Commoditization: What it is, How it Works

What Is Commoditization?

Commoditization refers to the process of making something into a commodity. More broadly, commodification is taking something that previously was not available in the market and making it so, for instance the commoditization of the food chain has brought many more foods to the market, but has left small producers behind in favor large, low-cost producers.

Commoditization moreover often removes the individual, unique characteristics, and brand identity of the product so that it becomes interchangeable with other products of the same type. Making commodities interchangeable allows competition with a basis of price only and not on different characteristics.

When a financial contract such as a mortgage becomes commoditized, the contract becomes more liquid because it can be bought and sold readily. This liquidity promotes trading in that market because the agreements do not have to be assessed individually and treated uniquely.

Understanding Commoditization

A commodity is a fundamental good used in commerce that is interchangeable with other commodities of the same type.

Commoditization is an action converts products, including financial products, into such an interchangeable and marketable item, such that it strips a good or service of differentiating characteristics. The good or service becomes indistinguishable from others in that same category.

Commoditization may happen with a product, service or security, but in all cases three conditions must be met for a good or service to become a commodity:

1. Standardized removes variations. Agricultural products must be in a raw state. For example, corn is a commodity, but light corn syrup is not.
2. The item must be usable when purchased, without requiring processing or alterations. Corn is a commodity, but stalks of corn on the cob in the husk is not.
3. Products must vary enough in price that a market develops for it. Corn is a commodity because the price fluctuates and changes, but an item which costs the same amount without regulation or pressures is not.

Commoditization lends itself when a good or service can be standardized enough to be purchased as a transaction instead of customized. In finance, a financial contract such as a bond or loan undergoes commoditization when it is no longer necessary to become involved in all the varied terms of the bond or loan. Imagine an example of a mortgage, where the loan can be unique to the borrower, but a commodity to an investor who buys mortgages as investments and then pools them together in mortgage backed securities (MBS), which are then carved up and sold to new investors. When financial products are commoditized, it often goes by the name securitization.

Effects of Commoditization

Commoditization creates a more liquid market because it makes it easier to buy and sell whatever the commodity is. Without involved sales processes based on differentiation and brand identities or individual characteristics, purchases of the commodity become transactional and more straightforward, and they increase in volume. This increased selling volume may create more variability in the price of the commodity, but it also generates more activity and injects cash into the market.

Returning to the example of mortgage loans, the rise in buying and selling of these loans increases the amount of cash circulating and available. Increases in cash flows allow banks and other lenders to write more loans to more borrowers. This increase is beneficial for the industry as a whole as well as for borrowers.

Critics, however, argue that commoditization can have some negative effects, by eliminating unique or customized products large corporations come to dominate while small or craft producers are no longer able to compete. Commoditization of certain things may also be deemed immoral or unethical, for instance by creating a market for body parts, spouses, or even something a trifling as adding a fee to a previously free town park.