Commodities Corruption
The Disturbing State of Commodities Trading & How We Got Here
Written by Stuart Kerr in collaboration with Lloyd Bernhardt and Erin Mussolum.
The purpose of this paper is to provide insight into the current state of the commodities
exchange market (in particular coffee) and how it has developed to reach its current
state.
Executive Summary
The industrial revolution brought about massive changes to the way we conduct our
lives and the way we do business. In a world of commodity trading where large supplies
began being shifted around the globe, a system was required to ensure the proper
transfer of goods over great distances. The intermediary solution was the formation of a
central market accessible by both producers and buyers that contained rules and
regulations to ensure that a fair market price was established for all.
After the Great Depression sent commodities prices into a tailspin, U.S. President
Franklin Roosevelt stepped in proposing his ʻNew Dealʼ thereby revamping the
regulatory requirements surrounding commodities speculation and futures contracts with
the 1936 “Commodities Exchange Act”. This Act kept speculators in check by
differentiating between them and the traders of physical goods and provided the right
climate to allow supply and demand to determine pricing.
But all began to crumble in1991 when a little known Goldman Sachs subsidiary named
J. Aron & Company wrote the regulatory body for commodities trading, the Commodities
Futures Trade Commission (CFTC) and argued that they, as speculators should receive
the same considerations as the physical traders because they were bearing similar
financial risks. Once cleared for this special status the floodgates opened and similar
requests were cleared.
In 2000 commodity trading regulation was really thrown to the wolves when Senator Phil
Gramm very subtly slipped the Commodities Futures Modernization Act (CFMA) past
congress without any consideration or debate. The slip occurred because it happened to
be conveniently attached to the back of an 11,000-page Senate appropriation bill that
likely garnered little to no readings. This, for all intensive purposes, eliminated any and
all restraints on commodities speculation and has extreme repercussions that today we
cannot yet fully comprehend.
The following paper explores the recent changes to how commodities are traded and
the impact it plays out globally.
A Brief History of Commodities Trading
In 1848, over eighty Chicago merchants established the worldʼs first futures
exchange. They began trading flour, timothy seed and hay in what were then
known as “to arrive” contracts. The first official “forward” contracts came into play
in 1851 with trading in corn and were popular with merchants and food
processors. These merchant exchanges and partnerships spun into
organizations such as the Chicago Butter and Egg Board of 1898 better known
today as the Chicago Mercantile Exchange.1
Over the next few decades, the industrialization of the United States created a
demand for many other products that could be purchased for future delivery. With
this increase in demand came the need for regulations. This need became
extremely apparent following events that led to the great depression, stock
market crash, and the eventual dramatic dive in commodity prices. At that time
President Franklin D. Roosevelt stepped in with his “New Deal” reforms
demanding regulations for both securities and commodities futures contracts.
This regulation of commodities contracts was envisioned as a way of providing
farmers with protection against any future collapses in the market, writes the
legal scholar on securities regulation Jerry W. Markham. 2 “During the hearing on
this legislation, Congress found numerous abuses, including what were
described as speculative ʻorgiesʼ and manipulations by large speculators that
were thought to be driving down commodity prices.” 3
In 1936, the U.S. Government passed the Commodity Exchange Act to regulate
futures and commodities trading. The Act was designed to avoid cornering
agriculture markets, reduce speculation and stabilize prices. It also advanced the
obligation first enacted in “the 1922 Grain Futures Act that commodity futures
trading on ʻregulatedʼ commodities be traded only on licensed contract markets.
Fraud was prohibited and brokerage firms handling customer orders (referred to
in the industry as ʻfutures commission merchantsʼ) were required to register with
the federal government. The Commodity Exchange Act was to be administered
by a Commodity Exchange Commission composed of the attorney general and
1
http://www.lind-waldock.com/education/commodities/history.shtml
http://www.enotes.com/major-acts-congress/commodity-exchange-act
3
http://www.enotes.com/major-acts-congress/commodity-exchange-act
2
the secretaries of agriculture and commerce, a structure carried over from the
Grain Futures Act.” 4
The Conventional Global Coffee Market
In the conventional (non-fairtrade) journey of coffee traveling from producing nations to
those importing a few steps are necessary. Once the coffee has been harvested an
exporter will buy the green beans from the farmers. When the exporters buy stocks of
coffee they have effectively taken a ʻlongʼ position in the coffee market, much like an
investor in the stock market buying shares in a company. This leaves them exposed to
the risk that coffee prices will drop and they will have to take a loss upon selling the
coffee. To avoid this risk, exporters will ʻhedgeʼ their position in the market through
purchasing a ʻshortʼ contract, an agreement to sell their coffee at a pre-determined price
in the future. The company importing (buying the coffee) will do exactly the opposite
purchasing a contract to buy coffee in the future, effectively taking a ʻlongʼ position.
These two companies would never directly deal with each other but rather buy the
contracts through the exchange or market maker. In the case of coffee futures
contracts, this is the InterContinental Exchange (ICE).
Speculation Increases Margins, Squeezes out
Traditional Hedgers
When the coffee trading companies enter futures contracts with the exchange they are
required to deposit a certain percentage of the value of the contract into what is called a
margin account. This is to safeguard the exchange against losses in the case of
companies defaulting on their contracts. In the case of importers the exchange will debit
money from the margin accounts in the case that the market value of their future
contract falls below what they are obliged to pay upon settling their position. The
opposite holds true for exporters. If the companyʼs margin account balance falls below
the minimum the exchange will issue a margin call for more money.
As coffee prices skyrocket the amount of money that exporters must pay in margins
increases as well. For instance only 7 months ago it cost $1,800 to hedge a lot of coffee
- 250 to 275 sacks or one standard shipping container. It now costs $5,400 to hedge the
same amount. After a certain point companies can no longer afford to both pay these
margins as well as buy and ship coffee. They are forced to either forgo hedging (that
was designed as insurance for them, not speculators) and bear the risk, or seek
alternate ways to mitigate such as selling at fixed prices or buying options or puts.
As coffee prices rally, many companies have chosen to go without hedging which works
only as long as prices continue to rise. However in the case of a steep drop or ʻbubble4
http://www.cftc.gov/About/HistoryoftheCFTC/history_precftc.html
burstʼ they will be left with stocks of coffee suddenly worth significantly less than what
they were bought for. This is potentially catastrophic for companies.
More Speculation, Less Regulation
The following is taken from an article written by Matt Taibbi and published by Rolling
Stone Magazine on April 5th, 2010. Taibbi is an acclaimed columnist who covers politics
and the economy:
[It was] 1991 when, unbeknownst to almost everyone in the world, a
Goldman Sachs commodities-trading subsidiary called J. Aron wrote to the
CFTC [Commodities Futures Trade Commission] and made an unusual
argument. Farmers with big stores of corn, Goldman argued, weren't the
only ones who needed to hedge their risk against future price drops —
Wall Street dealers who made big bets on oil prices also needed to hedge
their risk, because, well, they stood to lose a lot too...The 1936
[Commodities Exchange Act] law, remember, was specifically designed to
maintain distinctions between people who were buying and selling real
tangible stuff and people who were trading in paper alone. But the CFTC,
amazingly, bought Goldman's argument. It issued the bank a free
pass, called the "Bona Fide Hedging" exemption, allowing
Goldman's subsidiary to call itself a physical hedger and escape
virtually all limits placed on speculators. In the years that followed, the
commission would quietly issue 14 similar exemptions to other companies.
Now Goldman and other banks were free to drive more investors into the
commodities markets, enabling speculators to place increasingly big bets.
That 1991 letter from Goldman more or less directly led to the oil bubble in
2008, when the number of speculators in the market — driven there by
fear of the falling dollar and the housing crash — finally overwhelmed the
real physical suppliers and consumers. By 2008, at least three quarters
of the activity on the commodity exchanges was speculative,
according to a congressional staffer who studied the numbers —
and that's likely a conservative estimate.5
These letters were the beginning of the end for the regulation of commodities trading.
The wheels truly fell off the wagon in the late 1990ʻs when Republican Senator Phil
Gramm wrote a piece of legislation named the Commodities Futures Modernization Act
(CFMA). When the act was passed and signed by President Clinton in 2000, federal
regulation of the commodities future trading market in the United States was heavily
relaxed and in some cases completely eliminated. The bill has already been widely
5
http://www.rollingstone.com/politics/news/the-great-american-bubble-machine-20100405?page=6
blamed in part for the Enron debacle and the sub-prime mortgage crisis earning US
Senator Gramm the moniker ʻForeclosure Phil.ʼ
“Gramm slipped the controversial legislation through by attaching it to an 11,000 page
omnibus Senate appropriation bill.” Before the year 2000 “speculation in the
commodities market was limited to experienced investment firms whose trading
practices were regulated by congress. After 2000, world commodity markets were
opened to the whims of day-traders and less experienced and unregulated
investors.” 6 “With the emergence of organized and sophisticated ways of investment in
commodities, traders have now started exploring the commodities they earlier kept
away from.” 7
To add fuel to the fire 2007 the New York Board of Trade (NYBOT), which housed the
Arabica coffee trading system, was sold to the International Commodities Exchange
(ICE), a British energy marketplace. Of note, the ICE was founded by Goldman Sachs,
Morgan Stanley, BP, Total, Royal Dutch Shell, Deutsche Bank and Societe Generale.
These founders were now in control of how the marketplace functioned and captured
the trading fees that were previously being made by individual brokers. The transfer to
the ICE made it even easier for anyone to begin trading commodities contracts and
even harder to regulate as it put the exchange outside the constraints of US law.
An article written by Wallace C. Turbeville, the former CEO of VMAC LLC and a former
Vice President of Goldman Sachs, outlines the rise of the InterContinental Exchange:
“ICE evolved and its scope expanded. Cutting out the brokers was small
potatoes compared with cutting out the exchanges and clearinghouses.
ICE added a clearing function and the electronic trade matching was
adapted to compete with the exchanges. ICE took on NYMEX and other
exchanges as its product list grew. Trade volume was critical to ICE as a
source of fee income and the owners did their best to accommodate by
directing trade flow to the platform. If major institutions sent trades to ICE,
lesser players in the market had to follow if they wanted to transact with
them.” 8
With the falling American Dollar and huge dips in the stock market, commodities
become increasingly attractive for investors. This is scary as it is eerily similar to the
“dot com” and housing bubble increases and subsequent bursts. When prices for coffee
rise, it makes sense for poor farmers in developing countries to rip out all of their other
stocks (corn, wheat, etc.) that they and the people of their country depend on for
nutrition and plant more coffee in its place. As investment in commodities spirals upward
6
http://beanactivist.wordpress.com/2008/07/16/world-coffee-market-the-impact-of-speculation/
http://www.business-standard.com/india/news/investing-in-commodities-turns-attractive-as-pricessoar/427106/
8
http://www.rooseveltinstitute.org/new-roosevelt/owning-banking-system
7
driven by demand from wall street investors and the large pension funds and high networth individuals they have lured in, prices will continue to increase. The nowunregulated market allows for this, and a bubble begins to form. As the bubble grows
the farmers and the economies attached to them grow dependent on these increasing
prices to feed their families through coffee profits. The increased speculation drives up
prices of commodities like coffee above their intrinsic value until eventually a correction
will occur. This happens when growth is no longer sustainable and people realize the
intrinsic value of what they own is much less than the marketplace price, causing a ʻrun
to the bank.ʼ Prices plummet and coffee farmers are left with stocks of coffee and plants
in the field that are suddenly worth significantly less. Since they no longer have food
supplies and are dependent on the future income from high coffee prices they are left
with nothing.
The Growth and Impact of Commodity Speculation
Elise Foleyʼs article published in February of 2011 in the Huffington Post on how Wall
Street may be manipulating the commodities trading market sheds a further light on
many of these issues and their subsequent potential global effects:
Commodities traders have wielded huge influence over the
farmers and manufacturers for more than a century, and the
movement of the late 19th century was one of the first mass
against the growth of that influence. Regulations were eventually
to temper the role traders could play in the markets.
lives of
Populist
protests
enacted
Today, thanks to trillions of dollars worth of financial speculation in
commodities - which are bounced around on computer screens and
loosely regulated - Wall Street's role is even more entrenched and
potentially more destructive.
Commodity markets functioned fairly and effectively for over sixty years,
wrote David Frenk, executive director of the market-transparency
advocacy group Better Markets... In 2000, the Commodity Futures
Modernization Act deregulated commodities markets...providing loopholes
for speculation through completely unregulated shadow markets.
The lion's share of that speculation is taking place in an unregulated,
multitrillion-dollar dark market that was born in 2000, when Congress
passed the CFMA. A sweeping piece of legislation, it placed many
financial derivatives beyond the reach of regulatory supervision. Secret
trades were explicitly legalized, ensuring that most players in this so-called
ʻover-the-counterʼ market would be unable to access key price information.
For the U.S. housing market, the legislation ushered in the era of CDOs,
CMOS, CDOs-squared, the credit-default swap, and other ʻsyntheticʼ
products that zipped across the shadow banking system - a financial
joyride that ultimately ran aground. 9
This joyride, and absolute cash cow for investment banks that profited handsomely from
both itʼs rise and fall, has resulted in 3 million homes being foreclosed in America alone
since 2006, a number which is expected to double by 2013. 10
Foley Continues:
But the same legislation also radically changed the way basic
commodities changed hands in the global economy. Banks and hedge
funds can bid on the price of commodities either by purchasing physical
bushels of wheat or by taking out financial contracts tied to the value of
those bushels of wheat. Some contracts, known as futures, are traded
publicly like stocks at places like the Chicago Mercantile Exchange or the
Intercontinental Exchange, while others are traded in the secretive overthe-counter markets. But most over-the-counter contracts mimic the
futures contract - a bet that at a given point in time, the price of a
commodity will reach a certain level. Traders can bet that oil will be worth
$120 a barrel in March, or that wheat will reach $10 a bushel by April.
These contracts were initially developed as a type of price insurance for
farmers and manufacturers - if economic forces push prices too high or too
low, commercial businesses can still get paid. This all depends on
speculation to function. Every farmer who wants to be insured against
price fluctuations needs someone to take the other side of that bet - often,
a speculator.
Too much speculation, however, can wreak havoc. When the amount of
speculative capital in these markets overwhelms their usage by farmers
and commercial firms, speculation itself has the opportunity to drive prices.
“The recent flood of speculative money into commodities markets is
increasing price volatility and pushing up further the prices of raw
commodities and food products”, 10 Texas A&M economists wrote
in a 2008 report.
Speculation in other commodities can push up the price of food, since the
commodities are often ʻindexedʼ together. Speculation in oil is particularly
important, since transportation costs are a major factor in the prices of
food, and oil is a key ingredient for many fertilizers.
9
http://www.huffingtonpost.com/2011/02/15/gambling-on-hunger-food-crisis-regulators_n_823725.html
http://www.bloomberg.com/news/2011-01-13/u-s-foreclosure-filings-may-jump-20-this-year-as-crisispeaks.html
10
“Paper oil and physical oil are about the same thing, economically. If
you're going to have speculation, you're going to have some impact on the
price of physical oil," said economist John Parsons of MIT's Center for
Energy and Environmental Policy Research. "We can have speculation in
the share of a high-tech stock. If people believe that a stock is going to be
worth more in the future, they can bid up the price now. We can have
similar speculation in housing or oil or other commodities."
And speculation in commodities took off after the deregulation of 2000.
The over-the-counter market exploded from about $674 billion in
2001 to $13.2 trillion by June 2008, according to the Bank for
International Settlements. The more transparent, regulated forms of
speculation grew with the over-the-counter gambling. Between June of
2000 and June of 2008, the U.S. futures market for oil grew from bets on
517 million barrels, or $16 billion, to bets on 1.44 billion barrels, or $202.5
billion, according to a 2010 paper by Parsons. Commodity index funds new speculative vehicles that allowed fund managers to bet on ʻbasketsʼ of
multiple commodities all at once - jumped in popularity, growing from $15
billion in 2003 to $200 billion in 2008, according to a 2009 report by the
Senate Subcommittee on Investigations. 11
Investment in commodity markets has undoubtedly grown, but other commentators
found it difficult to quantify exactly. Even the larger market participants were unable to
accurately gauge the total size of the market, and estimates varied widely. There was a
similarly wide range of estimates regarding the breakdown of investments by market
sector. On-exchange volumes have certainly increased greatly in the past five to ten
years. There has been rapid growth in the number of contracts traded on both LIFFE
(soft commodities) and ICE Futures (energy). ICE Futures has seen volumes almost
double in the last year alone and volumes on LME have increased tenfold since 1990.
However in some markets OTC business is equal to several multiples of these volumes.
The December 2006 Bank for International Settlements (BIS) Quarterly Review includes
data on the amount of outstanding OTC commodity derivatives contracts among those
who report. The graph below shows that this market too has increased greatly in recent
years.
Notional amounts outstanding of commodity derivatives contracts
SOURCE: BIS Quarterly Review, December 2006 12
11
12
http://www.huffingtonpost.com/2011/02/15/gambling-on-hunger-food-crisis-regulators_n_823725.html
http://www.bis.org/publ/qtrpdf/r_qt0612.pdf
Who is Investing?
Dialogues with participants indicated that 75-80% of the funds invested in the GSCI
are from pension funds. The rest is from corporations investing their reserves.
Insurance companies are not at all heavily invested in commodities, although some
commodities may appear to be natural hedges against catastrophes. This was put down
to the restrictive regulatory requirements on what they may or may not invest in and the
range of alternative ways to spread their risk. 13
Real Life Impacts in the Developing World
Foleyʼs article provides a look into the damaging effects of Wall Streets actions by
bringing in the perspectives of a Catholic missioner who has seen the results first hand:
This year, the world hunger outlook is growing even bleaker than it was in
2008. According to the United Nations' Food and Agriculture Organization,
global food prices reached their highest level ever in January, after
climbing for seven straight months.
Food price hikes typically have a muted impact in the United States, where
consumers spend only a small fraction of their income on what they eat.
But in many other parts of the world, ordinary citizens spend as
much as 80% of their earnings on meals, and such increases can
have a devastating impact.
13
http://www.fsa.gov.uk/pubs/other/commodity_invest.pdf
"A box of cereal is a great example," said David Kane, a Catholic
missionary who has worked on poverty-relief efforts for most of his
professional life. "The actual commodity price influence on a box of cereal
is incredibly small - food prices can double and we'll just pay an extra dime
here. But for families in Africa or Asia who buy 50-pound sacks of wheat or
rice, that kind of price change is a huge problem. They're much closer to
the pure commodities themselves."
As reports of severe hunger poured into Kane's D.C. office in mid-2008, he
headed to João Pessoa, Brazil, where he'd spent nine years working with
people who survived by salvaging items from the local dump and selling
them to manufacturers. This was always a difficult lifestyle - these
“recyclers” lived in a landfill and fed themselves by selling trash. As
commodity prices surged, they had actually benefited.
But when the bubble burst, prices plummeted to levels lower than anyone
in the recycler community had ever endured. When Kane arrived in late
2008, “basic survival had become a struggle,” he said. Families he had
worked with as recently as 2005 had been torn apart. One old friend
turned to prostitution to fend off starvation, he said, while others started
selling crack cocaine.
"People's houses just became completely empty as they sold off their
radios, their clothes, everything they had to pay for food," Kane said.
"Speculation is not the only issue by any means, but it is certainly an issue
and it's very easy to address from a technical standpoint."
The U.N.'s Food and Agriculture Organization has taken notice. In a
September meeting, the group cited "growing linkage with outside
markets,” in particular the impact of “financialization on futures markets"
as a "root cause" of recent food price volatility.” 14
Is Speculation Alone to Blame?
Foley explains how many advocates of deregulation point to other reasons for the
recent “bull run” on commodities prices such as potential food sources being used for
biofuel and worsening growing climates:
Is speculation behind the current run-up in food prices? Experts are
divided. There have been major events in the physical economy for food a flood in Pakistan and the failure of a wheat crop in Russia, which may be
evidence of so-called global “weirding” brought on by climate change. The
14
http://www.huffingtonpost.com/2011/02/15/gambling-on-hunger-food-crisis-regulators_n_823725.html
use of corn in biofuels and depleting government grain stockpiles may also
be playing a role in spiking demand, as could increased living standards in
parts of the developing world. But the potential is certainly there.
Speculative bubbles often start with a price surge brought on by real
events. [Or they are at least used by speculators and investment banks as
scapegoats for the sudden spikes.]
According to [CFTC Commissioner Bart] Chilton, there are more
speculative bets in commodities markets today than ever before, even
2008. The number of bets on food, in fact, are up 18 percent from June
2008 levels. Individual traders are taking super-sized gambles, with a
single trader capturing upwards of 20 percent of the entire oil market at a
time.
"If there's a large concentration in markets, it can skew prices,"
Chilton said. "The folks that are taking the other side of the trade are folks
that are aware of what's going on. If they need to make a trade and there's
only a couple of people offering a trade, they've gotta accept it.” 15
Speculation IS to blame for the most part
Corn is probably the commodity most directly impacted by biofuels. An estimated 25 to
30 percent of the U.S. corn crop goes to ethanol.16 That equates to roughly 11% of
the world supply. Of course using that corn as food would bring up global supply and
presumably bring down food prices. However its not as if one day the government took
all that corn out of the food market and dedicated it to be used to produce ethanol. Over
the past decade increasing amounts of corn has been grown and used strictly for biofuel
production that was never available as food before. In addition, the steep increases in
commodities prices do not even come close to mirroring their increased use for biofuels.
This excerpt from the International Grains Councilʼs March 2011 report provides a good
lesson on how real world supply and demand for commodities is becoming secondary to
speculation when it comes to determining prices:
The past month saw exceptionally volatile conditions in the worldʼs major
commodity exchanges, with huge price swings in grains and oilseeds. After
nearing the peaks last seen in 2008, large-scale speculative selling of
futures contracts in the second week of March resulted in a $50 drop in
export prices of wheat and maize, followed by a renewed surge in values,
recapturing a sizeable portion of earlier losses. The fall was attributed to
15
16
http://www.huffingtonpost.com/2011/02/15/gambling-on-hunger-food-crisis-regulators_n_823725.html
http://news.cnet.com/8301-11128_3-9918741-54.html
Sp
increased economic uncertainties following the political unrest in parts of
North Africa and Near East Asia, with Japanʼs earthquake and tsunami
disaster also a factor. The subsequent partial recovery in prices was
triggered as the bullish underlying grain fundamentals reasserted
themselves...The past month saw wheat buying activity reduced somewhat
and also move from the US and the EU to Australia. Northern hemisphere
crop prospects mostly remained favourable, with the exception of continued
dryness in the southern US Plains, seen as affecting Hard Red Winter
wheat yields. 17
The fact that current supply and demand as well as their future prospects stayed
relatively stable yet the market incurred massive price swings tells us something:
speculation is overwhelmingly becoming the determining factor for commodity
prices. The tsunami in Japan and unrest in North Africa have miniscule real world
effects on the global supply and demand of grains but because of the massive amounts
of speculating now happening in commodities market, the response is grossly over
reactive.
“The markets are now heavily distorted by investment banks: "Let's say
news comes about bad crops and rain somewhere. Normally the price
would rise by about $1 [a bushel]. [But] when you have a 70-80%
speculative market it goes up $2-3 to account for the extra costs. It adds to
the volatility. It will end badly as all Wall Street fads do. It's going to blow
up."
“What for a poor man is a crust, for a rich man is a securitized asset class.”18
Regulation, or the Lack Thereof
Returning to Foleyʼs February article, we can see how vastly underfunded and illequipped the organizations charged with regulating the commodities trading market
have become:
Wall Street says that trading keeps food and energy markets liquid,
allowing farmers to plan ahead when planting their crops or helping oil
producers to know how much crude they can ship. Often, of course, that's
true. But there also can be a more brutal calculus at work: big price spikes
are good for traders holding onto wheat, coffee or oil contracts, allowing
them to stuff more money into their wallets while families struggling to
make ends meet thousands of miles away suddenly find that it's become
too expensive to feed themselves.
17
18
http://www.igc.int/downloads/gmrsummary/gmrsumme.pdf
http://www.guardian.co.uk/global-development/2011/jan/23/food-speculation-banks-hunger-poverty
The top lobby group for the derivatives industry, the International Swaps
and Derivatives Association, says it supports financial regulatory reform,
but resists blame for pricing problems. "Although speculation is often
blamed for causing problems in markets, the economic evidence shows
that it is in fact a necessary activity that makes markets more liquid and
efficient," ISDA Head of Research David Mengle wrote in a September
memo.
Meanwhile, derivatives trading remains a largely under-regulated affair,
even though such gambling was a major cause of the financial crisis in the
United States and broadened the severity of the entire debacle. Last
year's Dodd-Frank financial-regulatory legislation sought to address the
problem speculation can play in commodity markets specifically and
financial markets more generally, requiring federal regulators to police the
massive, multitrillion-dollar derivatives game. But to be effective cops,
regulators will need a bigger budget, something Republicans are already
lining up against.
The Commodity Futures Trading Commission, which will shoulder much of
the burden for monitoring derivatives trading, currently only oversees
about $5 trillion worth of trading on commodities exchanges. Dodd-Frank
envisions the CFTC empowered as the primary regulator of a much vaster
market that involves more than $500 trillion worth of trading. That's an
ambitious goal even with the new funds the Obama administration
proposed in its budget, which would increase the CFTC's annual funding
by 77 percent, from $168.8 million to $298.8 million. The Securities and
Exchange Commission, another key regulator of Wall Street trading, would
get a $300-million boost to its $1.12-billion annual budget, a jump of 27
percent.
Despite plans for a dramatically broader regulatory mandate at these
agencies, Republicans now openly plan to defund key elements of DoddFrank, legislation which most of the congressional GOP opposed. Among
the budgets that Republicans are seeking to kneecap? Those the
regulators need to do their work.
Last year's reform legislation specifically zeroed in on speculation
involving agricultural commodities in an effort to stave off the next food
price spike. In one of the few major victories the bill offered progressives
and other advocates of tighter regulation, then-Sen. Blanche Lincoln (DArk.) included language that would end federal subsidies for speculation
on food and energy derivatives, requiring banks that enjoy government
guarantees to spin off those derivatives operations into sub-companies
with no access to federal perks.
Another key Lincoln measure, known as a position limit, was designed to
clamp down on market manipulation by requiring regulators to limit the
total amount that individual traders can bet on any commodity. Former
House Financial Services Committee Chairman Barney Frank (D-Mass.)
said that the recent run-up in food prices demonstrates why Democrats
were right to address even areas of the financial system that weren't solely
or directly related to the banking collapse. It highlights the fact [that] there
are reasons to this over and above preventing another crash. The
derivatives issue was not just [about] preventing a major crash, but having
some limitation on the extent to which speculation drives up prices.
It is now widely accepted that speculation helped fueled the price hikes of
2008: Economists at Princeton University, World Bank, the European
Commission, the Peterson Institute for International Economics, the
International Monetary Fund, Rice University, the Massachusetts Institute
of Technology, and the Texas A&M University Agricultural and Food Policy
Center have all published studies indicating that speculation played a role
in 2008's commodity-price swings.
"Look, you have no market without speculators, so I like speculators," says
CFTC Commissioner Bart Chilton. "But it's more like a casino right now
than anything else." “It's a pretty easy thing to fix from a technical
standpoint, and would have massive effects all over the world” Said Kane.
“If financial speculators can just toy with food prices whenever they want,
there's nothing we can do for food security."19
Enter: Pension Funds & Hoarding
Foley also writes on how other investors, namely huge pension funds have distorted the
market even further:
New players entered the market, not all of them slick Wall Street highfliers. Some of the biggest money in commodities speculation today
comes from ordinary, boring pension funds and retirement investors that
make simple, relatively cautious long-term bets. And sometimes these
pension funds facilitate big problems.
“These big investors just come in and plop down billions of dollars on one
side of the bet," Kane said. "They make the obvious bet that prices are
19
http://www.huffingtonpost.com/2011/02/15/gambling-on-hunger-food-crisis-regulators_n_823725.html
going to go up over the long haul and it throws off the whole market.”
“They can't buy a 20-year contract for oil," Chilton noted, because such
long-term contracts don't exist. "They buy a three-month or a six-month
contract, and when they have to renew it, every trader in the market jumps
in and bids up the price."
The financial activity pushing up oil demand is not short-term speculation
in futures markets, but long-term investment by pension funds and other
permanent hoarders, not only of oil but also of gold, copper and even
agricultural commodities. 20
Antole Koletsky detailed the effects of raw commodity hoarding and speculation in her
March 2011 article published by The Australian:
In addition to the warehouses and tankers in Rotterdam, Singapore and
elsewhere that are stuffed with potentially productive commodities taken
off world markets by financial investors, enormous paper bets have been
placed by these institutions with investment banks. The banks in turn have
hedged these bets in futures markets by buying continuously and
regardless of price, in a process closely analogous to the subprime
mortgage boom. And just as rising house prices pulled more money into
mortgages, driving up prices still further, the recent rise in oil prices,
instead of reducing demand, has led to more financial hoarding, pushing
up both prices and demand.
If pension funds want to bet on higher commodity prices, they should do
this by buying shares in productive businesses such as oil companies,
agricultural businesses or mines. If instead they choose to hoard
commodities, they should, at a minimum, lose their tax privileges and
ultimately face outright bans. Ideologues will object that such intrusive
measures interfere with free market forces. But the world has learnt by
now that markets can sometimes be dangerously dysfunctional. Today's
commodities market is a frightening case in point. 21
Conclusion
Unless stringent regulations are imposed on commodity speculation it can be assumed
prices for everything from oil to coffee will continue to rise. Consumers in the third world
will begin being priced out of the market and be forced to either go hungry or find food
by other means. If this bubble is allowed to grow eventually, as in the cases of the “dot
com”, gas and housing bubbles, the market will reach a tipping point and the bubble will
20
http://www.huffingtonpost.com/2011/02/15/gambling-on-hunger-food-crisis-regulators_n_823725.html
http://www.theaustralian.com.au/business/two-ways-to-avert-catastrophe-that-may-be-on-its-way/storye6frg8zx-1226015538251
21
burst. Farmers and companies carrying physical stocks of commodities would be left
with potentially crippling losses and many would go bankrupt. In the mean time
investment banks and big businesses like the founders of the ICE will continue to profit
handsomely. Of course there will be other effects in both the long and short term that we
cannot predict. What we can do is to make sure our investments do not contribute to the
commodity bubble, and enlighten others as to how this corruption affects them and our
society at large.
Appendix
Investment Technicals and Terms
ETN: Exchange traded note - A type of unsecured, unsubordinated debt security
• The only pure coffee ETN is the iPath Dow Jones-UBS Coffee Subindex Total Return
Exchange Traded Note (NYSE:JO). ʻJOʼ grew from $36 to $70 over the past year.
ETF: Exchange traded fund - A security that tracks an index, a commodity or a basket
of assets like an index fund, but trades like a stock on an exchange.
• A few ETFs (and their coffee allocation %) that track coffee are DJCI (3%), RJI (5.7%)
and GSP (0.8%).
ETNs are structured investment products that are issued by a major bank or provider as
senior debt notes. This differs from an ETF that consists of an actual security or
sometimes commodity or currency derivative such as futures, forwards, and options.
When an investor purchases an ETN, they are purchasing a debt product similar to a
bond. The terms of the debt contract are determined by the structure of the ETN. When
an investor purchases an ETF, they are purchasing an asset like a stock or index.
Because ETNs are backed by a bank with a high credit rating, they are secure products.
However the notes are not without credit risk, just at a lower level of risk.
A following is a recent article clipping showing the rising attractiveness of commodity
investment in comparison with more traditional investments:
The S&P GSCI (Goldman Sachs Commodity Index) Total Return Index of
24 commodities (energy, metals, agriculture, livestock) gained 3.8 percent
in February and rose for a sixth consecutive month, the longest streak
since 2004, data compiled by Bloomberg show. The MSCI All-Country
World Index of equities in 45 nations returned 3 percent including
dividends, while corporate and government bonds rose 0.13 percent,
according to Bank of America Merrill Lynchʼs Global Broad Market Index
through Feb. 25, 2011. The U.S. Dollar Index, a gauge of the currency
against six counterparts such as the euro and yen, fell 1.1 percent.
It is easy to see the huge variety of ways to invest in coffee without actually buying any.
Especially when commodity ETFs and ETNs are tracked by large investment
organizations such as mutual and pension funds. The investment becomes so indirect
that people have no idea that they even have stock in coffee and other soft commodities
let alone the global impact of those investments.
Sources
The Australian - http://www.theaustralian.com.au/business/two-ways-to-avertcatastrophe-that-may-be-on-its-way/story-e6frg8zx-1226015538251
Bean Activist - http://beanactivist.wordpress.com/2008/07/16/world-coffee-market-theimpact-of-speculation/
BioTech Fuels - http://biofuels.croplife.org/index.php?page=crops
Bloomberg - http://www.bloomberg.com/news/2011-01-13/u-s-foreclosure-filings-mayjump-20-this-year-as-crisis-peaks.html
Business-Standard.com - http://www.business-standard.com/india/news/investing-incommodities-turns-attractive-as-prices-soar/427106/
BusinessWeek http://investing.businessweek.com/research/stocks/private/snapshot.asp?privcapId=276
3844
Commodities Futures Grains Council http://www.cftc.gov/About/HistoryoftheCFTC/history_precftc.html
Ehow - http://www.ehow.com/about_5037933_history-commodities-trading.html
Encyclopedia.com http://www.encyclopedia.com/topic/Commodity_Exchange_Act.aspx
Globe and Mail, The - http://www.theglobeandmail.com/news/world/crisis-in-egypt/foodriots-what-creates-the-anger/article1889679/
Harperʼs - http://www.harpers.org/archive/2010/07/0083022
Huffington Post, The - http://www.huffingtonpost.com/2011/02/15/gambling-on-hungerfood-crisis-regulators_n_823725.html
Independent, The - http://www.independent.co.uk/news/business/analysis-andfeatures/how-goldman-sachs-took-over-the-world-873869.html
InterContinental Exchange, The https://www.theice.com/publicdocs/futures_us_reports/all/Futures_US_Margin_Require
ments.pdf
International Grains Council (Market Report) http://www.igc.int/downloads/gmrsummary/gmrsumme.pdf
Lind Waldock - http://www.lind-waldock.com/education/commodities/history.shtml
Mother Jones - http://motherjones.com/politics/2008/05/foreclosure-phil
Nasdaq - http://www.nasdaq.com/asp/holdings.asp?symbol=ICE&selected=ICE
New York Times, The http://www.nytimes.com/2011/05/09/business/economy/09commodities.html?pagewant
ed=2&_r=1&ref=business
Population Institute - http://blog.populationinstitute.org/2011/01/25/dont-blame-thespeculators/
Rolling Stone, The - http://www.rollingstone.com/politics/news/the-great-americanbubble-machine-20100405?page=3
Roosevelt Institute, The - http://www.rooseveltinstitute.org/new-roosevelt/owningbanking-system
Rueters - http://www.reuters.com/article/2010/09/02/us-russia-grainidUSTRE68125J20100902
United States Department of Agriculture http://www.usda.gov/oce/commodity/wasde/latest.pdf
Vietnam Business Economy News - http://www.vneconomynews.com/2011/03/coffeemarket-jolted-as-prices-and.html
Wikipedia http://en.wikipedia.org/wiki_Commodity_Futures_Modernization_Act_of_2000