Commodity markets no reliable price beacon, experts say (April 2012)

Rethinking Bretton Woods | Sat, Apr 14, 2012

By Aldo Caliari

At a side-event co-sponsored by the International Working Group on Trade-Finance Linkages and the Institute for Agriculture and Trade Policy, in partnership with the Permanent Mission of France to the United Nations, experts spoke about the initiatives to respond to the financialization of commodity markets.

Experts spoke about the initiatives to respond to the financialization of commodity markets at a side-event held at the UN Headquarters on April 11. This side event took place at the occasion of a High Level event on excessive price volatility in food and related financial and commodity Markets that was held in implementation of a resolution issued last year by the United Nations General Assembly. In that resolution, the General Assembly had also called for measures to reduce excessive food price volatility.

The side-event was co-sponsored by the International Working Group on Trade-Finance Linkages (coordinated by the Center of Concern) and the Institute for Agriculture and Trade Policy, in partnership with the Permanent Mission of France to the United Nations. It offered a space for reflection and informal discussion of the impacts of the financialization of commodity markets on development, and the initiatives that might be needed to reduce the volatility not due to fundamentals.

One of the issues addressed by panelists was the reliability of the price signals sent by the commodity markets. While a characteristic of liquid markets is that one usually finds, for every transaction, a counterparty, a predominant feature in commodity markets had been so-called “herd behavior” driving prices in one direction only. The “herd behavior” is driven by the massive investments of commodity index funds that are “bets” to increase commodity prices regardless of supply demand fundamentals. Attempts by commercial hedger counterparties to drive prices down to fundamental justified levels are generally ineffective because of the index fund “weight of money. Participants in index investor-dominated markets, in turn, are able to derive large profits for a relatively long time from an upward trend in prices, so it is no surprise that these trends could be maintained for a long time, regardless of fundamentals."

“Changes in fundamentals alone do not explain the magnitude of price rises,” said Heiner Flassbeck, Director of the Globalization and Development Strategies at UNCTAD. “But sometimes I get the impression there is a tendency to try to ignore this part of the problem in international policy debates. If we plead ignorance not only we won’t be able to win the struggle against hunger, but any other struggle, whether on ecology, energy security, or others where financial markets have a bearing.” 

There were important obstacles conspiring against the better operation of financial markets and their ability to fulfill the public goods function they could fulfill. One of these issues highlighted at the event was the increasing domination in some of those markets by actors whose profitability is guaranteed by the government. In 2008-09 we had seen large bailouts with public funding of financial institutions that use those markets to plainly place bets.

The presence of this “safety net” for private banks was one reason why incentives were distorted and the discipline that could otherwise be exerted by the risk in commodity derivatives markets was not having an effect. This was something that the “Volcker rule” could prevent, by banning banks’ derivatives trading on their own account. But the Volcker rule, it was noted, was under attack, precisely because it would threaten these easy profits for large banks.

Another of these obstacles was the lack of transparency in the markets. A remedy to this was the move of transactions to public exchanges which are required to report trade data daily to regulators. But, “many people ignore how large a proportion of derivatives transactions takes place in unregulated Over the Counter markets,” said Steve Suppan, Senior Policy Analyst at the Institute for Agriculture and Trade Policy. The industry was up in arms against the requirements to move OTC derivatives transactions to public exchanges, alleging that OTC derivatives are uniquely customized to the needs of clients, therefore cannot be standardized as required in exchanges.  The industry is seeking broad exemptions to regulation, including for “customized” trades.

Suppan expressed skepticism, however, that these products needed to be customized and that some customization claims were made for purposes of regulatory evasion.

A distinction was also made between the problem of high prices and that of volatility, which sometimes were confounded, but needed to be distinguished. Volatility had multiple causes, and the difficulty for the policy response lied in pinning down how much was due to each cause and, in that sense, the exact bearing of financialization. To further complicate matters, this also has impacts on determining who in government has jurisdiction over the policy response. This could be noted in the strict adherence that G20 Agricultural Ministers had observed last year with regards to the language that Finance Ministers had employed to refer to financial markets regulation.

In his intervention, David Hallam, Director of the Trade and Markets Division of the Food and Agriculture Organization, pointed out that “there is enough information to say that so called "speculation" on the exchanges impacts on prices but we have no information about the extent and impacts of OTC trade and high frequency trading.” Greater transparency is essential and the use of position limits is a possible part of the required policy response, he advocated.

In regards to the need to increase markets transparency, participants highlighted the important role of the Agricultural Markets Information System, agreed last year by the Group of 20. As the International Working Group on Trade-Finance Linkages noted in a statement last year, AMIS will only work if corporate owners of stocks are required to supply accurate and complete information. This will likely not be easy.