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Transparency needed in futures trading
By Denis Drechsler,George Rapsomanikis,and Alexander Sarris |
July 9, 2010, Friday
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Print Edition
Print Edition
THE prices of many staple foods increased dramatically during 2007-2008, creating a food crisis for many poor and developing countries.
International prices of maize, rice, and wheat, for example, reached their highest levels in 30 years, causing political and economic instability ?? and leading to food riots ?? in many countries.
Several factors contributed to the crisis, including high oil prices, high demand for crops from the bio-fuel sector, falling global stockpiles of food commodities, and lower cereal production. Strong economic growth and expansive monetary policies further boosted the trend, as did protectionist measures, such as export restrictions.
While these factors undoubtedly placed upward pressure on food prices, they alone cannot explain the steep hikes. Some believe the crisis was amplified by speculative trading in commodity futures.
Commodity futures are formal agreements to buy or sell a specified amount of a commodity at a specified future date for a specified price. They thus provide an important instrument for hedging price risks in commodity markets.
By entering into a futures contract, both buyer and seller gain certainty as to the price of their subsequent transaction, independent of actual developments in the market.
Commodity futures are generally traded before their expiration date. Indeed, only 2 percent of contracts end in the delivery of the physical commodity. Thus, the market also attracts investors who are not interested in the commodity, but in speculative gain.
The growing presence of non-commercial investors has provided important liquidity to the market, as speculators assume risks related to commodity prices that hedgers wish to avoid. But their presence has also raised concerns that speculation in commodity futures could result in higher price volatility.
Economists generally consider commodity futures to be the solution to higher price volatility, not its cause. They argue that traders of commodity futures merely react to price signals that ultimately depend on market fundamentals. In this way, speculation accelerates the process of finding an equilibrium price and stabilizing the physical market.
But what about trend-following investors, or those with market power? In fact, in the short term, an investor might be attracted by the increasing price of a commodity, although the price is not based on any fundamental data.
These speculative investments can further strengthen the trend and push futures price further away from market equilibrium, especially if many investors follow suit or those who invest have sufficient funds to influence the market. Index funds are an example of such powerful investors. They have become key players in the market, holding about 25-35 percent of all agricultural futures contracts.
Besides investing large amounts of money, they hold futures contracts for a long time, which might make them less likely to react to changes in market fundamentals.
Empirical evidence yields no clear answer concerning which hypothesis is correct. For each study that finds a significant connection between speculative trading and market volatility, there is at least one that claims the contrary.
There are certain reasons to believe that speculation was not the main driver of the recent food-price surge. For example, although index-fund investments are important compared to the positions of other futures participants, their behavior is predictable, as they publicly announce both their commodity portfolio and the timing of their transactions.
Given the important role that commodity futures play for many market participants, regulatory measures should aim at enhancing confidence in the functioning of the market.
This can be achieved by increasing transparency. Recent initiatives by the US Commodity Futures Trading Commission point in the right direction.
In order to counteract suspicious behavior ?? such as traders requesting permission to invest amounts that are above their speculative-position limits ?? the commission lifted exemptions for two firms trading in maize, wheat, and soybean futures.
Such measures will contribute to shaping a more stable market environment and ensure that commodity futures reduce risks and volatility.
(Denis Drechsler is a policy analyst at the United Nations Food and Agriculture Organization. George Rapsomanikis is an economist with FAO's Trade and Markets division. Alexander Sarris is director of FAO's Trade and Markets division. Copyright: Project Syndicate, 2010. www.project-syndicate.org. Shanghai Daily condensed the article.)
International prices of maize, rice, and wheat, for example, reached their highest levels in 30 years, causing political and economic instability ?? and leading to food riots ?? in many countries.
Several factors contributed to the crisis, including high oil prices, high demand for crops from the bio-fuel sector, falling global stockpiles of food commodities, and lower cereal production. Strong economic growth and expansive monetary policies further boosted the trend, as did protectionist measures, such as export restrictions.
While these factors undoubtedly placed upward pressure on food prices, they alone cannot explain the steep hikes. Some believe the crisis was amplified by speculative trading in commodity futures.
Commodity futures are formal agreements to buy or sell a specified amount of a commodity at a specified future date for a specified price. They thus provide an important instrument for hedging price risks in commodity markets.
By entering into a futures contract, both buyer and seller gain certainty as to the price of their subsequent transaction, independent of actual developments in the market.
Commodity futures are generally traded before their expiration date. Indeed, only 2 percent of contracts end in the delivery of the physical commodity. Thus, the market also attracts investors who are not interested in the commodity, but in speculative gain.
The growing presence of non-commercial investors has provided important liquidity to the market, as speculators assume risks related to commodity prices that hedgers wish to avoid. But their presence has also raised concerns that speculation in commodity futures could result in higher price volatility.
Economists generally consider commodity futures to be the solution to higher price volatility, not its cause. They argue that traders of commodity futures merely react to price signals that ultimately depend on market fundamentals. In this way, speculation accelerates the process of finding an equilibrium price and stabilizing the physical market.
But what about trend-following investors, or those with market power? In fact, in the short term, an investor might be attracted by the increasing price of a commodity, although the price is not based on any fundamental data.
These speculative investments can further strengthen the trend and push futures price further away from market equilibrium, especially if many investors follow suit or those who invest have sufficient funds to influence the market. Index funds are an example of such powerful investors. They have become key players in the market, holding about 25-35 percent of all agricultural futures contracts.
Besides investing large amounts of money, they hold futures contracts for a long time, which might make them less likely to react to changes in market fundamentals.
Empirical evidence yields no clear answer concerning which hypothesis is correct. For each study that finds a significant connection between speculative trading and market volatility, there is at least one that claims the contrary.
There are certain reasons to believe that speculation was not the main driver of the recent food-price surge. For example, although index-fund investments are important compared to the positions of other futures participants, their behavior is predictable, as they publicly announce both their commodity portfolio and the timing of their transactions.
Given the important role that commodity futures play for many market participants, regulatory measures should aim at enhancing confidence in the functioning of the market.
This can be achieved by increasing transparency. Recent initiatives by the US Commodity Futures Trading Commission point in the right direction.
In order to counteract suspicious behavior ?? such as traders requesting permission to invest amounts that are above their speculative-position limits ?? the commission lifted exemptions for two firms trading in maize, wheat, and soybean futures.
Such measures will contribute to shaping a more stable market environment and ensure that commodity futures reduce risks and volatility.
(Denis Drechsler is a policy analyst at the United Nations Food and Agriculture Organization. George Rapsomanikis is an economist with FAO's Trade and Markets division. Alexander Sarris is director of FAO's Trade and Markets division. Copyright: Project Syndicate, 2010. www.project-syndicate.org. Shanghai Daily condensed the article.)
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