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Physical commodity trading refers to the buying, selling, and movement of actual commodity products from one location and/or entity to another. Unlike paper traders, who can conduct business instantly on a regulated exchange, physical traders must endure a wide range of business, logistics, and political risks in order to move “real goods” in the “real world”. But given the vast profits that can be derived at every stage of a transaction, and considering the number of fake and scam deals, it is no surprise that experienced physical traders jealously guard their information, connections, and references when evaluating new deals.

The consequence of the above is that new deal-making is very difficult. Whereas nearly anyone can trade futures contracts by passing the KYC process for an exchange, the financial barriers to entry in physical trading are much higher. This is especially true following reputational or monetary loss stemming from previous deal failure. A paper trader who lost half their portfolio on Monday can set new trades on Tuesday. But a physical trader who fails a shipment is very likely to lose their line of credit. A paper trader who gets into a dispute with their broker (or customer service) will still be able to log back in. But a physical trader who annoys the wrong person may lose their buyer or seller forever. And a paper trader does not have to deal with customs, quality inspections, or material risks on most transactions. There is no significant cost to trying again.

But a physical trader whose buyer disappears or refuses to pay will be forced to dump cargo (cost), sell at a discount (loss), or sue for restitution (difficult).  By virtue of having to produce, refine, store, insure, or transport products, physical traders must always “spend more” if they wish to initiate a second trade to make up for an initial loss. For example, a seller whose original buyer violated the contract and refused to make payment will have to pay extra for storage while searching for a new buyer. Similarly, a buyer whose original seller failed to supply product may be forced to purchase ready product at a premium in order to fulfil a resale contract to an end user. Although ex post facto recovery mechanisms such as lawsuits or insurance offer a degree of protection, they not only cost money, but are also time-consuming with no guarantee of success. This is especially true when doing business across different time zones with different languages, laws, and levels of corruption.

Like in all business, traders conduct deal review and due diligence prior to committing time and resources to pursuing an opportunity. However, two conflicting factors affect this process. On the one hand, many products have complex technical requirements related to transport, quality, and storage. The trader must know this information, have access to experts who do, or take the time to go learn it. But on the other hand, the fast pace of deal-flow and changing market conditions demands a fast turnaround on all deal review. Every trader knows that every day involves “pushing” and “being pushed” to more quickly complete due diligence.

Therefore, deal review is conducted by loss-averse satisficers who expedite due diligence by adopting conservative decision-making heuristic shortcuts, which we at Two Lakes refer to as “deal-breaking conditions”.

DBCs, DBVs, and DBC Analysis

Deal-breaking conditions (DBCs) and deal-breaking variables (DBVs) are so-named because any unsatisfied DBV acts as a “deal-breaker” that fails its related DBC and renders the overall transaction as unfeasible. Importantly, deal-breaking conditions such as “regulatory requirements” or “product quality” are shared by all goods, while deal-breaking variables such as “import quota status” (crude oil) or “protein content” (soybeans) are product-specific. Technical knowledge in or trade experience with a particular commodity can therefore be seen as having an up to date understanding of the actual limits of specific DBVs, as set by trade laws, local customs, financing capabilities, and geopolitical or market conditions.

This intuitive process of “DBC analysis” balances the need for speed with the need to avoid failure. Regardless of their individual risk tolerance and confidence towards the deal opportunity, this conservative and negative approach to deal validation is common to all physical traders.

About the author(s)

Lawrence Slade is CEO of the London-based Global Infrastructure Investor Association, or GIIA.

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