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The Future of Banking: Cryptocurrencies Will Need Some Rules to Change the Game

Blockchain in Trade Finance

‘Death by Amazon’…Don't Believe the Hype

Why Congressional Deadlines Don't Foreclose NAFTA Changes

Sign on the Digital Line

The Future of Banking: Cryptocurrencies Will Need Some Rules to Change the Game

Financial markets are abuzz with questions regarding the nature and viability of digital currencies. As far as rated financial institutions' risk exposure is concerned, however, S&P Global Ratings believes that it is much ado about nothing. In our opinion, in its current version, a cryptocurrency is a speculative instrument, and a collapse in its market value would be just a ripple across the financial services industry, still too small to disturb stability or affect the creditworthiness of banks we rate.

Cryptocurrencies are digital currencies that use encryption techniques to regulate the generation of units of currency and verify the transfer of funds. They have attracted a significant amount of attention from the market over the past 12 months. Cryptocurrencies are independent from central banks, and the risk of them infiltrating the traditional financial systems, exposing them to a possible bubble burst, is raising eyebrows at regulators.

We believe that cryptocurrencies, in their current version, have many characteristics of a speculative instrument. We think that retail investors would be the first to bear the brunt in the event of a collapse in their market value. We expect banks rated by S&P Global Ratings to be largely insulated, given that their direct or indirect exposure to cryptocurrencies appears to remain limited.

If cryptocurrencies become an asset class, the impact on financial services firms will be more gradual. That is because we believe that their future success will largely depend on the coordinated approach of global regulators and policymakers to regulate and enhance market participants' confidence in these instruments. More importantly, we believe that blockchain technology--which is what underpins cryptocurrencies, enabling the creation of a shared digital transaction ledger--could be a positive disrupter for various financial value-chains. If widely adopted, blockchain could have a meaningful and lasting impact on the celerity, traceability and cost of financial transactions. The financial market infrastructure segment might also see medium-term benefit from cryptocurrencies and blockchain through the launch of new income-generating products, such as futures or exchanges based on cryptocurrencies, or the replacement of current practices by new ones based on blockchain.

A Speculative Bet on Future Value

In our view, cryptocurrencies do not meet the basic two requisites of a currency: An effective mean of exchange and an effective store of value. First, cryptocurrencies are still not widely accepted as payment instruments, although the list of companies accepting them have increased over the past few years. Second, the volatility that we have observed over the past 12 months in the valuation of some cryptocurrencies and their market cap is the most meaningful evidence that they fail the test of value storage (see Chart 1). For example, in the first 10 days of February 2018, the market cap of cryptocurrencies dropped by around $185 billion from Jan. 28, 2018.

We also don't view cryptocurrencies as an asset class. For starters, the total outstanding aren't big enough yet. At Feb. 10, 2018, there were 1,523 outstanding cryptocurrencies with a market cap of around $394 billion (see Chart 2). By way of comparison, at the same date, this is well below the market capitalization of Apple Inc., around $794 billion. The oldest and most renowned cryptocurrency is Bitcoin, which emerged in the aftermath of the global financial crisis as a decentralized peer-to-peer payment instrument. It intended to restore the credibility of the payment system by removing intermediaries such as banks and central banks from the equation and relying on end users' powered network. Bitcoin was originally used as a means of payment for transactions but its credibility dipped when it was allegedly associated with illegal transactions. Bitcoin and other cryptocurrencies reemerged in 2017 when their market cap increased exponentially. However, we believe that their usage changed from a payment instrument to a speculative instrument when buyers began to largely bet on their future value instead of using them for transactions.

Bubble Or No Bubble

Cryptocurrencies are most like a speculative instrument, versus an asset class or a currency. We are of the view that the current version has many characteristics of a traditional bubble, mainly based on the following three reasons:

  • The offer of the oldest cryptocurrency (Bitcoin) is limited by definition to 21 million coins of which around 16.9 million are already in circulation. One could argue that an infinite number of cryptocurrencies could be created, but we believe that this process takes time, as these currencies need to earn their credibility. As such, the top 10 cryptocurrencies represent roughly 80% of their total market cap (see Chart 3).
  • The volatility of the value of cryptocurrencies is extremely high. Over the past 12 months, cryptocurrencies' market cap has increased 33x from $17 billion to $579 billion at Jan. 28, 2018 compared with an increase of 1.4X over 2014-2016. In the first 10 days of February 2018, the market cap dropped by around $185 billion reaching $394 billion. That was reportedly underpinned by the crackdown of some countries, particularly China and South Korea. Moreover, the single-name concentration in the holdings of these instruments is high. For example, at Feb. 10, 2018, 1,650 users (addresses) with more than 1,000 Bitcoins in their portfolio controlled as much Bitcoins as the 26.3 million users with less than 100 Bitcoins in their portfolios (Chart 4). We believe that this concentration, along with the unregulated nature of this instrument makes it prone to market manipulation for example.
  • Finally, cryptocurrencies do not benefit from the backing of cash flows or a credible central issuer, which would give it an intrinsic value. Market perception/sentiment rather drives their valuation.

If cryptocurrencies were to take off and become an effective currency issued in a decentralized manner, the impact on monetary policy implementation would be deep, since central banks might lose their ability to control money supply. Conversely, if central banks were to back cryptocurrencies, the central banks would be better positioned to predict money demand and therefore adjust supply accordingly. It is still too early to tell in which direction this instruments will move.

Rated Banks Largely Unscathed By a Collapse in Value

In the event of a correction of the cryptocurrencies' valuation, we think that retail investors would feel most of the heat, because we understand that these investors contribute to most of the activity on this market. While there are no official statistics on the holdings of cryptocurrencies by countries, investors in the U.S., China, Japan, and South Korea are reportedly the most exposed. Positively, the relative contribution of cryptocurrencies in the global wealth formation is still limited. For example, the global stock market capitalization reached approximately $80 trillion at year-end 2017, meaning that cryptocurrencies are still a marginal instrument. Therefore, we do not foresee any systemic wealth effect risk. From a risk perspective, because of the lack of regulation and possible use of cryptocurrencies in illegal activities, banks might expose themselves to operational and legal risks, if regulators accuse them of helping money laundering, for instance. Recent cases show how expensive this could be for banks.

Because of the high volatility of their valuations, cryptocurrencies could also pose risks for financial advisers in dealing with their clients. Merrill Lynch, for example, banned its clients' advisors from trading Bitcoin-related investments. Finally, other channels of transmission to banks include credit cards and brokerage operations on behalf of clients. Whenever retail investors fund their cryptocurrencies purchases with credit cards, the deterioration of clients' creditworthiness following a slump in cryptocurrencies prices could drive an increase in delinquency rates. Faced with this risk, many U.S. issuers--such as Citigroup, Bank of America, Discover, and Capital One--recently decided to prohibit their customers from purchasing Bitcoin with their credit cards. European banks, such as Lloyds, are also following this trend. U.S. brokers--including TD Ameritrade, which was the first to allow its clients to trade Bitcoin futures in the U.S.--are also exposed to credit risk whenever clients trading Bitcoin futures are unable to meet their margin calls and their positions are liquidated at a loss. This risk is limited so far, however, owing to the low open interest in Bitcoin futures.

Beyond these immediate impacts, we think that the creation of a cryptocurrency backed by a central bank that gives citizens direct access to this central bank's ledger is potentially a game-changer to banks as we know them. This does not mean that banks will disappear but it would mean significant changes in the way they do business.

Non-Bank Financial Institutions Could Benefit

Because non-bank financial institutions have, generally, greater flexibility than banks, they are both more adept and more vulnerable to the rise of cryptocurrencies and bitcoin as a new instrument. From a business perspective, investment banks and stock exchanges around the world are somewhat affected by the development of Initial Coin Offerings (ICOs). ICOs allow companies to raise capital to fund, generally start-ups, at the very early stage of its creation. Currently unregulated, some market participants view ICOs as an alternative way to bypass the regulated capital raising processes (see Table 1). Non-bank financial institutions, particularly financial market infrastructure (FMI) companies, enjoy a certain level of revenue protection from the customary, standardized capital-raising process, which generally requires coordination between underwriters, investment banks, and regulators. ICOs circumvent the traditional roles of underwriting, regulatory oversight, and voting privileges. The unregulated landscape of cryptocurrencies and ICOs could threaten this.

Table: The Differences Between IPOS and ICOs

Document Prospectus Whitepaper
Purchase Equity Tokens
Payment Fiat money Tokens
Compensation Ownership and potential dividend Product offering via Tokens
Legal environment Heavily regulated Unregulated
Liquidity Generally high Uncertain
Investor base Mainly institutional investors Open to all participants
Advisors Investment banks, lawyers, etc. Anyone

ICOs only attracted approximately $4 billion of capital worldwide in 2017, which is less than 15% of total capital raised in IPOs at the New York Stock Exchange and around 2% of the total capital raised in IPOs globally. However, the pace of ICOs accelerated in the last quarter of 2017. Some countries such as China or South Korea have prohibited ICOs, while others have embraced it. The SEC announced its first-ever enforcement action against an ICO on Dec. 4, 2017 and in January, froze the assets of an ICO worth an estimated $600 million, with increasing regulation in the U.S. likely. We expect that if regulation diminished the anonymity associated with cryptocurrencies, the assets' proliferation would decline. Investor engagement seems supported by cryptocurrencies' position outside the formal banking system.

Despite lingering reputational risk with cryptocurrencies, well-established FMIs have expanded their product portfolio to this new asset class. High-frequency traders have recently moved into the space by exploiting arbitrage opportunities across crypto-currencies exchanges. U.S. exchanges including Cboe Global Markets and CME Group Inc. launched Bitcoin futures contracts in December 2017, with Nasdaq Inc. planning to debut a cryptocurrency contract in 2018. While these adoptions are not likely to move credit ratings at this stage, they certainly can inform S&P Global Ratings' assessment of business diversity and risk appetite.

Policymakers Hold the Key

We have observed a differentiated reaction from some regulators/policymakers toward cryptocurrencies. Some of them have recognized these instruments as a means of exchange while others have banned them. Some countries have also introduced tax friendly regulations for cryptocurrencies such as Japan, which reportedly eliminated consumption tax on Bitcoin trading in 2017. Others have reportedly banned them such as Bolivia. To date, European authorities have mainly called for investors' caution when dealing with cryptocurrencies. We believe that, if the market is to take up, it will imply great regulatory scrutiny and may be on the agenda of G20 or other supranational bodies. Some of the key risks that regulations may try to address include consumer protection, impeding illegal activity, and central bank backing.

The short history of cryptocurrencies has been marked by few episodes of instability. One of the most important was in 2014 with the collapse of the largest cryptocurrency exchange (Mt. Gox in Japan) that triggered a loss of around $450 million for its users. More recently, hackers have reportedly stolen around $530 million of cryptocurrencies from another exchange. Finally, in the first 10 days of this month, the market cap of cryptocurrencies dropped by around $185 billion from the level at Jan. 28, 2018. The response to such risks could take the form of regulation to ensure the financial solidity of cryptocurrencies exchange and their technical readiness to encounter cyber risks. Moreover, the fact that few investors, reportedly, hold a large number of these instruments could result in new regulation to mitigate the risks related to manipulating their value.

The anonymity behind cryptocurrencies make them an easy tool for illegal activities. The use of Bitcoin in Silk Road, an online black market for selling illegal drugs is an example. While the traceability of transactions is possible through the cryptocurrencies ledger, the anonymity of end users makes it an attractive domain for potential illegal activity, money launderers or terrorists. We acknowledge that supporters of cryptocurrencies have used the same argument for cash or even the global financial system. However, the existence of anti-money-laundering legislations and the scrutiny of regulators are supposed to help minimize the risk. Enforcing similar regulation for cryptocurrencies could help reinforcing their credibility.

Many central banks are carefully looking at cryptocurrencies and exploring the potential for creation of a central bank backed cryptocurrency. Japan's Mitsubishi UFJ Financial Group, Inc. (MUFG) announced plans to launch a cryptocurrency exchange pegged to the Japanese yen, and Venezuela intends to begin selling a petroleum-linked cryptocurrency on February 20, with each coin valued at one barrel of Venezuelan crude oil. In some markets, we think that a framework backed by authorities could boost the general public adoption and the new currency might be used as a means of exchange or a currency instead of an investment asset class or a speculative instrument. We also believe that a coordinated approach among global regulators could help ward off any potential arbitrage.

Blockchain Could Drive a Positive Disruption

Blockchain technology enables the creation of a shared digital transaction ledger. We believe that, at the very least, blockchain presents an opportunity for financial institutions to cut costs by streamlining back-office operations; shortening clearing and settlement times; facilitating payments; and even generating new revenue streams. Blockchain can be used for many banking services, including bank payments, trade finance, money transfer and post-trade services. Having a real-time standardized view of transaction data without needing to conduct multiple reconciliations would remove many of the inefficiencies that hinder the financial system, and could reduce costs considerably.

Whether cryptocurrencies take off or not, we believe that banks' role in the payment business might change materially in the next decade. Some market participants are challenging the benefit of blockchain, arguing that the technology was created a decade ago and has not yet disrupted the financial system in a meaningful manner. That said, we project that, because of this technology and the growth in other peer-to-peer services, smaller and more innovative market participants could have more opportunities to challenge established banking groups' existing product offering.

Blockchain in Trade Finance

Trade-based money laundering, or TBML, is a new frontier in financial crime. It is likely the most complicated and intricate method of money laundering. Investigating money laundering in trade activities has become one of the most daunting, labor-intensive, time-consuming and expensive activities across the globe.

According to Global Financial Integrity (GFI) estimates, a staggering $950 billion has been moved illegally out of economically under-developed countries since 2011. Further, it estimates that four-fifths of TBML is directly linked to drug trafficking, illegal arms dealing, terrorist financing and corruption activities globally.

A simple example of TBML would be a shell company for drug trafficking exporting pencils (actual worth of $500,000) for $3 million (on paper) and converting illicit gains of $2.5 million into legitimate cash.

In large economies with high inflation in food and essential commodities, TBML is difficult to track and hard to investigate. Launderers can invoice for exporting essential commodities at an inflated price when receiving the actual value from the importer. This inflated value can be adjusted against the illicit gains obtained through various illegal activities and the illegitimate funds can be converted to legal currency.

In this document, we will discuss the standard red flags for TBML, the regulatory landscape, especially in Asian trading hubs and large economies, for tackling TBML. Also, we will discuss the benefits of Blockchain and its implementation for trade finance activities, with the illustration of a letter of credit workflow.

‘Death by Amazon’…Don't Believe the Hype

From an online bookseller that launched in 1995 to a high-tech conglomerate with global reach, Inc. has a bullseye on every market it touches. Today, Amazon is a retailer, hardware developer, cloud services provider, content streaming service, clothing designer, and, more recently, a home security company with its announcement to purchase Ring Inc. on February 27, 2018.

The company has rallied 37% this year, crushing Wall Street expectations for its first quarter earnings, posting $1.6 billion in profit and prompting nearly two dozen firms to up their price targets on the e-commerce giant. A few of those newly minted price targets place the company north of the $1 trillion threshold.

Not surprisingly, the market is questioning — is Amazon unstoppable? And if so, what is Amazon’s next target?

How do Amazon’s acquisitions stack up?

Amazon, along with its subsidiaries, has made 96 merger and acquisition transactions since its 1995 launch, the largest being its acquisition of Whole Foods Market Inc. for approximately $13.7 billion, announced on June 16, 2017.


Why Congressional Deadlines Don't Foreclose NAFTA Changes

As prospects fade for a complete overhaul of the North American Free Trade Agreement this year, the White House could still alter important provisions by negotiating changes outside of rules that set deadlines for congressional action, trade experts said.

That approach could be used to adjust the rules of origin for automobiles under the current agreement, said Simon Lester, a trade policy analyst at the Cato Institute, a libertarian think tank in Washington, D.C.

Other experts agree that the May 17 deadline set by House Speaker Paul Ryan for congressional consideration of a NAFTA revamp does not necessarily prevent President Donald Trump from reworking the trading relationship among the U.S., Canada and Mexico.

"The most likely scenario is a modest set of changes that can be implemented through executive action alone," said Todd Tucker, a fellow at the Roosevelt Institute, a left-leaning think tank, in an email. "There is no reason that [Trump] couldn't chop off bits of NAFTA 2.0 and introduce them to Congress outside of Fast Track procedures."

A slower track?

Fast track trade promotion authority allows U.S. presidents to negotiate trade agreements without congressional oversight. The president is required to notify congress that he intends to sign an agreement at least 90 days before doing so, while providing lawmakers with a list of what needs to change under U.S. law for the country to comply with the agreement within 60 days of signing it. The U.S. International Trade Commission, or ITC, is required to produce an economic assessment report 105 days before the signing of any treaty before Congress can hold a vote. Ryan said at an event earlier this month that lawmakers will not have enough time this year to consider a completely new treaty unless Congress receives a notice of intent to sign a deal by May 17.

That deadline may require the Trump administration to change its approach and take more incremental steps to changing the free trade pact. While the administration has not publicly discussed that strategy, it is plausible that the White House might consider it, Cato's Lester said.

"Maybe there's a way to do smaller tweaks," Lester said in a phone interview, suggesting that the automotive rules might be one such amendment. "What if that was the only change? Well, maybe that's a little easier then. Maybe then it doesn't even require a congressional vote, or maybe the analysis by the ITC is so much easier."

The Korean example

Such a strategy would mirror the approach the Trump administration took with recent changes to the Korea-US Free Trade Agreement, said Gary Hufbauer, a senior resident at the Peterson Institute for International Economics. In that case, the two countries agreed to a series of changes to tariffs and safety standards that did not require Congressional approval.

"They just did some amendments, and then the administration said, 'Well, these amendments don't require a congressional vote,'" Hufbauer told S&P Global Market Intelligence in a phone interview. "The legal point is that if there's any change in U.S. law, Congress has to vote it, but there's a lot that can be done by executive action."

While the president may be able to use executive authority to modify existing trade agreements, a piecemeal approach is uncharted territory in Congress, Lester said.

"Normally, you just do it a certain way. You make big changes or you propose a new agreement — we've never had these kinds of amendments before, or renegotiations. Usually, the expectation is you go to congress," he said. "We now have the possibility ... where we're just going to make small changes that don't require changes to U.S. law and therefore don't require a vote. Could they come up with something on NAFTA like that? What's the threshold for that? We don't know the answer to that. That would be breaking new ground."

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?