Taming financial speculation, stabilising food prices

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THIRD WORLD RESURGENCE
Taming financial speculation, stabilising food prices The enormous influx of financial speculation into agricultural commodity derivative markets has effectively broken them. Strong regulation is urgently needed to restore these markets to their normal functioning and to help prevent repeated global food crises. FOOD is a fundamental human right and essential to our survival. Yet many are unaware of the powerful position that financial markets have come to hold in the global food system. Alongside markets for trading food (physical markets), financial markets for futures and other derivatives play a central role in setting the prices of the world's food. Futures markets were originally developed to help those involved in producing food to manage their risk. Food producers and other commercial participants involved in the supply chain are inherently exposed to the risk of fluctuating prices. A producer growing a crop, such as wheat or maize, has to invest in production through buying seeds or other inputs such as fertiliser. However, this investment is at risk as the price of the crop may fall while it is being grown. Futures markets allow food producers and other commercial participants to transfer their price risk to someone else more willing to take on that risk. This could be another commercial hedger, or a financial speculator who hopes to profit from changing prices over the life of the futures contract. Futures markets were developed for the benefit of those involved in the production of food, yet they have now changed almost beyond recognition. Over the past 10 years, financial markets for agricultural commodities have become dominated by speculators who simply use them as another form of investment. As a result, they are no longer able to fulfil their intended functions. Moreover, most of the world's food producers, the majority of whom are small farmers in developing countries who lack access to credit, do not have access to nor rely on commodity futures markets to manage risk. Many alternatives to market-based risk management exist which would be better suited to the needs of most of the world's farmers. Wider structural changes are needed to ensure the global food system can meet the needs of a growing population and the needs of those who produce the world's food. A food system that is not shaped by unjust trade rules and a handful of powerful corporations, but instead supports ecologically sustainable small-scale food producers, is vital to achieving this goal. Regulating agricultural commodity markets alone will not tackle the many challenges of global food production. But in the wake of the financial crisis, there is a unique opportunity to introduce financial market regulation, taking the first steps to improving the global food system for the benefit of food producers and consumers. The enormous influx of financial speculation into agricultural commodity derivative markets has effectively broken them. Strong regulation is urgently needed to restore these markets to their normal functioning and to help to prevent repeated global food crises. The case for urgent action to tackle the damaging impacts of financial speculation could not be clearer. According to the UN Food and Agriculture Organisation (FAO), food prices have recently exceeded those seen during the last food crisis in 2007-08, rising by 39% in the year to July 2011. In the last six months of 2010 alone, 44 million people were pushed into extreme poverty by rising food prices, equivalent to almost two in every three people in the UK. A financial takeover: How speculation has taken hold In order for futures markets to function effectively, a degree of financial speculation is needed. Financial speculation can provide liquidity to the market and can also play an important role in transferring price risk away from food producers. However, the extent to which it is beneficial to the market is hotly debated. In recent years, speculation has exploded in scale across agricultural commodity markets. Rather than just providing liquidity to help markets' core functions of hedging and price discovery, financial speculation has come to dominate them. Financial domination Deregulation of commodity markets in the US in the late 1990s and early 2000s has allowed an enormous growth in financial speculation in these markets, allowing purely financial actors a much greater role in the markets and facilitating the development of new financial products that allow investors to treat commodities as another asset class, like equity (shares). Investment banks offering access to commodity markets also pitched them as an ideal addition to a portfolio of investments. They promoted research which showed that commodity market returns were less volatile than equities or bonds and provide a good hedge against inflation. Over the course of the last decade agricultural commodity markets have become dominated by financial speculators, overwhelming the normal functioning of these markets. Historically, when commodity markets functioned effectively, providing sufficient liquidity for commercial hedgers and allowing effective price discovery, commercial hedgers dominated the markets, with only a tiny percentage held by financial speculators. This has now reversed, with financial speculators holding the majority of the market. Looking at the largest wheat futures market in the US, in the mid-1990s financial speculators held just 12% of the market, with the rest held by commercial hedgers. In 2011, 61% of the market is held by purely financial speculators and commercial hedgers only make up 39% of the market. This dominance of financial speculators is also reflected in the size of the market held by financial institutions. In the last five years alone the total assets of financial speculators in agricultural commodity markets have nearly doubled from $65 billion in 2006 to $126 billion in March 2011. This money is purely speculative, with none of it being invested in agricultural production, yet it is over 20 times more than the total amount of aid money given globally for agriculture. 'Massive passives' One of the key innovations that facilitated the enormous growth of financial speculation has been the use of commodity index funds, first pioneered by Goldman Sachs in 1991. Commodity index funds work to transfer commodity contracts into an asset that can be bought by other financial institutions such as pension funds. These funds are 'long only', which means they only take positions speculating that prices will rise and 'roll' their positions, replacing contracts each month to maintain the same position in the market. These funds are also completely passive; their trading does not respond to price changes in the market or changes on the ground, but is instead influenced by the amount of money investors hold in the fund. The purpose of index funds was to accumulate an 'everlasting, ever-growing long position, unremittingly regenerated'. Index funds also speculate across a basket of commodities; the most popular funds include oil, gas, metals and agricultural commodities. Commodity index funds were highly attractive to a range of investors, notably pension funds, because they allowed investors to gain exposure to a wide range of commodities markets without having to engage in costly and risky direct trading in the market. This led to an enormous growth in index funds holdings in agricultural commodity markets, increasing 26-fold from around $3 billion in 2003 to $80 billion in 2011, with index funds now making up over 60% of overall financial holdings in agricultural futures markets. This combination of enormous size and their passive trading strategy led Bart Chilton, a commissioner on the Commodity Futures Trading Commission (CFTC), the US commodity regulator, to describe them as 'massive passives'. Active speculators While passive investment has remained popular amongst investors, a survey in December 2010 found that 43% were planning to choose active management to engage in commodity markets in 2011. These active strategies can include the use of other investment vehicles, such as exchange traded products (ETPs), which are traded on stock markets and track either one or a set of commodities. These can allow much smaller investors much easier access to commodity markets, while others are designed to better suit the needs of large-scale investors such as pension funds. As well as there being a vast array of financial products for investors, some speculators such as investment banks and hedge funds trade directly in the markets themselves. These active speculators approach the market in a radically different way from investors using index funds to gain long-term exposure to commodity markets, seeking to profit from short-term price changes in the market. Price-based technical analysis is often used to inform trading decisions, where past price movements are analysed to provide information for likely future price trends. This is the 'traditional' approach to speculation, seeking to buy into rising markets and then aiming to sell out before the market falls. One strategy increasingly used by active speculators is computerised high-frequency trading, often based on analysis of previous price trends, and trading in the market for very short periods of time. High-frequency algorithmic trading can add significant volatility to markets by buying or selling into price movements. The dangers of this form of trading are most clearly seen in the 'flash crashes' that took place in the international sugar market in late 2010 and the cocoa market in early 2011. Falling prices triggered the computerised models to automatically sell, fuelling a downward trend that led to prices falling 11% for sugar and 12.5% for cocoa in a single day. While high-frequency trading has been hugely profitable for commodity exchanges, which profit from the increased trading volume, it has been heavily criticised for providing little if any benefit to commercial hedgers. High-frequency traders only enter the market for short periods of time and will often close out any positions at the end of every trading day. As a result, they do not provide the long-term hedging partner needed for commercial hedgers to transfer price risk. The huge growth in high-frequency trading has led to outcry from commercial traders in the market. Earlier this year the chairman of the World Sugar Committee, the industry body that represents the major sugar traders, wrote to the US sugar exchange: 'Computer-based traders do not even contribute to the traditional function of the speculator in allowing producers and consumers to transfer price risk, since they do not take price risk home. Instead, it would appear that the computer-based traders are parasitic.' Over the past 10 years there has been a radical change in the make-up of agricultural derivative markets. Whereas previously markets were predominantly made up of commercial buyers and sellers involved in the production of food, these markets are increasingly dominated by index funds, traders using investment products like ETPs and high-frequency algorithmic-driven speculation. 'Dark markets': Over-the-counter trading At present only futures and some options trading takes place on exchanges; the rest of the derivatives market, such as swaps, is traded through unregulated bilateral deals known as 'over-the-counter' (OTC) trading. As OTC trading takes place bilaterally and without effective regulatory oversight, prices are not reported publicly, little data is available on the size of the market and there are no requirements for trade reporting, as would happen on a regulated exchange. This has led OTC trading to be referred to as the 'dark markets' due to the lack of market transparency. This lack of transparency and regulation is thought by many to have been at the heart of the 2008 credit crisis and the G20 group of major economies has now resolved to bring more transparency to these markets. The value of outstanding OTC derivatives for all commodities (not just agricultural commodities) stands at nearly $3 trillion, nearly one-and-a-half times the UK's GDP. One of the major advantages of trading OTC is the comparatively low margin requirements for any contract, compared to trading on a regulated futures exchange. Margins are a sum of money that is paid to the exchange for all futures contracts to cover the risk the trader has taken on through this contract. As OTC trading does not go through a central exchange, margin requirements are often very low, reducing the costs to both the parties but taking away the vital risk management function served by margin payments. The other significant feature of OTC trading that has made it attractive to financial and commercial traders is the opportunity to produce highly customised swaps. While all futures contracts are standardised, swaps can be highly complex and exotic, tailored to meet the specifications of individual companies. Rather than benefiting the overall market, OTC trading also allows a tiny group of financial institutions dealing in large volumes of swaps, such as investment banks like Goldman Sachs, to maintain and exploit information asymmetries at the expense of their clients; as the swaps dealers are central to the market, they have access to information unavailable to all of their clients. As OTC trading does not require publicly quoted prices for contracts, there is also no guarantee that swaps dealers are offering fair and equal pricing between their clients. The subprime crisis clearly showed the dangers of unregulated trading in OTC derivatives, yet the risks of this trading in dark markets still exist for agricultural commodities, with potentially even greater risks. Broken markets: The effects of excessive speculation The increase in financial speculation in commodity markets over the last 10 years is clear; however, the effects that this has had are hotly debated. Proponents of efficient market theory have argued that speculation is inherently stabilising. By buying when prices are low and selling when prices are high, speculators are believed to help smooth volatility in the market. In practice this has not been the case. Increasing financial speculation has in fact: �� Distorted prices away from expectations of supply and demand. �� Increased price volatility. �� Caused the prices of unrelated commodities to move together. �� Increased costs for traditional hedgers, forcing them out of the market. The effect of the increasing presence of financial speculators in agricultural derivative markets has been to undermine their basic functions of risk hedging and supporting price discovery. These markets are now barely fit for purpose both for those who rely on these markets directly and in terms of their devastating impact on food prices around the world. Supply and demand? In theory, trading in futures markets should be motivated by information and expectations of the supply and demand of the underlying commodity, ensuring that the price reflects the best available market information. However, financial speculators are much less likely to trade based on information regarding supply and demand but are motivated by a desire to diversify a range of investments. Commodities are simply seen as an investment alternative to 'traditional' investment asset classes such as equities (shares), bonds (debt) or property. One clear example of the impact of financial speculators trading on information unrelated to supply and demand was seen in the cocoa futures market following the release of US employment data in 2010. The release of this data should theoretically have little or no impact on cocoa prices, as there is no causal link between US employment and world chocolate consumption. However, the cocoa futures price dropped nearly 1% in under five minutes after this data was released. If traders based their trading purely on supply and demand information, there would be little or no change in prices. But the spillover from other financial markets and the impact on investor sentiment led to a sharp drop in cocoa prices. By using commodity markets as another asset class, financial speculators distort the price of agricultural commodities. Instead of prices being determined simply by information about the supply and demand of an agricultural commodity, they are now strongly influenced by their value to financial speculators for a whole range of other motivations. When combined with the dominance of financial speculators in the market, this undermines the ability of futures markets to provide effective, informed price signals for the physical market. How index funds cause price inflation While the increasing presence of financial speculators as a whole has moved prices away from expectations of supply and demand, index funds have been singled out by many commentators for their particularly damaging effects, driving price inflation in commodity markets. Due to index funds' size and long-only positions, they place a structural upward pressure on prices in futures markets, with huge amounts of money speculating on rising prices. The enormous scale of this buying on one side of the market then forces prices upwards; as the prominent financier George Soros describes it, 'institutional investors are piling in on one side of the market and they have sufficient weight to unbalance it.' Commentators sceptical of the role of commodity index funds in the recent dramatic increase in prices have argued that index funds could not exert an upward pressure since there is an unlimited supply of futures on an exchange. Due to the limitless supply of futures contracts, they argue, the additional money buying into the long side of the market does not represent new demand; therefore prices would only change in response to new market information, not the trading of index investors. This view, however, grossly oversimplifies trading on commodity exchanges. In order for a transaction to take place, traders on both the long and short side of the contract must reach a price they both agree on. If there is huge demand on one side of the market, traders will demand that they are paid a premium to enter a contract on the other side, inflating the price. This dynamic of buyers moving the market price up is well recognised; as noted by Goldman Sachs to the US Senate, 'Buyers need to enter the market, drive the market price to a place where it attracts sellers. That is the natural balancing act that goes on day in and day out.' Oil, metals and food: Price movements of unrelated commodities Commodity index funds not only work to push up commodity futures prices, they also cause the prices of previously unrelated commodities, such as oil, metals and food, to move together.� As financial investors generally lack commodity-specific knowledge, they buy investment products which include a range of commodities. This could be motivated primarily by a desire to gain access to a specific class of commodities, such as energy and metals which make up the bulk of most commodity indices, but by doing so they also drive money into agricultural commodity markets. This then causes the rises and falls of the larger markets, such as oil and metals, to drive price changes across a whole range of commodities including food. Empirical research into price trends across a range of commodities found that the prices of non-energy commodities, such as agricultural commodities, became increasingly correlated with oil during the mid-2000s, in parallel with the huge growth in financial speculation in commodity index funds. At the end of the 1990s there was almost no correlation between food and oil prices, but by 2008 this correlation had become extremely high. Herding upwards The increased presence of financial speculators in commodity derivative markets has also facilitated greater herding behaviour amongst traders. Herding is when traders act following the actions of a larger group rather than acting independently and rationally based on the information available to them. Herding behaviour is most common in situations of uncertainty, a key feature of commodity markets due to the lack of standardised and reliable data on commodity supply and demand. While data is available from a range of sources such as FAO and the US Department of Agriculture, these sources are often criticised as being unreliable and provide an incomplete picture of global food production. Furthermore much information, such as stocks held by private companies, is only available to a minority of traders, leading to greater uncertainty amongst other traders in the market. Herding behaviours can come in many forms and can be both rational and irrational. One example of irrational herding common in commodity markets is that led by investor beliefs or market sentiment, independent of individual fundamentals, as a major determinant of asset market prices. In commodity markets this is particularly seen in a widely held assumption that in the medium to long term commodity prices will continue to rise. The impact of the beliefs and sentiment of traders can also be clearly seen in the sharp rise in commodity prices following the financial crisis of 2008. It is widely believed, and has been seen following previous crises, that during a recovery commodity prices rise in parallel with economic growth as demand for physical commodities increases. However, following the 2008 economic crash, commodity prices rose much earlier in the economic cycle, significantly ahead of increasing physical demand. Rather than being driven by rising demand, market participants' belief that commodity prices would rise as a result of the recovery drove prices up, completely unrelated to supply or demand. Another form of irrational herding as a result of greater participation of financial speculators has been that of trading based on price-based technical analysis, or 'trend chasing', by active speculators. They are often termed momentum traders as they buy into the momentum of pre-existing upward or downward price trends within the market. These traders add significantly to the volatility in commodity futures markets, increasing the likelihood of markets overshooting both when prices rise and fall. Many of these traders also use similar forms of statistical analysis to inform their trading strategies. This can risk creating a self-fulfilling cycle whereby traders collectively generate and then follow price trends entirely separate from anything dictated by information about supply and demand fundamentals. Not all herding behaviours are irrational. In a market where information is limited and uncertain, and traders know that other market participants may have access to private information they do not have access to, traders can believe that they can gain this information through assessing the trading movements of others. If one trader sees a trend towards betting on higher prices, they may believe that other traders have access to information they do not have access to and so will seek to follow their trading activities, believing them to be based on information about underlying supply and demand. While such actions can be seen to be entirely rational when information is limited, these forms of herding can again become self-fulfilling, distorting prices away from the fundamentals of supply and demand. An additional complexity to such herding behaviour is created by the significant presence of index funds and other passive speculators in commodity markets. As they take a passive approach and speculate across a range of commodities, index traders make decisions irrespective of prevailing conditions in the underlying commodity markets, instead led by other external motivations. Their presence makes it difficult for other traders to judge whether price changes are occurring due to the position changes of index funds or as a response to new information about market fundamentals. This can then lead to traders believing they are rationally following the actions of more informed traders, when they are actually replicating the movements of index funds whose trading decisions are wholly unrelated to supply and demand. Collectively these forms of herding lead to increased price volatility as traders buy into upward trends and sell out of downward price trends, exacerbating the volatility that already existed in the market. As many of these forms of herding are individually and collectively self-reinforcing, they can also lead to long-term and persistent price deviations away from prices that would be determined by supply and demand. Given the current context, where commodity prices are expected to rise following the financial crisis, and a widespread sentiment that food prices will rise due to long-term population pressures, these price deviations serve to inflate prices. In other words, increasing financial speculation fuels and sustains price bubbles within commodity derivative markets. Persistence of bubbles According to efficient market theory, bubbles can only persist for a very short period of time, if at all. Any traders who trade against prices driven by the fundamentals will be punished when traders who trade 'correctly' seek to correct prices back to prices informed by supply and demand. According to this theory, any traders that take positions that are not driven by information about fundamentals will not profit and therefore be driven out of the market. Through this analysis of commodity markets, financial speculators could only move prices away from the levels indicated by supply and demand in the very short term, but there could be no lasting price bubble in commodity prices. While over a long enough period of time it is possible that commodity prices may return to the anchor of fundamentals, commodity markets are highly unlikely to quickly correct back to fundamental levels. This is due to well-recognised limitations on the availability of reliable data about supply and demand fundamentals, significant information asymmetries, very limited elasticity of supply and demand, and an overwhelming number of financial speculators not trading based on supply and demand. For the market to correct, it requires other, informed participants to trade against the financial speculators whose trading does not reflect supply and demand. However, these informed traders face potential losses if prices move still higher under the influence of herding financial speculators, so their short selling may not bring prices back down. Due to this inherent risk it is often not logical for informed traders to attempt to restore prices to a level dictated by the fundamentals. In a market where index funds, hedge funds and investment banks hold such a large influence, exerting a sustained influence on prices, it also may not be possible for informed traders to trade against them. Once financial speculators who do not trade based on supply and demand hold such a strong influence in the market, it no longer makes sense for any trader to swim against the tide by vainly clinging onto market fundamentals. The end result of this is that bubble prices can be sustained in commodity markets for at least the medium term, if not over the longer term. Taking the example of currency markets, where the fundamentals are clear price differentials, currency speculation can be seen to move exchange rates away from the fundamentals for extended periods of time, in some cases for three to five years. Given that information on fundamentals is much less clear in commodity markets, there is little reason to believe that food price bubbles could not persist for as long, if not longer. The 2007-08 food price spike lasted less than two years yet had a devastating impact on people throughout the global South. How futures markets change the price of food Financial speculation has overwhelmed agricultural derivative markets. It has inflated prices, increased price volatility and created bubbles completely unrelated to supply and demand. However, the fact that this speculation takes place in the financial rather than physical markets has led some to question the extent to which this activity can have an impact on the physical price. The US economist Paul Krugman argued that 'a futures contract is a bet about the future price. It has no, zero, nada direct effect on the spot (physical) price'. Others, including research papers for the Organisation for Economic Cooperation and Development (OECD) and the UK government, have all argued that financial speculators could only affect the physical price if they took physical delivery and held these supplies off the market, thereby changing the supply of the commodity. This view is based on the economic theory that the pricing of commodities is led only by the supply-and-demand relationship of the physical commodity. If this theory were correct, recent changes in food prices would be driven by clear and corresponding changes in the fundamentals of supply and demand. However, this is not the case. Taking data from the US Department of Agriculture on global supply and demand for wheat and maize, there is no significant shortfall of supply or excessive demand associated with the sharp price spikes seen in these markets in recent years. Rather than prices being affected only by changes in supply and demand of the physical commodity, futures markets are at the heart of changing commodity prices. They provide price information and signals, acting as a benchmark for the physical markets. Futures markets affect the price of food in the physical commodity markets through: �� Influencing the expectations of buyers and sellers in the physical market. �� The incorporation of futures prices directly into contracts for food. �� Traders taking advantage of differences between prices in futures and physical markets. It is important to recognise that financial investors do also trade in the physical market. Separate from speculation in derivative markets, financial traders are increasingly involved in physical commodities. This was seen in the cocoa market in 2010 when the hedge fund Armajaro attempted to 'corner' the physical market by trying to buy up huge amounts of the world's supply, forcing up prices. There is also a growing trend to financial investment in physically-backed exchange traded products, where physical commodities are essentially hoarded by financial speculators seeking to profit from rising prices in the physical market, though these remain a smaller market than for futures-backed ETPs. While these kinds of interventions in the physical market can force up prices, betting in the financial market can translate directly into changing food prices without financial speculators touching a grain of wheat. Great expectations* The role of futures markets in providing price signals to the physical market is well recognised by regulators in both the US and the UK. As noted above, this is due to the fact that futures markets are generally more liquid and transparent than the physical markets, and are believed to be better able to react to emerging market information and reflect this through changing prices. In practice, prices in the futures markets provide information and help set the expectations of traders in the physical markets. Put simply, traders in the physical markets use the futures market as a benchmark on which to bid in physical auctions. If futures market prices are high and rising, this then changes the expectations of both buyers and sellers in the physical markets, pushing up the price of physical commodities. If food producers, informed by prices in the futures markets, believe that they will be able to gain a higher price in the future, they will be likely to withhold their supply, anticipating a higher price in the future. This withdrawal of supply then pushes up the price. Some critics, such as those noted above, have argued that if price transmission occurred in this way then there would be a significant growth in inventories as commodities are held off the market by producers anticipating higher prices. Such an argument assumes that futures prices only affect the expectations of food producers and not of food buyers. As food buyers also look to the futures market to inform their expectations, they may also be willing to pay a higher price now to avoid paying a higher price in future. As food producers are then able to sell their food at a higher price now (as both buyer and seller have agreed at a higher price), commodities are not held off the market, but the price of the commodity has risen. If the impact on expectations is greater on buyers than on sellers, it would clearly be possible for the physical commodity price to rise in response to changes in the futures markets, while at the same time inventories are falling. The short-run price elasticity of supply and demand for agricultural commodities is also very low; in other words, supply and demand do not respond quickly to changing prices. People need to eat and will be willing to give up other expenditure in order to maintain their levels of consumption. Production of food takes months or years, so producers cannot react quickly in response to rising or falling prices. Therefore only very significant and long-lasting price changes could be expected to change supply and demand sufficiently to produce a noticeable change in actual inventories. Physical commodity contracts In addition to informing the expectations of participants in the physical markets, futures prices are often used as the basis of pricing physical market contracts. Long-term contracts and many forward contracts are often based on the futures price plus or minus an agreed 'basis' for other factors such as location of delivery or quality of the physical product. As noted by the UN special rapporteur on the right to food: 'The grain futures prices quoted by the Chicago Mercantile Exchange tend to be incorporated directly into grain trade contracts the world over.' This type of 'basis' forward contract is reflected in publications from multiple agricultural product associations describing physical delivery contracts. With the futures price directly incorporated into physical commodity contracts, the price discovery process takes place entirely through the futures market, completely separate from the supply and demand of the commodity. Through their incorporation into physical market contracts, increases in futures prices as a result of financial speculation directly increase the cost of food. Arbitrage Arbitrage is the process through which traders can take advantage of an asset being quoted simultaneously at different prices in two different markets. In theory, there should be no significant difference in value between a futures contract for a tonne of wheat for delivery today and an actual tonne of wheat. Therefore traders (arbitrageurs) who are willing and able to take physical delivery, such as the large commodity firms and some hedge funds, can seek to profit from differing prices between futures near their delivery date and the price of the physical commodity. This process of arbitrage then works to close the difference in price between the two markets. If futures prices are higher than physical prices, traders seeking to buy physical commodities who hold futures near to their delivery date will close out their positions in the futures market and seek to take ownership of physical commodities, rather than continuing to hold more expensive futures contracts through to delivery. This increase in demand in the physical market pushes up prices. Taken together, the processes of informing traders' price expectations, direct inclusion in physical commodity contracts and arbitrage provide strong mechanisms for price changes in futures markets to translate directly through into changing prices in the physical market. Fixing broken markets Excessive speculation on food prices is having a devastating impact in the global South, increasing hunger, malnutrition and poverty. Effective financial market regulation can ensure that these markets work both for those who use these markets for the hedging of commercial risk and to the benefit of food consumers throughout the world. The US has already passed legislation including provisions to tackle excessive speculation in financial commodity markets. The G20 and the European Union (EU) are now looking at what new measures are needed to effectively regulate markets outside of the US. In order for all of these reforms to be effective in combating excessive speculation, regulators need to ensure market transparency by moving commodity derivative trading onto well-regulated exchanges and to place strict limits on the overall amount of the market that can be held by financial institutions. Reforms that fall short of these measures are highly unlikely to tackle the dominance of financial speculators within these markets or the enormous inflation in basic food commodity prices they have caused. Transparency: Exchange trading and position reporting The first step in ensuring commodity derivative markets work effectively is ensuring proper market transparency. Commodity derivative trading in Europe currently takes place either on exchanges, such as the NYSE Liffe in London and Paris, where there is little transparency in the positions of different categories of traders, or off exchanges altogether through OTC deals. This lack of transparency inhibits effective market oversight and regulation, prevents fair access to markets and fair pricing, and is associated with greater bid-offer spreads (the difference between the price someone is willing to buy something for, and the price they are willing to sell it for). Introducing proper market transparency through exchange trading and effective position reporting will allow regulators to address excessive speculation. It will also allow the public to effectively assess the impact financial speculation is having in financial commodity markets and to ensure these markets work effectively for the food buyers and producers who rely on them. Exchange trading All standardised and sufficiently liquid commodity derivatives should be moved out of OTC trading and onto well-regulated exchanges, in the same way other financial assets such as equities are traded on the stock market. The aim of such regulation should be to ensure that the vast majority of, if not all, commodity derivative transactions which currently take place via the 'dark' OTC markets are moved onto public exchanges. Regulators need to work with commercial and financial participants to standardise OTC derivatives so as to ensure that greater liquidity can be achieved in a smaller number of standardised derivatives. The Committee of European Securities Regulators proposed this approach in their advice to the European Commission on financial market reform, calling for 'ambitious targets to be set for an increased and high level of standardisation', with clear powers for regulators to intervene if these targets are not met. Without efforts to ensure standardisation of key derivatives that are currently traded OTC, there is the risk of a huge increase in the use of intentionally complex bespoke OTC derivatives intended to have insufficient liquidity to be exchange-traded. Once a greater standardisation of derivative contracts has been established, the responsibility must lie with market participants to prove to regulators that any remaining OTC contracts exist for the hedging of genuine commercial risk which cannot be achieved through standardised exchange-traded contracts. Without effective work to preemptively close loopholes and ensure standardisation, there is significant risk that OTC trading could continue to make up a large part of financial commodity markets. If this were to continue, it would benefit a handful of financial institutions at the expense of other market participants and the effective functioning of derivative exchanges. Position reporting To ensure effective market oversight by regulators, and to allow meaningful analysis, all market participants should be required to provide position reporting information to regulators across all contract types, including OTC markets. Position data should be provided frequently and regularly, preferably daily, by exchanges to regulators. Data should be aggregated and made available to the public by category of trader (e.g., commercial, financial), type of company (e.g., hedge fund, investment bank) and also by investment vehicle (e.g., index fund). This aggregated data must also be provided to the public frequently and on a regular basis. Such position reporting is vital for regulators, analysts and the public to clearly assess the impact of different categories of traders, such as financial speculators, on commodity prices. Position reporting from commodity exchanges takes place in the US through the CFTC, providing public data on the overall positions of different categories of traders, yet no such reporting currently takes place for European commodity markets. Controlling speculation: Position limits Improving transparency alone is not enough to tackle excessive financial speculation. Regulators also need the power to limit the amount of market share financial speculators can hold, reducing their influence on food prices. Individual position limits cap the amount of the market that can be held by an individual trader. These position limits can be used to prevent market manipulation where one participant corners the market by holding the majority of the market for the underlying commodity and squeezing up prices. Such limits can be useful in preventing large financial firms from having too great an influence on the market through holding excessive positions and can tackle 'commercial speculators' - large multinationals which use commodity markets for speculation as well as hedging. The limitation of individual position limits is that while they can help prevent individual traders having too large an influence on the market, they do not tackle the influence of a category of traders, such as financial speculators, on the market. To address this, aggregate position limits are needed. Aggregate position limits cap the amount of any market that can be held by any category or group of traders in total, ensuring there is not an excessive concentration of such a group. Position limits require active analysis, oversight and intervention by regulators. If a category of traders reach their aggregate position limit, regulators would intervene to require the largest market participants within that category to reduce their positions until that category fell below the aggregate limit. Any such limits should be permanently established throughout the lifetime of the derivative contract and ensure a sustainable balance of commercial and non-commercial participants, while allowing sufficient liquidity. Given the lack of transparency in UK and EU markets in terms of composition, liquidity and trading volumes, it is very difficult to independently assess the exact levels at which they should be set. However, data from the US markets in the 1990s suggests that commodity markets worked effectively for commercial participants, without a lack of liquidity and with relatively stable prices, with as little as 25% of the market being held by financial speculators. In setting aggregate position limits, regulators should use this historical data, together with ongoing market analysis, as the reference point for setting limits. Enforcement of position limits should be absolute and market participants should be strictly prevented from exceeding them, without exception. The limits must work across contract types - establishing them only in futures markets without addressing OTC trading would be likely to simply see a huge shift in trading off regulated exchanges and onto dark, unregulated markets. Effective permanent position limits which strictly control the amount of the market that can be held by financial speculators, such as index funds or investment banks, can prevent them having dominance over the price discovery functions of these markets. It is only through regulatory intervention to ensure a sustainable balance of commercial and financial participants that these markets can be brought back to delivering their intended purposes of allowing commercial participants to hedge risk and of price discovery for the physical markets. Without effective regulation to limit the impact financial speculators can have within the futures market, it is likely that prices will become increasingly disconnected from supply and demand fundamentals, become more volatile and continue the dramatic upward trend seen in recent years. Additional measures In addition to introducing exchange trading and position limits, a range of other measures can be considered which may also help to reduce the damaging impacts of financial speculation: �� Margins: Increasing margin requirements for financial speculators both increases trading costs and increases firms' own financial risk in each transaction. Combined, the increased costs and risk could help reduce excessive speculation. �� Financial transactions tax (FTT): An FTT on all commodity derivative transactions, set at a high enough level, could increase costs for high-frequency traders and short-term speculators who increase volatility and herding in the market. �� Regulatory capacity: At present specific regulatory expertise and capacity on commodity markets is lacking in the UK and throughout the EU. Dedicated expertise and increased capacity for commodity market regulators is required to ensure any rules proposed are enforced effectively. Conclusion* Excessive financial speculation in any market can cause harm, as the subprime mortgage crisis and the ensuing credit crunch demonstrated. Now it is all too apparent in food commodity markets. The enormous growth in financial speculation in agricultural commodity markets has overwhelmed these markets, making them unable to fulfil their intended purpose of managing risk and supporting price discovery based on supply and demand. Speculation on food prices has led to price inflation, increased price volatility and, most importantly, has caused massive harm to the people most at risk of hunger and poverty. Around one billion people currently go hungry and millions more are at risk of hunger, malnutrition and poverty if prices rise further. Effective regulation of financial commodity markets is urgently needed, to prevent excessive speculation leading to further hunger and poverty and to make markets work for the commercial traders who rely on them. In the light of the devastating impact of speculation, commodity derivatives cannot be left unregulated, as if they were just another asset class for financial investors. Far from stabilising commodity markets, the high volume of financial speculation has had the effect of a devastating flood. The level of speculation is far beyond that needed to provide liquidity to commercial hedgers, and is now undermining the effective working of these markets. Reducing the amount of the market that can be held by purely financial speculators is vital to make these markets work. Financial market regulation is feasible and can be implemented without damaging the functioning of the markets for the commercial traders who rely on them. While the challenges of the global food system will not be solved by curbing speculation alone, such regulation would have a significant impact on ensuring fairer and more stable food prices. The financial services industry, which has capitalised on agricultural commodity markets at the expense of commercial traders and the world's consumers, is lobbying hard to prevent regulation. With banks like Goldman Sachs making over $1 billion� and Barclays making as much as $550 million from speculation on food in one year alone, it appears their motivation to oppose reform is driven more by financial self-interest than a concern for the effective functioning of these markets. Those who oppose clear and strict regulations to tackle excessive speculation, including the UK government, risk condemning millions of people to a future of hunger and poverty. In the US, at the G20 and through the European Commission's review of the Markets in Financial Instruments Directive (MiFID), there is a unique opportunity to put in place the regulation that is so urgently needed. Regulation of agricultural derivative markets would end the dominance of financial speculators, and make these markets work for the benefit of food producers and consumers throughout the world. Regulators must take this opportunity to act for the benefit of all.�� The above is extracted from the World Development Movement report Broken Markets: How Financial Market Regulation Can Help Prevent Another Global Food Crisis (September 2011) written by Murray Worthy. The full report with references is available on the World Development Movement's website www.wdm.org.uk. *Third World Resurgence No. 254, October 2011, pp 12-20
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THIRD WORLD RESURGENCE
Taming financial speculation, stabilising food prices The enormous influx of financial speculation into agricultural commodity derivative markets has effectively broken them. Strong regulation is urgently needed to restore these markets to their normal functioning and to help prevent repeated global food crises. FOOD is a fundamental human right and essential to our survival. Yet many are unaware of the powerful position that financial markets have come to hold in the global food system. Alongside markets for trading food (physical markets), financial markets for futures and other derivatives play a central role in setting the prices of the world's food. Futures markets were originally developed to help those involved in producing food to manage their risk. Food producers and other commercial participants involved in the supply chain are inherently exposed to the risk of fluctuating prices. A producer growing a crop, such as wheat or maize, has to invest in production through buying seeds or other inputs such as fertiliser. However, this investment is at risk as the price of the crop may fall while it is being grown. Futures markets allow food producers and other commercial participants to transfer their price risk to someone else more willing to take on that risk. This could be another commercial hedger, or a financial speculator who hopes to profit from changing prices over the life of the futures contract. Futures markets were developed for the benefit of those involved in the production of food, yet they have now changed almost beyond recognition. Over the past 10 years, financial markets for agricultural commodities have become dominated by speculators who simply use them as another form of investment. As a result, they are no longer able to fulfil their intended functions. Moreover, most of the world's food producers, the majority of whom are small farmers in developing countries who lack access to credit, do not have access to nor rely on commodity futures markets to manage risk. Many alternatives to market-based risk management exist which would be better suited to the needs of most of the world's farmers. Wider structural changes are needed to ensure the global food system can meet the needs of a growing population and the needs of those who produce the world's food. A food system that is not shaped by unjust trade rules and a handful of powerful corporations, but instead supports ecologically sustainable small-scale food producers, is vital to achieving this goal. Regulating agricultural commodity markets alone will not tackle the many challenges of global food production. But in the wake of the financial crisis, there is a unique opportunity to introduce financial market regulation, taking the first steps to improving the global food system for the benefit of food producers and consumers. The enormous influx of financial speculation into agricultural commodity derivative markets has effectively broken them. Strong regulation is urgently needed to restore these markets to their normal functioning and to help to prevent repeated global food crises. The case for urgent action to tackle the damaging impacts of financial speculation could not be clearer. According to the UN Food and Agriculture Organisation (FAO), food prices have recently exceeded those seen during the last food crisis in 2007-08, rising by 39% in the year to July 2011. In the last six months of 2010 alone, 44 million people were pushed into extreme poverty by rising food prices, equivalent to almost two in every three people in the UK. A financial takeover: How speculation has taken hold In order for futures markets to function effectively, a degree of financial speculation is needed. Financial speculation can provide liquidity to the market and can also play an important role in transferring price risk away from food producers. However, the extent to which it is beneficial to the market is hotly debated. In recent years, speculation has exploded in scale across agricultural commodity markets. Rather than just providing liquidity to help markets' core functions of hedging and price discovery, financial speculation has come to dominate them. Financial domination Deregulation of commodity markets in the US in the late 1990s and early 2000s has allowed an enormous growth in financial speculation in these markets, allowing purely financial actors a much greater role in the markets and facilitating the development of new financial products that allow investors to treat commodities as another asset class, like equity (shares). Investment banks offering access to commodity markets also pitched them as an ideal addition to a portfolio of investments. They promoted research which showed that commodity market returns were less volatile than equities or bonds and provide a good hedge against inflation. Over the course of the last decade agricultural commodity markets have become dominated by financial speculators, overwhelming the normal functioning of these markets. Historically, when commodity markets functioned effectively, providing sufficient liquidity for commercial hedgers and allowing effective price discovery, commercial hedgers dominated the markets, with only a tiny percentage held by financial speculators. This has now reversed, with financial speculators holding the majority of the market. Looking at the largest wheat futures market in the US, in the mid-1990s financial speculators held just 12% of the market, with the rest held by commercial hedgers. In 2011, 61% of the market is held by purely financial speculators and commercial hedgers only make up 39% of the market. This dominance of financial speculators is also reflected in the size of the market held by financial institutions. In the last five years alone the total assets of financial speculators in agricultural commodity markets have nearly doubled from $65 billion in 2006 to $126 billion in March 2011. This money is purely speculative, with none of it being invested in agricultural production, yet it is over 20 times more than the total amount of aid money given globally for agriculture. 'Massive passives' One of the key innovations that facilitated the enormous growth of financial speculation has been the use of commodity index funds, first pioneered by Goldman Sachs in 1991. Commodity index funds work to transfer commodity contracts into an asset that can be bought by other financial institutions such as pension funds. These funds are 'long only', which means they only take positions speculating that prices will rise and 'roll' their positions, replacing contracts each month to maintain the same position in the market. These funds are also completely passive; their trading does not respond to price changes in the market or changes on the ground, but is instead influenced by the amount of money investors hold in the fund. The purpose of index funds was to accumulate an 'everlasting, ever-growing long position, unremittingly regenerated'. Index funds also speculate across a basket of commodities; the most popular funds include oil, gas, metals and agricultural commodities. Commodity index funds were highly attractive to a range of investors, notably pension funds, because they allowed investors to gain exposure to a wide range of commodities markets without having to engage in costly and risky direct trading in the market. This led to an enormous growth in index funds holdings in agricultural commodity markets, increasing 26-fold from around $3 billion in 2003 to $80 billion in 2011, with index funds now making up over 60% of overall financial holdings in agricultural futures markets. This combination of enormous size and their passive trading strategy led Bart Chilton, a commissioner on the Commodity Futures Trading Commission (CFTC), the US commodity regulator, to describe them as 'massive passives'. Active speculators While passive investment has remained popular amongst investors, a survey in December 2010 found that 43% were planning to choose active management to engage in commodity markets in 2011. These active strategies can include the use of other investment vehicles, such as exchange traded products (ETPs), which are traded on stock markets and track either one or a set of commodities. These can allow much smaller investors much easier access to commodity markets, while others are designed to better suit the needs of large-scale investors such as pension funds. As well as there being a vast array of financial products for investors, some speculators such as investment banks and hedge funds trade directly in the markets themselves. These active speculators approach the market in a radically different way from investors using index funds to gain long-term exposure to commodity markets, seeking to profit from short-term price changes in the market. Price-based technical analysis is often used to inform trading decisions, where past price movements are analysed to provide information for likely future price trends. This is the 'traditional' approach to speculation, seeking to buy into rising markets and then aiming to sell out before the market falls. One strategy increasingly used by active speculators is computerised high-frequency trading, often based on analysis of previous price trends, and trading in the market for very short periods of time. High-frequency algorithmic trading can add significant volatility to markets by buying or selling into price movements. The dangers of this form of trading are most clearly seen in the 'flash crashes' that took place in the international sugar market in late 2010 and the cocoa market in early 2011. Falling prices triggered the computerised models to automatically sell, fuelling a downward trend that led to prices falling 11% for sugar and 12.5% for cocoa in a single day. While high-frequency trading has been hugely profitable for commodity exchanges, which profit from the increased trading volume, it has been heavily criticised for providing little if any benefit to commercial hedgers. High-frequency traders only enter the market for short periods of time and will often close out any positions at the end of every trading day. As a result, they do not provide the long-term hedging partner needed for commercial hedgers to transfer price risk. The huge growth in high-frequency trading has led to outcry from commercial traders in the market. Earlier this year the chairman of the World Sugar Committee, the industry body that represents the major sugar traders, wrote to the US sugar exchange: 'Computer-based traders do not even contribute to the traditional function of the speculator in allowing producers and consumers to transfer price risk, since they do not take price risk home. Instead, it would appear that the computer-based traders are parasitic.' Over the past 10 years there has been a radical change in the make-up of agricultural derivative markets. Whereas previously markets were predominantly made up of commercial buyers and sellers involved in the production of food, these markets are increasingly dominated by index funds, traders using investment products like ETPs and high-frequency algorithmic-driven speculation. 'Dark markets': Over-the-counter trading At present only futures and some options trading takes place on exchanges; the rest of the derivatives market, such as swaps, is traded through unregulated bilateral deals known as 'over-the-counter' (OTC) trading. As OTC trading takes place bilaterally and without effective regulatory oversight, prices are not reported publicly, little data is available on the size of the market and there are no requirements for trade reporting, as would happen on a regulated exchange. This has led OTC trading to be referred to as the 'dark markets' due to the lack of market transparency. This lack of transparency and regulation is thought by many to have been at the heart of the 2008 credit crisis and the G20 group of major economies has now resolved to bring more transparency to these markets. The value of outstanding OTC derivatives for all commodities (not just agricultural commodities) stands at nearly $3 trillion, nearly one-and-a-half times the UK's GDP. One of the major advantages of trading OTC is the comparatively low margin requirements for any contract, compared to trading on a regulated futures exchange. Margins are a sum of money that is paid to the exchange for all futures contracts to cover the risk the trader has taken on through this contract. As OTC trading does not go through a central exchange, margin requirements are often very low, reducing the costs to both the parties but taking away the vital risk management function served by margin payments. The other significant feature of OTC trading that has made it attractive to financial and commercial traders is the opportunity to produce highly customised swaps. While all futures contracts are standardised, swaps can be highly complex and exotic, tailored to meet the specifications of individual companies. Rather than benefiting the overall market, OTC trading also allows a tiny group of financial institutions dealing in large volumes of swaps, such as investment banks like Goldman Sachs, to maintain and exploit information asymmetries at the expense of their clients; as the swaps dealers are central to the market, they have access to information unavailable to all of their clients. As OTC trading does not require publicly quoted prices for contracts, there is also no guarantee that swaps dealers are offering fair and equal pricing between their clients. The subprime crisis clearly showed the dangers of unregulated trading in OTC derivatives, yet the risks of this trading in dark markets still exist for agricultural commodities, with potentially even greater risks. Broken markets: The effects of excessive speculation The increase in financial speculation in commodity markets over the last 10 years is clear; however, the effects that this has had are hotly debated. Proponents of efficient market theory have argued that speculation is inherently stabilising. By buying when prices are low and selling when prices are high, speculators are believed to help smooth volatility in the market. In practice this has not been the case. Increasing financial speculation has in fact: �� Distorted prices away from expectations of supply and demand. �� Increased price volatility. �� Caused the prices of unrelated commodities to move together. �� Increased costs for traditional hedgers, forcing them out of the market. The effect of the increasing presence of financial speculators in agricultural derivative markets has been to undermine their basic functions of risk hedging and supporting price discovery. These markets are now barely fit for purpose both for those who rely on these markets directly and in terms of their devastating impact on food prices around the world. Supply and demand? In theory, trading in futures markets should be motivated by information and expectations of the supply and demand of the underlying commodity, ensuring that the price reflects the best available market information. However, financial speculators are much less likely to trade based on information regarding supply and demand but are motivated by a desire to diversify a range of investments. Commodities are simply seen as an investment alternative to 'traditional' investment asset classes such as equities (shares), bonds (debt) or property. One clear example of the impact of financial speculators trading on information unrelated to supply and demand was seen in the cocoa futures market following the release of US employment data in 2010. The release of this data should theoretically have little or no impact on cocoa prices, as there is no causal link between US employment and world chocolate consumption. However, the cocoa futures price dropped nearly 1% in under five minutes after this data was released. If traders based their trading purely on supply and demand information, there would be little or no change in prices. But the spillover from other financial markets and the impact on investor sentiment led to a sharp drop in cocoa prices. By using commodity markets as another asset class, financial speculators distort the price of agricultural commodities. Instead of prices being determined simply by information about the supply and demand of an agricultural commodity, they are now strongly influenced by their value to financial speculators for a whole range of other motivations. When combined with the dominance of financial speculators in the market, this undermines the ability of futures markets to provide effective, informed price signals for the physical market. How index funds cause price inflation While the increasing presence of financial speculators as a whole has moved prices away from expectations of supply and demand, index funds have been singled out by many commentators for their particularly damaging effects, driving price inflation in commodity markets. Due to index funds' size and long-only positions, they place a structural upward pressure on prices in futures markets, with huge amounts of money speculating on rising prices. The enormous scale of this buying on one side of the market then forces prices upwards; as the prominent financier George Soros describes it, 'institutional investors are piling in on one side of the market and they have sufficient weight to unbalance it.' Commentators sceptical of the role of commodity index funds in the recent dramatic increase in prices have argued that index funds could not exert an upward pressure since there is an unlimited supply of futures on an exchange. Due to the limitless supply of futures contracts, they argue, the additional money buying into the long side of the market does not represent new demand; therefore prices would only change in response to new market information, not the trading of index investors. This view, however, grossly oversimplifies trading on commodity exchanges. In order for a transaction to take place, traders on both the long and short side of the contract must reach a price they both agree on. If there is huge demand on one side of the market, traders will demand that they are paid a premium to enter a contract on the other side, inflating the price. This dynamic of buyers moving the market price up is well recognised; as noted by Goldman Sachs to the US Senate, 'Buyers need to enter the market, drive the market price to a place where it attracts sellers. That is the natural balancing act that goes on day in and day out.' Oil, metals and food: Price movements of unrelated commodities Commodity index funds not only work to push up commodity futures prices, they also cause the prices of previously unrelated commodities, such as oil, metals and food, to move together.� As financial investors generally lack commodity-specific knowledge, they buy investment products which include a range of commodities. This could be motivated primarily by a desire to gain access to a specific class of commodities, such as energy and metals which make up the bulk of most commodity indices, but by doing so they also drive money into agricultural commodity markets. This then causes the rises and falls of the larger markets, such as oil and metals, to drive price changes across a whole range of commodities including food. Empirical research into price trends across a range of commodities found that the prices of non-energy commodities, such as agricultural commodities, became increasingly correlated with oil during the mid-2000s, in parallel with the huge growth in financial speculation in commodity index funds. At the end of the 1990s there was almost no correlation between food and oil prices, but by 2008 this correlation had become extremely high. Herding upwards The increased presence of financial speculators in commodity derivative markets has also facilitated greater herding behaviour amongst traders. Herding is when traders act following the actions of a larger group rather than acting independently and rationally based on the information available to them. Herding behaviour is most common in situations of uncertainty, a key feature of commodity markets due to the lack of standardised and reliable data on commodity supply and demand. While data is available from a range of sources such as FAO and the US Department of Agriculture, these sources are often criticised as being unreliable and provide an incomplete picture of global food production. Furthermore much information, such as stocks held by private companies, is only available to a minority of traders, leading to greater uncertainty amongst other traders in the market. Herding behaviours can come in many forms and can be both rational and irrational. One example of irrational herding common in commodity markets is that led by investor beliefs or market sentiment, independent of individual fundamentals, as a major determinant of asset market prices. In commodity markets this is particularly seen in a widely held assumption that in the medium to long term commodity prices will continue to rise. The impact of the beliefs and sentiment of traders can also be clearly seen in the sharp rise in commodity prices following the financial crisis of 2008. It is widely believed, and has been seen following previous crises, that during a recovery commodity prices rise in parallel with economic growth as demand for physical commodities increases. However, following the 2008 economic crash, commodity prices rose much earlier in the economic cycle, significantly ahead of increasing physical demand. Rather than being driven by rising demand, market participants' belief that commodity prices would rise as a result of the recovery drove prices up, completely unrelated to supply or demand. Another form of irrational herding as a result of greater participation of financial speculators has been that of trading based on price-based technical analysis, or 'trend chasing', by active speculators. They are often termed momentum traders as they buy into the momentum of pre-existing upward or downward price trends within the market. These traders add significantly to the volatility in commodity futures markets, increasing the likelihood of markets overshooting both when prices rise and fall. Many of these traders also use similar forms of statistical analysis to inform their trading strategies. This can risk creating a self-fulfilling cycle whereby traders collectively generate and then follow price trends entirely separate from anything dictated by information about supply and demand fundamentals. Not all herding behaviours are irrational. In a market where information is limited and uncertain, and traders know that other market participants may have access to private information they do not have access to, traders can believe that they can gain this information through assessing the trading movements of others. If one trader sees a trend towards betting on higher prices, they may believe that other traders have access to information they do not have access to and so will seek to follow their trading activities, believing them to be based on information about underlying supply and demand. While such actions can be seen to be entirely rational when information is limited, these forms of herding can again become self-fulfilling, distorting prices away from the fundamentals of supply and demand. An additional complexity to such herding behaviour is created by the significant presence of index funds and other passive speculators in commodity markets. As they take a passive approach and speculate across a range of commodities, index traders make decisions irrespective of prevailing conditions in the underlying commodity markets, instead led by other external motivations. Their presence makes it difficult for other traders to judge whether price changes are occurring due to the position changes of index funds or as a response to new information about market fundamentals. This can then lead to traders believing they are rationally following the actions of more informed traders, when they are actually replicating the movements of index funds whose trading decisions are wholly unrelated to supply and demand. Collectively these forms of herding lead to increased price volatility as traders buy into upward trends and sell out of downward price trends, exacerbating the volatility that already existed in the market. As many of these forms of herding are individually and collectively self-reinforcing, they can also lead to long-term and persistent price deviations away from prices that would be determined by supply and demand. Given the current context, where commodity prices are expected to rise following the financial crisis, and a widespread sentiment that food prices will rise due to long-term population pressures, these price deviations serve to inflate prices. In other words, increasing financial speculation fuels and sustains price bubbles within commodity derivative markets. Persistence of bubbles According to efficient market theory, bubbles can only persist for a very short period of time, if at all. Any traders who trade against prices driven by the fundamentals will be punished when traders who trade 'correctly' seek to correct prices back to prices informed by supply and demand. According to this theory, any traders that take positions that are not driven by information about fundamentals will not profit and therefore be driven out of the market. Through this analysis of commodity markets, financial speculators could only move prices away from the levels indicated by supply and demand in the very short term, but there could be no lasting price bubble in commodity prices. While over a long enough period of time it is possible that commodity prices may return to the anchor of fundamentals, commodity markets are highly unlikely to quickly correct back to fundamental levels. This is due to well-recognised limitations on the availability of reliable data about supply and demand fundamentals, significant information asymmetries, very limited elasticity of supply and demand, and an overwhelming number of financial speculators not trading based on supply and demand. For the market to correct, it requires other, informed participants to trade against the financial speculators whose trading does not reflect supply and demand. However, these informed traders face potential losses if prices move still higher under the influence of herding financial speculators, so their short selling may not bring prices back down. Due to this inherent risk it is often not logical for informed traders to attempt to restore prices to a level dictated by the fundamentals. In a market where index funds, hedge funds and investment banks hold such a large influence, exerting a sustained influence on prices, it also may not be possible for informed traders to trade against them. Once financial speculators who do not trade based on supply and demand hold such a strong influence in the market, it no longer makes sense for any trader to swim against the tide by vainly clinging onto market fundamentals. The end result of this is that bubble prices can be sustained in commodity markets for at least the medium term, if not over the longer term. Taking the example of currency markets, where the fundamentals are clear price differentials, currency speculation can be seen to move exchange rates away from the fundamentals for extended periods of time, in some cases for three to five years. Given that information on fundamentals is much less clear in commodity markets, there is little reason to believe that food price bubbles could not persist for as long, if not longer. The 2007-08 food price spike lasted less than two years yet had a devastating impact on people throughout the global South. How futures markets change the price of food Financial speculation has overwhelmed agricultural derivative markets. It has inflated prices, increased price volatility and created bubbles completely unrelated to supply and demand. However, the fact that this speculation takes place in the financial rather than physical markets has led some to question the extent to which this activity can have an impact on the physical price. The US economist Paul Krugman argued that 'a futures contract is a bet about the future price. It has no, zero, nada direct effect on the spot (physical) price'. Others, including research papers for the Organisation for Economic Cooperation and Development (OECD) and the UK government, have all argued that financial speculators could only affect the physical price if they took physical delivery and held these supplies off the market, thereby changing the supply of the commodity. This view is based on the economic theory that the pricing of commodities is led only by the supply-and-demand relationship of the physical commodity. If this theory were correct, recent changes in food prices would be driven by clear and corresponding changes in the fundamentals of supply and demand. However, this is not the case. Taking data from the US Department of Agriculture on global supply and demand for wheat and maize, there is no significant shortfall of supply or excessive demand associated with the sharp price spikes seen in these markets in recent years. Rather than prices being affected only by changes in supply and demand of the physical commodity, futures markets are at the heart of changing commodity prices. They provide price information and signals, acting as a benchmark for the physical markets. Futures markets affect the price of food in the physical commodity markets through: �� Influencing the expectations of buyers and sellers in the physical market. �� The incorporation of futures prices directly into contracts for food. �� Traders taking advantage of differences between prices in futures and physical markets. It is important to recognise that financial investors do also trade in the physical market. Separate from speculation in derivative markets, financial traders are increasingly involved in physical commodities. This was seen in the cocoa market in 2010 when the hedge fund Armajaro attempted to 'corner' the physical market by trying to buy up huge amounts of the world's supply, forcing up prices. There is also a growing trend to financial investment in physically-backed exchange traded products, where physical commodities are essentially hoarded by financial speculators seeking to profit from rising prices in the physical market, though these remain a smaller market than for futures-backed ETPs. While these kinds of interventions in the physical market can force up prices, betting in the financial market can translate directly into changing food prices without financial speculators touching a grain of wheat. Great expectations* The role of futures markets in providing price signals to the physical market is well recognised by regulators in both the US and the UK. As noted above, this is due to the fact that futures markets are generally more liquid and transparent than the physical markets, and are believed to be better able to react to emerging market information and reflect this through changing prices. In practice, prices in the futures markets provide information and help set the expectations of traders in the physical markets. Put simply, traders in the physical markets use the futures market as a benchmark on which to bid in physical auctions. If futures market prices are high and rising, this then changes the expectations of both buyers and sellers in the physical markets, pushing up the price of physical commodities. If food producers, informed by prices in the futures markets, believe that they will be able to gain a higher price in the future, they will be likely to withhold their supply, anticipating a higher price in the future. This withdrawal of supply then pushes up the price. Some critics, such as those noted above, have argued that if price transmission occurred in this way then there would be a significant growth in inventories as commodities are held off the market by producers anticipating higher prices. Such an argument assumes that futures prices only affect the expectations of food producers and not of food buyers. As food buyers also look to the futures market to inform their expectations, they may also be willing to pay a higher price now to avoid paying a higher price in future. As food producers are then able to sell their food at a higher price now (as both buyer and seller have agreed at a higher price), commodities are not held off the market, but the price of the commodity has risen. If the impact on expectations is greater on buyers than on sellers, it would clearly be possible for the physical commodity price to rise in response to changes in the futures markets, while at the same time inventories are falling. The short-run price elasticity of supply and demand for agricultural commodities is also very low; in other words, supply and demand do not respond quickly to changing prices. People need to eat and will be willing to give up other expenditure in order to maintain their levels of consumption. Production of food takes months or years, so producers cannot react quickly in response to rising or falling prices. Therefore only very significant and long-lasting price changes could be expected to change supply and demand sufficiently to produce a noticeable change in actual inventories. Physical commodity contracts In addition to informing the expectations of participants in the physical markets, futures prices are often used as the basis of pricing physical market contracts. Long-term contracts and many forward contracts are often based on the futures price plus or minus an agreed 'basis' for other factors such as location of delivery or quality of the physical product. As noted by the UN special rapporteur on the right to food: 'The grain futures prices quoted by the Chicago Mercantile Exchange tend to be incorporated directly into grain trade contracts the world over.' This type of 'basis' forward contract is reflected in publications from multiple agricultural product associations describing physical delivery contracts. With the futures price directly incorporated into physical commodity contracts, the price discovery process takes place entirely through the futures market, completely separate from the supply and demand of the commodity. Through their incorporation into physical market contracts, increases in futures prices as a result of financial speculation directly increase the cost of food. Arbitrage Arbitrage is the process through which traders can take advantage of an asset being quoted simultaneously at different prices in two different markets. In theory, there should be no significant difference in value between a futures contract for a tonne of wheat for delivery today and an actual tonne of wheat. Therefore traders (arbitrageurs) who are willing and able to take physical delivery, such as the large commodity firms and some hedge funds, can seek to profit from differing prices between futures near their delivery date and the price of the physical commodity. This process of arbitrage then works to close the difference in price between the two markets. If futures prices are higher than physical prices, traders seeking to buy physical commodities who hold futures near to their delivery date will close out their positions in the futures market and seek to take ownership of physical commodities, rather than continuing to hold more expensive futures contracts through to delivery. This increase in demand in the physical market pushes up prices. Taken together, the processes of informing traders' price expectations, direct inclusion in physical commodity contracts and arbitrage provide strong mechanisms for price changes in futures markets to translate directly through into changing prices in the physical market. Fixing broken markets Excessive speculation on food prices is having a devastating impact in the global South, increasing hunger, malnutrition and poverty. Effective financial market regulation can ensure that these markets work both for those who use these markets for the hedging of commercial risk and to the benefit of food consumers throughout the world. The US has already passed legislation including provisions to tackle excessive speculation in financial commodity markets. The G20 and the European Union (EU) are now looking at what new measures are needed to effectively regulate markets outside of the US. In order for all of these reforms to be effective in combating excessive speculation, regulators need to ensure market transparency by moving commodity derivative trading onto well-regulated exchanges and to place strict limits on the overall amount of the market that can be held by financial institutions. Reforms that fall short of these measures are highly unlikely to tackle the dominance of financial speculators within these markets or the enormous inflation in basic food commodity prices they have caused. Transparency: Exchange trading and position reporting The first step in ensuring commodity derivative markets work effectively is ensuring proper market transparency. Commodity derivative trading in Europe currently takes place either on exchanges, such as the NYSE Liffe in London and Paris, where there is little transparency in the positions of different categories of traders, or off exchanges altogether through OTC deals. This lack of transparency inhibits effective market oversight and regulation, prevents fair access to markets and fair pricing, and is associated with greater bid-offer spreads (the difference between the price someone is willing to buy something for, and the price they are willing to sell it for). Introducing proper market transparency through exchange trading and effective position reporting will allow regulators to address excessive speculation. It will also allow the public to effectively assess the impact financial speculation is having in financial commodity markets and to ensure these markets work effectively for the food buyers and producers who rely on them. Exchange trading All standardised and sufficiently liquid commodity derivatives should be moved out of OTC trading and onto well-regulated exchanges, in the same way other financial assets such as equities are traded on the stock market. The aim of such regulation should be to ensure that the vast majority of, if not all, commodity derivative transactions which currently take place via the 'dark' OTC markets are moved onto public exchanges. Regulators need to work with commercial and financial participants to standardise OTC derivatives so as to ensure that greater liquidity can be achieved in a smaller number of standardised derivatives. The Committee of European Securities Regulators proposed this approach in their advice to the European Commission on financial market reform, calling for 'ambitious targets to be set for an increased and high level of standardisation', with clear powers for regulators to intervene if these targets are not met. Without efforts to ensure standardisation of key derivatives that are currently traded OTC, there is the risk of a huge increase in the use of intentionally complex bespoke OTC derivatives intended to have insufficient liquidity to be exchange-traded. Once a greater standardisation of derivative contracts has been established, the responsibility must lie with market participants to prove to regulators that any remaining OTC contracts exist for the hedging of genuine commercial risk which cannot be achieved through standardised exchange-traded contracts. Without effective work to preemptively close loopholes and ensure standardisation, there is significant risk that OTC trading could continue to make up a large part of financial commodity markets. If this were to continue, it would benefit a handful of financial institutions at the expense of other market participants and the effective functioning of derivative exchanges. Position reporting To ensure effective market oversight by regulators, and to allow meaningful analysis, all market participants should be required to provide position reporting information to regulators across all contract types, including OTC markets. Position data should be provided frequently and regularly, preferably daily, by exchanges to regulators. Data should be aggregated and made available to the public by category of trader (e.g., commercial, financial), type of company (e.g., hedge fund, investment bank) and also by investment vehicle (e.g., index fund). This aggregated data must also be provided to the public frequently and on a regular basis. Such position reporting is vital for regulators, analysts and the public to clearly assess the impact of different categories of traders, such as financial speculators, on commodity prices. Position reporting from commodity exchanges takes place in the US through the CFTC, providing public data on the overall positions of different categories of traders, yet no such reporting currently takes place for European commodity markets. Controlling speculation: Position limits Improving transparency alone is not enough to tackle excessive financial speculation. Regulators also need the power to limit the amount of market share financial speculators can hold, reducing their influence on food prices. Individual position limits cap the amount of the market that can be held by an individual trader. These position limits can be used to prevent market manipulation where one participant corners the market by holding the majority of the market for the underlying commodity and squeezing up prices. Such limits can be useful in preventing large financial firms from having too great an influence on the market through holding excessive positions and can tackle 'commercial speculators' - large multinationals which use commodity markets for speculation as well as hedging. The limitation of individual position limits is that while they can help prevent individual traders having too large an influence on the market, they do not tackle the influence of a category of traders, such as financial speculators, on the market. To address this, aggregate position limits are needed. Aggregate position limits cap the amount of any market that can be held by any category or group of traders in total, ensuring there is not an excessive concentration of such a group. Position limits require active analysis, oversight and intervention by regulators. If a category of traders reach their aggregate position limit, regulators would intervene to require the largest market participants within that category to reduce their positions until that category fell below the aggregate limit. Any such limits should be permanently established throughout the lifetime of the derivative contract and ensure a sustainable balance of commercial and non-commercial participants, while allowing sufficient liquidity. Given the lack of transparency in UK and EU markets in terms of composition, liquidity and trading volumes, it is very difficult to independently assess the exact levels at which they should be set. However, data from the US markets in the 1990s suggests that commodity markets worked effectively for commercial participants, without a lack of liquidity and with relatively stable prices, with as little as 25% of the market being held by financial speculators. In setting aggregate position limits, regulators should use this historical data, together with ongoing market analysis, as the reference point for setting limits. Enforcement of position limits should be absolute and market participants should be strictly prevented from exceeding them, without exception. The limits must work across contract types - establishing them only in futures markets without addressing OTC trading would be likely to simply see a huge shift in trading off regulated exchanges and onto dark, unregulated markets. Effective permanent position limits which strictly control the amount of the market that can be held by financial speculators, such as index funds or investment banks, can prevent them having dominance over the price discovery functions of these markets. It is only through regulatory intervention to ensure a sustainable balance of commercial and financial participants that these markets can be brought back to delivering their intended purposes of allowing commercial participants to hedge risk and of price discovery for the physical markets. Without effective regulation to limit the impact financial speculators can have within the futures market, it is likely that prices will become increasingly disconnected from supply and demand fundamentals, become more volatile and continue the dramatic upward trend seen in recent years. Additional measures In addition to introducing exchange trading and position limits, a range of other measures can be considered which may also help to reduce the damaging impacts of financial speculation: �� Margins: Increasing margin requirements for financial speculators both increases trading costs and increases firms' own financial risk in each transaction. Combined, the increased costs and risk could help reduce excessive speculation. �� Financial transactions tax (FTT): An FTT on all commodity derivative transactions, set at a high enough level, could increase costs for high-frequency traders and short-term speculators who increase volatility and herding in the market. �� Regulatory capacity: At present specific regulatory expertise and capacity on commodity markets is lacking in the UK and throughout the EU. Dedicated expertise and increased capacity for commodity market regulators is required to ensure any rules proposed are enforced effectively. Conclusion* Excessive financial speculation in any market can cause harm, as the subprime mortgage crisis and the ensuing credit crunch demonstrated. Now it is all too apparent in food commodity markets. The enormous growth in financial speculation in agricultural commodity markets has overwhelmed these markets, making them unable to fulfil their intended purpose of managing risk and supporting price discovery based on supply and demand. Speculation on food prices has led to price inflation, increased price volatility and, most importantly, has caused massive harm to the people most at risk of hunger and poverty. Around one billion people currently go hungry and millions more are at risk of hunger, malnutrition and poverty if prices rise further. Effective regulation of financial commodity markets is urgently needed, to prevent excessive speculation leading to further hunger and poverty and to make markets work for the commercial traders who rely on them. In the light of the devastating impact of speculation, commodity derivatives cannot be left unregulated, as if they were just another asset class for financial investors. Far from stabilising commodity markets, the high volume of financial speculation has had the effect of a devastating flood. The level of speculation is far beyond that needed to provide liquidity to commercial hedgers, and is now undermining the effective working of these markets. Reducing the amount of the market that can be held by purely financial speculators is vital to make these markets work. Financial market regulation is feasible and can be implemented without damaging the functioning of the markets for the commercial traders who rely on them. While the challenges of the global food system will not be solved by curbing speculation alone, such regulation would have a significant impact on ensuring fairer and more stable food prices. The financial services industry, which has capitalised on agricultural commodity markets at the expense of commercial traders and the world's consumers, is lobbying hard to prevent regulation. With banks like Goldman Sachs making over $1 billion� and Barclays making as much as $550 million from speculation on food in one year alone, it appears their motivation to oppose reform is driven more by financial self-interest than a concern for the effective functioning of these markets. Those who oppose clear and strict regulations to tackle excessive speculation, including the UK government, risk condemning millions of people to a future of hunger and poverty. In the US, at the G20 and through the European Commission's review of the Markets in Financial Instruments Directive (MiFID), there is a unique opportunity to put in place the regulation that is so urgently needed. Regulation of agricultural derivative markets would end the dominance of financial speculators, and make these markets work for the benefit of food producers and consumers throughout the world. Regulators must take this opportunity to act for the benefit of all.�� The above is extracted from the World Development Movement report Broken Markets: How Financial Market Regulation Can Help Prevent Another Global Food Crisis (September 2011) written by Murray Worthy. The full report with references is available on the World Development Movement's website www.wdm.org.uk. *Third World Resurgence No. 254, October 2011, pp 12-20
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