The
ongoing attempts at legislating financial reform in
the U.S. Congress are of great interest to the rest
of the world. This is not only because everything
the U.S. does is bound to have ripple effects, but
because the proposed regulations may have an impact
in controlling at least some of the rampant excesses
and extreme volatility that we have been experiencing
in financial markets.
One of the most important aspects of the legislation
that has been passed by the U.S. Senate (which still
has to be reconciled with the version passed by the
U.S. House of Representatives) has to do with derivatives
markets and their effects on commodity trading. It
is now widely accepted that increasing financial involvement
in primary commodity markets (including oil, minerals
and agricultural products) played a significant role
in generating or amplifying price volatility in these
markets.
While financial involvement in commodity markets has
been growing since the early 2000s, the impact of
these players has been particularly evident since
early 2007, causing dramatic and rapid changes in
world prices of these goods in both futures and spot
markets. There were huge increases of most commodity
prices between January 2007 and June 2008, followed
by collapses in price until early 2009, followed by
significant increases once again until early 2010.
The chart indicates the extent to which the spot prices
of some of the important categories of primary commodities
fluctuated in the period since the start of 2007.
These price changes had hugely adverse effects in
the developing world. They sent out confusing, misleading
and often completely wrong price signals to farmers
that caused over-sowing in some phases and under cultivation
in others. They created havoc among mineral exporters
who were not sure of the prices at which they should
sign export contracts. Consumers were especially badly
affected: while the increase in global prices tended
to be transmitted (even if not fully) to consumers
in developing countries, when global prices fell there
was no such immediate tendency. The continued rise
in food prices in many developing countries has impacted
on the incidence of poverty and hunger, and become
a political issue of some importance.
So both the direct producers and consumers lost out
because of this price instability. The only gainers
were the financial and marketing intermediaries, typically
large corporations, who were able to profit from rapidly
changing prices.
Global commodity prices have always
been volatile to some degree and prone to boom-bust
cycles. In the 1950s and 1960s, commodity boards and
international commodity agreements were seen as one
means of stabilising global prices. Since their decline
from the mid-1970s, and especially as financial deregulation
and innovation became more pronounced from the early
1980s, the emergence of commodity futures markets
was touted as providing the advantages of such agreements
in a more market-friendly framework. There were several
features of such futures markets that were perceived
to be of value: they allowed for better risk management
through hedging by different layers of producers,
consumers and intermediaries; they enabled open-market
price discovery of commodities through buying and
selling on the exchanges; they were therefore perceived
to lower transaction costs.
Financial deregulation in the early part of the current
decade gave a major boost to the entry of new financial
players into the commodity exchanges. In the U.S.,
which has the greatest volume and turnover of both
spot and future commodity trading, the significant
regulatory transformation occurred in 2000. While
commodity futures contracts existed before, they were
traded only on regulated exchanges under the control
of the Commodity Futures Trading Commission (CFTC),
which required traders to disclose their holdings
of each commodity and stick to specified position
limits, so as to prevent market manipulation. Therefore
they were dominated by commercial players who were
using it for the reasons mentioned above, rather than
for mainly speculative purposes.
In 2000, the Commodity Futures Modernization Act effectively
deregulated commodity trading in the United States,
by exempting over-the-counter (OTC) commodity trading
(outside of regulated exchanges) from CFTC oversight.
Soon after this, several unregulated commodity exchanges
opened. These allowed any and all investors, including
hedge funds, pension funds and investment banks, to
trade commodity futures contracts without any position
limits, disclosure requirements, or regulatory oversight.
The value of such unregulated trading zoomed to reach
around $9 trillion at the end of 2007, which was estimated
to be more than twice the value of the commodity contracts
on the regulated exchanges. According to the Bank
for International Settlements, the value of outstanding
amounts of OTC commodity-linked derivatives for commodities
other than gold and precious metals increased from
$5.85 trillion in June 2006 to $7.05 trillion in June
2007 to as much as $12.39 trillion in June 2008.
Unlike producers and consumers who use such markets
for hedging purposes, financial firms and other speculators
increasingly entered the market in order to profit
from short-term changes in price. They were aided
by the 'swap-dealer loophole' in the 2000 legislation,
which allowed traders to use swap agreements to take
long-term positions in commodity indexes. There was
a consequent emergence of commodity index funds that
were essentially 'index traders' who focus on returns
from changes in the index of a commodity, by periodically
rolling over commodity futures contracts prior to
their maturity date and reinvesting the proceeds in
new contracts. A study by Christopher Gilbert ("Speculative
influences on commodity futures 2006-08", UNCTAD
Discussion Paper No. 197, Geneva) has found that index
traders amplified price volatility to the extent of
30 per cent in oil and metals prices, and around 15
per cent in food grains prices.
Such commodity funds dealt only in forward positions
with no physical ownership of the commodities involved.
This further aggravated the treatment of these markets
as vehicles for a diversified portfolio of commodities
(including not only food but also raw materials and
energy) as an asset class, rather than as mechanisms
for managing the risk of actual producers and consumers.
The CFTC estimated that of the $161 billion of commodity
index business in the United States markets at the
end of 30 June 2008, approximately 24 per cent was
held by index funds, 42 per cent by institutional
investors, 9 per cent by sovereign wealth funds and
the remaining 25 per cent by other traders. An official
probe by the U.S. Senate found "substantial and
persuasive evidence" that non-commercial traders
pushed up futures prices, disrupted convergence between
futures and cash prices and increased costs for farmers,
the grain industry and consumers.
Now, one important proposal in the financial reform
legislation passed by the U.S. Senate seeks to plug,
at least partially, the loopholes that allowed such
frenzied activity in commodity futures markets. It
requires that previously unregu¬lated over-the-counter
(OTC) trades be traded on public exchanges. This would
reverse the effect of the 2000 Act, and enable the
CFTC to analyse daily trade data and determine when
traders have exceeded the CFTC's commodity-specific
position limits (which provide a percentage ceiling
for all commodity contracts open for trade during
a specific trading period). It has been estimated
that around ninety per cent of this market in the
U.S. would move from over-the-counter swaps trading
to the more transparent and capitalized exchange trading
environment for futures contracts.
In addition, another important amendment brought by
Senator Blanche Lincoln of Arkansas would force the
banks to spin off their highly profitable derivative
trading into entities that would be separate from
their commercial banking. Section 716 ("Prohibition
against Federal Government Bailouts of Swaps Entities")
would sharply reduce the possibility of taxpayer-financed
bailouts for speculative activity that does not serve
the real economy. This would mean that purely commercial
banks with guaranteed deposits would have much lower
dependence on the unregulated and risky over-the-counter
swaps market.
It would also, of course, reduce the profitability
of the big banks that have been able to hunt with
the hounds and run with the hares through such OTC
transactions. As expected, this particular provision
is under sharp attack from the U.S. finance industry,
with major banks such as Morgan Stanley and Goldman
Sachs lobbying fiercely to remove it. Both the Chairperson
of the Federal Deposit Insurance Corporation Sheila
Bair, and the head of the Federal Reserve Ben Bernanke,
have spoken out against it, saying it could destabilise
the financial system. The danger is that during the
"reconciliation" process of the Senate and
House bills, which is typically conducted within closed
doors, the financial lobbyists will win and the motion
may get killed.
That is only one of the dangers. Another is that providing
muscle to regulators need not ensure that the regulators
do their job appropriately. So, even if the CFTC acquires
the ability to control and regulate trading activity
in commodity futures, its actions may not be that
effective. For example, in late January this year
the CFTC announced that it would place position limits
on oil, natural gas, heating oil and gasoline futures.
However, the limits announced were so high that, even
by the CFTC's own calculations, they were unlikely
to affect much of the trade.
There have also been arguments that such activity
will simply move to other players, such as hedge funds,
which are expected to be major beneficiaries of the
move. Or that OTC contracts in commodity futures will
increasingly take place in other financial centres,
in London, Tokyo or even Singapore. But such arguments
underestimate the tremendous influence of the U.S.
in shaping financial systems globally. Thus far, it
could be argued that this influence has essentially
been a negative force, but if even these relatively
limited new regulations actually come into play, they
could force some positive changes elsewhere as well.
So, just as the deregulation of U.S. mar¬kets
contributed to excessive speculation and global price
volatility, the regulatory reform measures - if they
are properly defined and implemented in the right
spirit - could operate to prevent future episodes
of the very extreme volatility that is so damaging
to developing countries.
Of course, this does not in any way mean that the
world food crisis is over, or that commodity prices
will not continue to behave in a volatile fashion
without other measures adopted by governments. But
it may mean that developing countries will get some
breathing space from excessive price volatility that
should help them to get the policies in place to tackle
the real problems in the food economy and elsewhere.
June
8, 2010.
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