The Blockchain Energy Commodity Transaction Lifecycle

Glenn Reitman, Mark Radcliffe, Deanna Reitman
DLA Piper

Introduction

Blockchain technology (sometimes referred to as distributed ledger technology) is the technology behind cryptocurrencies, such as Bitcoin and Ether (the cryptocurrency of the Ethereum blockchain), and it is fast becoming a platform for innovation in peer-to-peer transactions. In this article, we attempt to consider blockchain technology in the trading of energy commodities. As an example, we review the current lifecycle of a natural gas trade, the parties involved and how blockchain technology could be used to effectuate ease of transaction and reliability through the use of smart contracts. We understand that the technology fluctuates quite rapidly; however, our analysis is focused on both the transaction process and the regulatory environment for an energy commodity transaction, using current market and regulatory practices.

Blockchain – What is it?

Blockchain is a decentralized, distributed ledger on which transactions are recorded. The transaction ledger is maintained simultaneously across a network of unrelated computers or servers called nodes, like a spreadsheet that is duplicated thousands of times across a network of computers. The ledger contains a continuous and complete record (the chain) of all transactions performed which are grouped into blocks. A block is only added to the chain if the nodes, which are members in the blockchain network with high levels of computing power, reach consensus on the next valid block to be added to the chain. A transaction can only be verified and form part of a candidate block if percentage of nodes on the network needed by such network’s protocol confirm that the transaction is valid; the method of determining this issue is called the “consensus” protocol.

A block generally contains four pieces of information:

The “hash” of the previous block
A summary of the included transaction
A time stamp and
The “Proof of Work” (the consensus protocol for several of the major public blockchains − but other forms of consensus mechanisms are being used) that went into creating the secure block.

Once information is entered on the blockchain, it is extremely difficult to alter because a blockchain network lacks a centralized point of vulnerability for hackers to exploit and each block includes the previous block’s hash; any attempts to alter any transaction with the blockchain are easily detectable because every block in the chain is affected. Subsequently, if a participant attempts to modify the data in a block, it would cause an error, notifying every participant in the blockchain of the attempted change.

In other words, blockchain is a self-maintaining database which typically has a “functionality wrapper,” or application development platform, on top. Blockchain can be thought of as an operating system for which useful applications, particularly “smart contracts,” can be written. Assets and information about transactions can be stored and tracked without the involvement of a typical intermediary, such as a bank, a central authority or some other trusted third party.

These blockchains can be shared and corroborated with anyone who has permission to be inside the blockchain environment. This enables direct peer-to-peer transactions and transaction data share between internal departments of a single organization and across counterparties, without the need for the services of an intermediary, such as a broker that provides pricing information, for example, or centralized authorities to verify and/or consolidate and share transaction data information.

Three Types of Blockchain Environments

There are three types of blockchain environments, each of which is in various development phases of the blockchain technology:

Public, or permission-less, blockchain environments
Private and permissioned blockchain environments and
Hybrid blockchain environments.

In the public, or permission-less, blockchain environments, all transaction data is open to the public and no permission is required to have access to the blockchains. An example of the public, or permission-less, blockchain is Bitcoin or Ethereum.

In the private and permissioned blockchain environments, the environment is private and participants need permission from the owner or manager of the blockchain environment to join the blockchain environment.

It is in the private and permissioned blockchain environment that trial energy trading environments have been established. Private and permissioned blockchain environments, using smart contracts could be used to facilitate the trading of energy commodities.

In the hybrid blockchain environment, different blockchains are allowed to communicate with each other, enabling transactions between participants in different blockchain environments.

The Smart Contract

A smart contract represents a digital protocol that automatically executes pre-defined processes of a transaction without requiring the involvement of a third party. Smart contracts are one of the applications of the blockchain technology.[i] The classic form of smart contract uses the “if/then” process, meaning if something happens, then something else will happen in response. Applying this to an energy commodity contract, the “if” portion could be multiple inputs such as trade reconciliation and/or delivery information. These inputs, if they come from outside of the blockchain environment, are known as oracles. When the contract has all its inputs, the “then” activities are triggered, such as a quantity of energy commodity is transferred. “If/then” statements within the smart contract are created through code.

These classic form of smart contracts are the starting point as to how smart contracts may be used in the future in energy commodity transactions. In energy commodity transactions, many of the terms are standardized, such as quantity and quality. In the future, the participants in a private and permissioned blockchain environment designed for the execution of energy commodity transactions could develop the standardized components of the smart contracts in said particular blockchain environment. The non-standardized terms could be pre-agreed between counterparties coded into the smart contract for automatic execution when such terms are met. For example, the smart contract will have the ability to automatically execute the energy commodity trade contracts once the agreed terms, such as the pricing or volume conditions, are met. This is important because the smart contract information is in a decentralized system which is accessible by anyone given access to the particular blockchain environment. This would make it unnecessary for a broker, for example, to relay the price requirements for any particular counterparty because it is already embedded in the smart contract and known to everyone in the blockchain environment.

Energy Commodity Transaction Lifecycle

At the highest level, there are three components to an energy commodity transaction:

Pre-trade
Trade execution and
Post-trade.

Pre-Trade

The departments involved in the pre-trade component may include:

Legal
Credit
Compliance
Analytics
Operations and Finance

In general, during pre-trade preparations, the following occurs:

Counterparty agreements and/or agreement templates are created
Credit limits, policies and procedures are established, as well as a credit tracking information system
Compliance policies and procedures are established
Accounts on exchanges, trading platforms and scheduling systems for physical movement are set up
Pricing information services and systems to obtain and/or maintain such pricing information are purchased
Brokerage relationships and accounts are established
Research and analysis on energy commodities to be bought, sold and possibly moved is conducted.

Trade Execution

The departments involved in the trade execution component are the:

Front office sales personnel and traders
Risk management department and
Credit department.

In general, during the trade execution component, the:

Trade is executed and the details are captured in the trade capture system and
Trade is analyzed and assessed for risk, which is entered into the risk management systems and credit management systems.

Post-Trade

The departments involved in post-trade component may include:

Confirmations
Risk
Credit
Settlements
Legal
Front Office
Finance
Compliance
Operations
Finance

In general, after a trade is executed:

The confirmations department exchanges documentation to confirm the exact terms of the transaction, as well as ancillary legal obligations surrounding the transaction and record such information in the confirmations system.
Once a transaction is confirmed, the risk management department continues to conduct analysis on the transaction, including the conduct of a mark-to-market on the transaction in order to determine if any collateral and/or margin funds need to be exchanged with the counterparty. This continued analysis and information is distributed back to the front office department, in order for the front office to continuously monitor the value of its executed transactions. Additionally, this continued analysis is distributed to the finance department for the generation of accounting statements.
Additionally, in order to manage credit risk, the credit department continuously runs an analysis on the transactions with particular counterparties, measure the amount of credit exposure to each counterparty. This continued analysis and information is distributed back to the front office department, in order for the front office and the credit department to have a dialogue about any additional and/or different credit needs.
The transaction details are also fed into accounting department’s settlement systems, where the settlements team, determines the amount of actual funds that are to be exchanged between the counterparties, either on a transaction by transaction basis or on a counterparty basis through netting the transactions. This settlements information, accounts payable and accounts receivable, is distributed to the finance department and into the finance department’s systems for the generation of accounting statements.
Because some regulators require periodic reports on the details of energy commodity transactions, the compliance department also needs access to the transactions details in order to enter those details into the compliance systems and run the necessary compliance reports to be distributed to regulators.
Physically settled transaction details must be provided to the scheduling department, so that the operations, or scheduling, department can enter the details into the bulletin boards and scheduling systems in order to ensure the commodities physically bought and sold are transported to the seller’s location.

A multitude of departments, systems and interfaces to systems are required to facilitate an energy commodities transaction. Now, multiply this by all the counterparties in the energy commodity transaction. Controls, policies and procedures are needed not only to maintain the accuracy of the entered information and the exchange of information between these departments and systems, but to maintain the accuracy and reconcile the exchange of information between counterparties.

Enter blockchain technology, which allows all the energy commodity transaction data to be stored on a distributed blockchain, with all the relevant information being stored identically on all the computers of all the participants, including the computers of the different internal departments and the computers of counterparties.

Potential Use of Blockchain Technology in Energy Commodities Transactions

Efficiency, accuracy and cost savings would be the main drivers for a shift to blockchain technology in energy commodity transactions. Blockchain technology creates a transactional platform that is highly secure, low cos and fast, with fewer interfaces between systems and departments, thus lowering the possible instances of data entry and/or data sharing errors, all of which could possibly reduce the capital requirements for energy commodity transactions.

Pretend you are on an energy commodity trading floor that is a participant in a private and permissioned blockchain environment designed for the sale/purchase of natural gas and your company needs to sell/purchase natural gas. Trading algorithms inside the blockchain environment will scan smart contract terms to gauge the interest to purchase natural gas and the prices at which purchasers are willing to buy the natural gas. The algorithm will find the best possible deal, matching the amount needed to be sold with the best possible purchase prices offered. Once the deal terms are approved by the seller and purchaser, who have previously negotiated a smart contract, the transaction is executed and recorded in a blockchain. Alternatively, once the algorithm finds matching prices and quantity, the smart contract is automatically executed. The transaction details are automatically confirmed because both the seller and purchaser have access to the transaction details on the blockchain. In addition to the information being readily available between the seller and the purchaser, the transaction details and the physical nomination information that is recorded on the blockchain is available to:

the pipeline bulletin boards, so the natural gas may be scheduled for delivery
the risk management department for its continued analysis on the transaction until it is actually delivered
the credit department to measure the effect on the risk exposure between the seller and purchaser
the settlements department for the issuance of invoices
the finance department for the running of finance reports, such as cash flow statements
the compliance department for the preparation of the Federal Energy Regulatory Commission physical natural gas purchase and sale reports.

As the example above shows, there could be many advantages to energy commodity transactions occurring in a blockchain environment that uses the smart contract model, including:

the removal of the need for a broker relationship or a price discovery system, because the seller is able to directly communicate with the buyers and see the actual prices at which the buyer is willing to buy the natural gas
the removal of a centralized trading platform, or exchange, to show the bid and offer information of the seller and purchaser and then subsequently capture the executed transaction details, because the seller and purchaser are able to enter into the transaction directly with each other
the removal of an internal trade capture system, into which the trader has to manually enter the transaction details, thus reducing input errors and the possibility of transactions being intentionally withheld from the trade capture system
the removal of the need for software and systems to communicate the transaction details to and confirm such details with the counterparty, greatly reducing the possibility of entering erroneous information into the confirmation and reducing the need to hire confirmation personnel
the streamlining of internal department processes, because the information is available to all departments without the need for each internal department to have its own system to communicate internally and with the trade capture system, increasing the efficiency and accuracy of the risk, credit and regulatory analysis and report generation
the removal of the need to establish accounts at the pipeline electronic bulletin board and enter the physical transaction details to ensure the natural gas sold is actually moved on a pipeline to the purchaser, reducing the need to maintain accounts on an external pipeline electronic bulletin board, reducing the possibility of entering erred information into the pipeline bulletin board and reducing the need to hire scheduling personnel
the automation of the cash settlement process, because the blockchain will contain the information showing natural gas purchase is to be invoiced and then subsequently contain the information showing when the invoice was paid.

Current Regulatory Framework for Energy Commodity Transactions

The Commodity Futures Trading Commission (CFTC) has exclusive jurisdiction over commodity futures and options trading in the United States.[ii] The CFTC regulations require all commodity futures and options to be traded on an exchange designated as a contract market by the CFTC to be legal and enforceable.[iii] More specifically, transactions involving contracts for the purchase or sale of a commodity for future delivery is only permissible if:

Such transaction is conducted on or subject to the rules of a board of trade that has been designated by, or registered with, the CFTC as a contract market or derivatives transaction execution facility and
Such contract contains certain required information, such as date, parties and their addresses, the commodity covered and its price and the term of its delivery
Each transaction record must be maintained for a period of three years, or longer if the CFTC requires, and be open for inspection by the CFTC or Department of Justice.[iv]

Prior to 2010, there were certain commodities, such as energy, that were exempt from this board of trade requirement if certain other requirements were met. This exemption led to the creation of an over-the-counter derivatives trading market in energy commodities in the US.

In 2010, the U.S. Congress enacted the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act), which implemented changes to the regulation of the US over-the-counter energy derivatives markets and its participants.[v] Essentially, the distinctions for exempt commodities were removed and regulation focused on transactions involving “swaps.”[vi] Under the Dodd-Frank revised CEA, it unlawful for a person who is not an eligible contract participant to enter into a swap – even if the swap involved energy and even if for hedging purposes – unless that swap is entered into on an exchange designated by the CFTC as a contract market.[vii] In general, an eligible contract participant is defined as a participant acting for its own account that is a financial institution or a corporation, partnership, proprietorship, organization, trust or other entity that has total assets exceeding $10 million or net worth exceeding $1 million and enters into the transaction in connection with the conduct of managing business risk.[viii]

This is different from a forward or spot contract in which the parties intend to make or take physical delivery of the commodity, which has generally always been excluded from the Commodity Exchange Act (CEA) and CFTC regulation.[ix] This is called the forward exclusion. Dodd-Frank amended the CEA to add a forward exclusion to the definition of a swap.[x] To fall within the exclusion, a transaction must include three things:

A nonfinancial commodity
Deferred shipment or delivery of the nonfinancial commodity and
An intent to physically deliver the nonfinancial commodity.[xi]

The CFTC has interpreted the term nonfinancial commodity to be a commodity that can be physically delivered and that is an exempt commodity.[xii] Energy is an exempt commodity. A spot contract is one that calls for immediate or near-immediate delivery of the commodity. The CEA excludes spot, or cash, transactions from the CFTC’s jurisdiction.[xiii]

It is important to note, however, that even though forward contracts are exempt from CFTC regulations regarding exchange trading, the CFTC does have authority over forward contracts under the CEA to prohibit market manipulation, making false and misleading statements and omissions of material fact to the CFTC, fraud and deceptive practices and false reporting.[xiv]

Questions of Using Blockchain Technology under Current Regulatory Framework for Energy Commodity Transactions

There is a question as to how a blockchain environment created for conducting energy commodity transactions would:

Be permissible under the current United States regulatory regime and/or
Require changes to the current United States regulatory regime to be permissible.

We believe that a private and permissioned blockchain environment for transacting in:

energy commodities swaps that utilizes smart contracts could be permissible under the exemption that the transactions are executed solely between eligible contract participants, provided that the blockchain environment only permits participants that meet the definition of an eligible contract participant under the CEA
energy commodity forward, or swap, contracts that utilizes smart contracts could be permissible under the forward exemption if the blockchain participants agree that only physical forward, or spot, contracts will be executed between the participants.

Given that the blockchain environment is completely decentralized, there is a question as to whether the CFTC could actually regulate these transactions. If there is no centralized authority for the CFTC to mandate requirements, how can the CFTC effectively regulate? One concern would be the argument that because the CFTC cannot regulate the transactions through a centralized authority, then under the current regulatory framework a private and permissioned blockchain between eligible contract participants for the transacting of energy swaps may not be allowed. We believe that one solution to this problem is simple, in that the CFTC can establish certain requirements to be placed into a smart contract model. Additionally, there is a question as to how blockchain environment participants could fulfill their self-regulatory duties. Perhaps the solution to this, again, is simple. For example, for each blockchain environment created for transacting in energy commodities swaps, the CFTC could be made a participant, giving it visibility into all of the transactions details of the blockchain environment, thus removing the CFTC active submission of reports requirement.[xv] Another example would be to build into the smart contract model algorithms that automatically implement position or trading limits.

Additionally, because the private and permissioned blockchain environment is extremely secure, the use of it in energy commodity trading may reduce market manipulation and/or fraud risk. Not only is the permissioned blockchain environment closed to anyone who does not have permission to access it, it would be very difficult for someone to alter the transaction details. Additionally, it would be very difficult for traders to enter into fraudulent transactions or hide transactions from the market. Using the blockchain environment, traders would not have the ability to transact and then purposefully not enter the transaction into the trade capture system, because the transaction is conducted directly with the counterparty and automatically recorded in the blockchain. Possible market manipulation would also be reduced because pricing and supply information would be available to every participant in the blockchain environment, making it very hard for traders to portray a non-market price or unfounded supply.

Conclusion

The application of the blockchain technology, if constructed correctly, may provide many benefits in the form of efficiency, risk reduction and cost-savings to the energy commodities transaction lifecycle. And even though it is uncertain how a blockchain environment established to facilitate energy commodity transactions fits into the current United States regulatory regime or how it will be regulated, we believe that there are also certain inherent regulatory benefits from the use of blockchains in energy commodity transactions.

—Glenn Reitman is a partner, Mark Radcliffe is a partner, and Deanna Reitman is of counsel with global law firm DLA Piper.

Footnotes

[1] We use the term “blockchain” in this article, although it is also commonly known as “distributed ledger technology.”

[i] Note This document does not address the possible flaws in the smart contract application, such as (1) errors in code or coding or (2) the inability to retroactively fix mistakes that may have been caused by errors in code or coding.

[ii][ii] Commodity Futures Commission Trading Act of 1974, Pub. L. No. 93-463, 88 Stat. 1389 (1974), codified in 7 U.S. Code.

[iii] 7 U.S. Code Section 6(a). The CFTC defines a futures contract as an agreement to purchase or sell a commodity for delivery in the future: (1) at a price that is determined at initiation of the contract; (2) that obligates each party to the contract to fulfill the contract at the specified price; (3) that is used to assume or shift price risk; and (4) that may be satisfied by delivery or offset. See www.cftc.gov/glossary. The CFTC defines an option contract as A contract that gives the buyer the right, but not the obligation, to buy or sell a specified quantity of a commodity or other instrument at a specific price within a specified period of time, regardless of the market price of that instrument. Types of option contracts are a put or a call. See www.cftc.gov/glossary.

[iv] 7 U.S. Code Section 6(a).

[v] See Dodd-Frank Act Section 750.

[vi] The Dodd-Frank Act defines a “swap” in very broad terms to include (a) options, including puts, calls, caps, floors and collars, (b) event contracts, (c) swap structures that exchange fixed payments for floating payments and (d) instruments commonly known to trade as swaps. See 7 U.S. Code Section 1a(47)(A).

[vii] See U.S. Code Section 2(e).

[viii] See 7 U.S. Code Section 1a(18) for complete definition of Eligible Contract Participant.

[ix] 7 See U.S. Code Section 1a(27) in which the term “Future Delivery” excludes any sale of any cash commodity for deferred shipment or delivery.

[x] See U.S. Code Section 1(a)(47)(B)(ii).

[xi] See id.

[xii] See 77 Fed. Reg. at 48,232. The CEA defines an “exempt commodity” as “a commodity that is not an excluded commodity or an agricultural commodity.” See 7 U.S. Code 1a(20).

[xiii] See CFTC Letter No. 98-73 (October 8, 1998).

[xiv] 7 U.S. Code Section 12(d); Section 9, 13b, 13(a)(2).

[xv] Note Although there are certain exemptions for clearing and margin in swaps, CFTC does not have these exemptions with regards to reporting and recordkeeping, but has implemented different recordkeeping and reporting requirements for swaps, depending upon the whether or not the entity transacting the swap is a “Swap Dealer” or “Major Swap Participant,” See CFTC Q&A on Swap Data Record Keeping and Reporting Requirements, http://www.cftc.gov/idc/groups/public/@newsroom/documents/file/sdrr_qa.pdf . Note CFTC also exempts certain entities that engage in swaps for customers that do not trade above the de minimums threshold, See CFTC Q&A on Final Rules Regarding the Definition of “Swap Dealer” “Major Swap Participant” and “Eligible Contract Participant”, http://www.cftc.gov/idc/groups/public/@newsroom/documents/file/msp_ecp_factsheet_final.pdf.