Commodification

What it is:

Commodification refers to a good or service becoming indistinguishable from similar products.

How it works/Example:

To be considered a commodity, an item must satisfy three conditions: 1) it must be standardized and, for agricultural and industrial commodities, in a "raw" state; 2) it must be usable upon delivery; and 3) its price must vary enough to justify creating a market for it.

Most people understand commoditization pertaining to corn, soybeans, cotton, or other raw materials (i.e., the idea that "it's all the same."), but financial instruments can be commoditized, too.

For example, in the past, every mortgage issued was considered unique -- that is, the terms and conditions of the loans were customized to the borrower and the property. Over time, however, the Federal National Mortgage Association (Fannie Mae) Mac), and the Government National Mortgage Association (GNMA) commoditized mortgages by offering to buy almost any mortgage that met a set of conforming standards. By creating a massive market for mortgages, these agencies encouraged banks to streamline and standardize the types of mortgages they offer to consumers.  Therefore, commodification is present in mortgages today.

Why it Matters:

Commodification makes an asset easier to trade makes the market more liquid. In some cases, this can add volatility to the price of the commoditized entity, but in other cases it can spur economic activity.

In the mortgage industry, commodification allows lenders to receive cash from selling conforming mortgages to government agencies and government-sponsored entities. Banks can then use the cash to issue more loans, which theoretically spurs economic growth.

Best execution refers to the imperative that a broker, market maker, or other agent acting on behalf of an investor is obligated to execute the investor's order in a way that is most advantageous to the investor rather than the agent.