What is a Commoditization
Commoditization refers to the process of making something into a commodity. A commodity is a fundamental good used in commerce that is interchangeable with other commodities of the same type.
Commoditization removes the individual, unique characteristics and brand identity so that the product 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 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.
BREAKING DOWN Commoditization
Commoditization is an action that 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. Three conditions must be met for a good or service to become a commodity:
- Standardized removes variations. Agricultural products must be in a raw state. For example, corn is a commodity, but light corn syrup is not.
- 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.
- 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 happens 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.
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 increase 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.