Commoditization

Reviewed by Anjaneyulu | Updated on Aug 26, 2020

Introduction

Commoditization means the process of making something into a commodity. It refers to a good or service becoming indistinguishable from similar products.

Understanding Commoditization

Any item should satisfy the following three conditions to consider is as a commodity:

  1. It must be standardized, for agricultural and industrial commodities, in a ""raw"" state
  2. It must be usable upon delivery
  3. Its price must vary to justify creating a market

Most of the people think that commoditization applies to agricultural products and other raw materials only, but commoditization can be applied to financial instruments.

For example, when issuing loans in the past, the terms and conditions of every loan were specialized as per the borrower and his property. But over time, the government authorities commoditized mortgages by offering to buy almost any mortgage that met a set of conforming standards. These agencies encourage banks to streamline and standardize the types of mortgages they offer to consumers.

When the terms of the bond or loan do not vary in a financial contract, it will undergo commoditization, 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.

Once commoditization happens, the company's ability to command premium prices for its products disappears, and commodity-based pricing usually leads to much lower profit margins. It's important to know what is a good commoditization so that the investor can recognize when it happens to a company in which he invested.

Commoditization makes an asset easier to trade. It also encourages a more liquid market. Sometimes this can add volatility to the price of the commoditized entity, but in other cases, it can promote economic activity. In the case of the mortgage industry, commoditization provides more cash from selling conforming mortgages to government agencies and government-sponsored entities. The banks can use the cash to issue more loans, theoretically encouraging economic growth.