a scam was a $3 billion fraud at the Qingdao port in China where there were allegedly fake, duplicated warehouse certificates. The incident roiled the metals markets in 2014 because the fake receipts had been used to pledge the same cargo of metal multiple times.

More recently, Australia’s ANZ and French bank Natixis came under the spotlight when both were embroiled in another case of alleged fraud involving warehouse receipts under a unit of commodities giant Glencore.

There is no complete information about how much money financiers are losing from such cheating cases, but banks and commodity firms are looking for a way to stop the practice once and for all. The answer, most say, is in developing a technology to accurately track goods.

A challenge, though, is getting companies to conform to one digital standard and building an ecosystem around it. That will require the buy-in of current trade participants including state-owned enterprises and regulators.

Plus, competition to be that chosen platform is stiff.

Oil and gas majors like BP and Royal Dutch Shell have already gotten into the act as part of a consortium that is developing a blockchain-based digital platform. The first trade on the system will take place in November, Platts reported.

"There's a full acceptance in the front office of any trading room in Singapore that blockchain will change not just how we trade, but potentially what we trade and who we trade with," said Iain Lawson, BP's head of structured products for the eastern hemisphere at a conference earlier this month organized by S&P Global Platts.

There are also the start-ups looking to win in the space, including the privately funded Arkratos, which said it operates on an “open blockchain" that will allow different parties to access its system.