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Sign on the Digital Line

Before blockchain changes the world-as its most ebullient backers have forecast-it is going to need to score smaller victories. For the commodities industry, smart contracts will likely be one of the first places where the technology can provide changes that all agree are needed and which would advance current systems stuck in a time warp.

How hard has change been to come by? As one panelist noted on a fintech-themed panel at the fall 2017 PIRA Week conference in New York, the way that a market goes about all the steps needed to move a shipment of commodity A from seller B to buyer C hasn't changed in so long that it's doubtful anybody could tell you when it was significantly different.

There's been some progress. Paper documents now are scanned and sent via email. That's better than faxing. Or telexes, which were still used recently enough that your correspondent is not too old to remember it-and even the turning off of telex machines at a strategic time of day by traders to avoid financial losses (it's a crazy story). But there's still a lot of paper, it's slow, and it's time consuming, and everybody wants it changed.

Enter, then, blockchain, and the smart contract hot on its heels. As a refresher course, blockchain is the technology that drives the bitcoin cryptocurrency, but the world is busily finding numerous ways in which its capabilities can be adopted to other markets: financial settlements, digital advertising and music, shared storage ... the list grows constantly.

Blockchain's sui generis classification is a distributed ledger. The key aspects of the blockchain ledger that could make it the basis for groundbreaking change in all of these markets are:

Shared: There is no central database in a distributed ledger application. The parties to the ledger-be it a public blockchain like bitcoin, or a private or permission ledger that would presumably be the choice of commodity markets-all run the same software, and share all the data on the ledger (as opposed to all of it sitting on a central database). There is no single entity "in charge," in the sense that there is a single point that can shut down commerce on the distributed ledger, which also means there is no single point of failure.

Immutable: The shared nature of the ledger means that data on it cannot be altered. To do so would mean needing to change a data point on every stop on the ledger­known as nodes-a task that would take enormous time, computing power and run a high risk of the scheme being found out. (Contrast that with Equifax, where hackers only needed to invade one system to steal a gigantic pile of data).

Consensus: The distributed and immutable nature of the data on the ledger provides "trust"-put in quote marks here because it is not the sort of trust that an individual earns from another by their actions. Rather, data on the ledger is trusted because its wide distribution provides an assurance that, for example, a party on the ledger does indeed own a particular diamond. (Diamond trade has long been based overwhelmingly on human trust, and was cited early in the blockchain era as a market that could benefit from the consensus-the "trust"-that a distributed ledger provides through its shared distribution of data, and its immutable nature.

With those characteristics in place, a smart contract can be developed. The idea of a smart contract is not something that popped up just through the advent of blockchain; references to it date back to the '90s.

At its root, smart contracts are an "if/then" process driven by technology. The smart contract is designed to automatically produce a certain outcome-deliver ownership and physical possession of a commodity, for example--as certain inputs are met. For example, in a smart contract written to facilitate the movement of aluminum, an entire series of "if" occurrences would be sought to propel the contract toward its goal: "if" the benchmark price of the commodity is received; "if" the digital bill of lading is provided for the shipment; "if" the digital letter of credit is provided ... "then" the transfer of the aluminum from seller to buyer is completed. Not only that, the seller would get paid.

Consensus: The distributed and immutable nature of the data on the ledger provides 'trust' - put in quote marks here because it is not the sort of trust that an individual earns from another by their actions.

There would need to be a lot more "ifs" than the three mentioned. And there would need to be things like digital bills of lading, which traders bemoan now are still produced on paper, digital only if one considers a scan or a PDF to be digital. But "if" these things can be produced, and can become industry standards, "then" the industry can use smart contracts to move away from their current antiquated processes.

But and there are always "buts"­the idea of decentralization sounds good on paper, yet is not completely accurate. Bitcoin may be the ultimate decentralized distributed ledger but Satoshi Nakomoto-the developer of bitcoin, whoever he/ she is, and however many humans actually make up him/her-still needed to make a choice that there would be 21 million bitcoins, and not one more. That's just one example of a centralized decision.

A smart contract behind a ledger serving a market will need to have rules and standards, just like a current not-smart contract today. What are the rules around a bill of lading? Are there ports that carry special surcharges? What is the expected delivery window? The list goes on, and while it's standardized now even in an analog contract, the slow, complicated nature of the deals means that humans can intervene and work around a problem.

A smart contract by definition would be far more efficient but wouldn't have that safety valve. Which means that the terms and conditions by which a particular market operates needs to be built into the contract, and that means somebody needs to be a leader and a convener, to get a market to agree to the basic terms of the market and adapt current rules of engagement to the blockchain world. There is the question of who that leader would be, and who would provide the funding to develop the software for running the smart contract. (The entire new capital market of initial coin offerings developed largely to serve a need: getting funding to develop blockchain protocols when monetizing the open source blockchain software was going to provide difficult).

That is a question, but those pied pipers referred to earlier are starting to emerge. In early November, in what appears to be an expansion of an earlier blockchain-driven consortium, BP and Shell joined up with a consortium that already included trading powerhouse Mercuria and Dutch bank ING in what was loosely called a blockchain "trading platform" for energy commodity trading. A closer read of the formal press release put out by the consortium shows it to say that the goal of the effort will be to "develop a blockchain-based digital platform intended to modernize and transform post-transaction management of physical energy commodities trading." Later on, the formal release says a goal will be "to manage physical energy transactions from trade entry to final settlement." The assumption in that sentence is that the trade being entered took place not on the ledger, but some other way, maybe even through an old-fashioned phone call. And once the trade was done, then the parties would turn to the blockchain being developed by the consortium to complete the antiquated systems used now for clearing and closing of deals.

The BP/Shell/Mercuria/lNG/etc group is not the first. Earlier in 2017, Natixis, IBM and Trafigura teamed up in a consortium, specifically built on the Hyperledger Fabric platform, of which IBM is a key backer. In its announcement, it too noted that its tool would kick in "from the time a new trade is confirmed and validated, to when the crude oil is inspected, to its final delivery and cancellation of the letter of credit." Again, nothing about actual trading, which everyone in the industry seems to agree is not ready to move to a distributed ledger system. You can hear theoretical discussions that a less-liquid market, always struggling with transparency, might find itself a candidate to trade on a distributed ledger. But the question then is what entity is going to risk the financial capital to develop one for markets where trade will always be light?