Financial Markets and Food Price Volatility

Proposals to reduce market related volatility

Monday 6 February 2012Institute of Development Studies

Christine Haigh

Starting pointImpact of financial speculation:“Large financial flows associated with herding behaviour of financial

investors can sometimes amplify commodity price movements and may sometimes cause prices to deviate temporarily from values consistent with physical supply and demand conditions… A growing body of research supports the view that financial investors have affected price dynamics over short time horizons.”

Report of the G20 Study Group on Commodities under the chairmanship of Mr. Hiroshi Nakaso

Opportunity cost:Lack of investment in productive economy“Revenues generated from commodity production in developing

countries have to be increasingly set aside as insurance against volatile prices, as opposed to providing a steady stream of income to fund investment in economic diversification”

UNCTAD (2012) Recent developments in key commodity markets: trends and challenges

What are these markets for?

• Price discovery

• Hedging commercial risk

Functions increasingly disrupted

Moral and practical imperatives to act

A historical perspective• 1930s: US Securities Act, Securities Exchange Act,

Commodity Exchange Act• 1991: exemptions from position limits; Goldman Sachs

creates commodity index fund• 1990-2000s: further deregulation e.g. Commodity Futures

Modernization Act of 2000 - deregulation of OTC• 2002-2008: number of derivative contracts in commodities

increases by 500 per cent• 2010: Dodd Frank Act passed• 2011: CFTC position limits rule instituted• 2012/13: European commodity derivative markets

regulated?

Transparency

• Price discovery

• Facilitate understanding of markets

• Prevent insider trading due to information asymmetries

• Enable better regulation

TransparencyExchange trading - virtually no need for OTC trading- most can be broken down into standardised

components- MiFIR: risk that substantial OTC market will remain

Position reporting- should be comparable to CFTC- MiFID: may not be standardised across EU

Balance of participants

June 1996

Hedging (88%)

Speculation (12%)

June 2011

Hedging (39%)

Speculation (61%)

Market share (Chicago wheat futures)

Position limits

• “Over 150 years of futures trading history demonstrates that position limits are necessary in commodities of finite supply to curb excessive speculation and hoarding.”

Ann Berg• Used in countries including South Africa, Brazil, India,

China; being re-introduced in US• Transparent• Provide regulatory certainty• Could be introduced gradually and reviewed for

effectiveness whilst ensuring sufficient liquidity, and adapted for different types of participant

Position limits

• Individual limits – stop market abuse• Category limits – address balance of participants

and activities

MiFID:• “Alternative arrangements”• Purpose not to tackle excessive speculation• Only individual position limits

Liquidity: when does rain becomes a flood?

• Liquidity important, but…• Liquidity ≠ volume of trading• Recent rise in liquidity associated with higher volatility• “It does not follow that ‘more liquidity is always limitlessly

beneficial’ since beyond some point there must be diminishing marginal returns to additional liquidity. It is also possible that more liquidity, while in some ways beneficial to end-users, could also, by facilitating pure speculation, produce more variable medium-term price trends.”

Adair Turner

Position management

• Poor track record: Armajaro, Frontier Agriculture

• Non-transparent• Reactive• May be perceived as subjective or

discriminatory• Creates conflict of interest for exchanges

Recipe for reducing volatility

• Exchange trading

• Position reporting

• Position limits

Regulation of commodity derivative markets is necessary but not sufficient for addressing

food price volatility.