Regulation is in

The ongoing attempts at legislating financial reform in the United States Congress are of great interest to the rest of the world. This is not only because everything the U.S. does is bound to have ripple effects, but because the proposed regulations may have an impact in controlling at least some of the rampant excesses and extreme volatility that we have experienced in financial markets.

One of the most important aspects of the legislation that has been passed by the U.S. Senate (which still has to be reconciled with the version passed by the U.S. House of Representatives) has to do with derivatives markets and their effects on commodity trading.

It is now widely accepted that increasing financial involvement in primary commodity markets (including oil, minerals and agricultural products) played a significant role in generating or amplifying price volatility in these markets.

While financial involvement in commodity markets has been growing since the early 2000s, the impact of these players has been particularly evident since early 2007, causing dramatic and rapid changes in world prices of these goods in both futures and spot markets. There were huge increases in most commodity prices between January 2007 and June 2008, followed by collapses in prices until early 2009, followed by significant increases once again until early 2010.

Wrong signals

These price changes had hugely adverse effects in the developing world. They sent out confusing, misleading and often completely wrong price signals to farmers, which caused over-sowing in some phases and under-cultivation in others.

They created havoc among mineral exporters who were not sure of the prices at which they should sign export contracts. Consumers, in particular, were badly affected: while global price increases tended to be transmitted (even if not fully) to consumers in developing countries, when global prices fell there was no such immediate tendency.

The continued rise in food prices in many developing countries has impacted on the incidence of poverty and hunger, and become a political issue of some importance.

So because of this price instability both the direct producers and the consumers lost out. The only gainers were the financial and marketing intermediaries, typically large corporations, who were able to profit from rapidly changing prices.

Global commodity prices have always been volatile to some degree and prone to boom-bust cycles. In the 1950s and the 1960s, commodity boards and international commodity agreements were seen as one means of stabilising global prices. Following their decline from the mid-1970s, and especially as financial deregulation and innovation became more pronounced since the early 1980s, the emergence of commodity futures markets was touted as providing the advantages of such agreements in a more market-friendly framework.

There were several features of such futures markets that were perceived to be of value: they allowed for better risk management through hedging by different layers of producers, consumers and intermediaries; they enabled open-market price discovery of commodities through buying and selling on exchanges; they were therefore perceived to lower transaction costs.

Financial deregulation in the early part of the current decade gave a major boost to the entry of new financial players into commodity exchanges. In the U.S., which has the greatest volume and turnover of both spot and future commodity trading, the significant regulatory transformation occurred in 2000.

While commodity futures contracts existed before, they were traded only on regulated exchanges under the control of the Commodity Futures Trading Commission (CFTC), which required traders to disclose their holdings of each commodity and stick to specified position limits, so as to prevent market manipulation.

Therefore, they were dominated by commercial players who were using it for the reasons mentioned above, rather than for mainly speculative purposes.

Deregulation

In 2000, the Commodity Futures Modernisation Act effectively deregulated commodity trading in the U.S. by exempting over-the-counter (OTC) commodity trading (outside of regulated exchanges) from CFTC oversight. Soon after this, several unregulated commodity exchanges opened.

These allowed any and all investors including hedge funds, pension funds and investment banks to trade commodity futures contracts without any position limits, disclosure requirements, or regulatory oversight.

The value of such unregulated trading zoomed to reach around $9 trillion at the end of 2007, which was estimated to be more than twice the value of commodity contracts on regulated exchanges. According to the Bank for International Settlements, the value of outstanding amounts of OTC commodity-linked derivatives for commodities other than gold and precious metals increased from $5.85 trillion in June 2006 to $7.05 trillion in June 2007 to as much as $12.39 trillion in June 2008.

Index traders

Unlike producers and consumers who use such markets for hedging purposes, financial firms and other speculators increasingly entered the market in order to profit from short-term changes in prices. They were aided by the swap-dealer loophole' in the 2000 legislation, which allowed traders to use swap agreements to take long-term positions in commodity indexes.

There was a consequent emergence of commodity index funds, which were essentially index traders' who focussed on returns from changes in the index of a commodity by periodically rolling over commodity futures contracts prior to their maturity date and reinvesting the proceeds in new contracts.

A study by Christopher Gilbert (Speculative influences on commodity futures 2006-08, UNCTAD Discussion Paper No 197, Geneva) found that index traders amplified price volatility to the extent of 30 per cent in oil and metal prices and around 15 per cent in food-grain prices.

Such commodity funds dealt only in forward positions with no physical ownership of the commodities involved. This further aggravated the treatment of these markets as vehicles for a diversified portfolio of commodities (including not only food but also raw materials and energy) as an asset class, rather than as mechanisms for managing the risk of actual producers and consumers.

The CFTC estimated that of the $161 billion of commodity index business in the U.S. markets at the end of June 30, 2008, approximately 24 per cent was held by index funds, 42 per cent by institutional investors, 9 per cent by sovereign wealth funds and the remaining 25 per cent by other traders. An official probe by the U.S. Senate found substantial and persuasive evidence that non-commercial traders pushed up futures prices, disrupted convergence between futures and cash prices and increased costs for farmers, the grain industry and consumers.

Plugging loopholes

Now, one important proposal in the financial reform legislation passed by the U.S. Senate seeks to plug, at least partially, the loopholes that allowed such frenzied activity in commodity futures markets.

It requires previously unregulated OTC trades to be traded on public exchanges. This would reverse the effect of the 2000 Act, and enable the CFTC to analyse daily-trade data and determine when traders have exceeded the CFTC's commodity-specific position limits (which provide a percentage ceiling for all commodity contracts open for trade during a specific trading period).

It is estimated that around 90 per cent of this market in the U.S. will move from OTC swaps trading to the more transparent and capitalised exchange trading environment for futures contracts.

In addition, another important amendment brought by Senator Blanche Lincoln of Arkansas will force the banks to spin off their highly profitable derivatives trading into entities that would be separate from their commercial banking. Section 716 (Prohibition against Federal Government Bailouts of Swaps Entities) will sharply reduce the possibility of taxpayer-financed bailouts for speculative activity that does not serve the real economy.

This would mean that purely commercial banks with guaranteed deposits would have much lower dependence on the unregulated and risky OTC swaps market.

It would also, of course, reduce the profitability of the big banks that were, through such OTC transactions, able to hunt with the hounds and run with the hares.

Financial lobby

As expected, this particular provision is under sharp attack from the finance industry, with major banks such as Morgan Stanley and Goldman Sachs lobbying fiercely to remove it. Both the Chairperson of the Federal Deposit Insurance Corporation, Sheila Bair, and the head of the Federal Reserve, Ben Bernanke, have spoken out against it, saying it could destabilise the financial system. The danger is that during the process of reconciliation Bills of the Senate and the House of Representatives, which is typically conducted behind closed doors, the financial lobbyists may get the motion killed.

That is only one of the dangers. Another is that providing muscle to regulators need not ensure that the regulators do their job appropriately. So even if the CFTC acquires the ability to control and regulate trading activity in commodity futures, its actions may not be so effective. For instance, in late January the CFTC announced that it would place position limits on oil, natural gas, heating oil and gasoline futures. However, the limits announced were so high that, even by the CFTC's own calculations, they were unlikely to affect much of the trade.

There have also been arguments that such activity will simply move to other players, such as hedge funds, which are expected to be major beneficiaries of the move. Or that OTC contracts in commodity futures will take place increasingly in other financial centres, in London, Tokyo or even Singapore. But such arguments underestimate the tremendous influence of the U.S. in shaping financial systems globally. Thus far it can be argued that this influence has essentially been a negative force, but these relatively limited new regulations, if they actually come into play, can force some positive changes elsewhere as well.

So, just as the deregulation of U.S. markets contributed to excessive speculation and global price volatility, the regulatory reform measures if they are defined properly and implemented in the right spirit can prevent future episodes of the very extreme volatility that is so damaging to developing countries.

Of course, this does not in any way mean that the world food crisis is over, or that commodity prices will not continue to behave in a volatile fashion without other measures adopted by governments. But it may mean some breathing space from excessive price volatility for developing countries, which should help them to get policies in place to tackle the real problems in the food economy and elsewhere.