Almost unnoticed, a new category of speculators has entered the commodity futures market in massive numbers since 2004: institutional investors, mostly in the form of so-called Index Funds.
Since the late 19th century commodity futures markets have supported participants in the physical trade of commodities, giving them the possibility to hedge price risk and to find a market price for the product they trade. Since their buying and selling of futures reflect the underlying physical commodity exposure, their futures trading decisions strengthen the critical price discovery function of the futures markets. The second group of players – the traditional speculators – also follow a buying and selling strategy based on a thorough understanding of the market fundamentals underlying the specific commodities. Their role is essential as they add liquidity to the market.
Research by Michael Masters and Adam White in the United States shows that the impact of this new category of players over the past few years has been a strong upward price pressure (we all remember the 2008 food riots) and increased price volatility. Both reflect a distortion of the price discovery function of the commodity exchanges. Not surprising as every futures contract traded for reasons other than physical supply and demand damages price discovery.
Millennium Development Goal 9 calls for an ‘open, rule-based, predictable, non-discriminatory trading and financial system’. Many developing countries depend on the export of commodities. Although higher commodity prices seem attractive they can actually do harm when artificial and strongly volatile. Wrong price signals lead to wrong investment and trading decisions.
Is another bubble being created? A bubble that brings a few short-term benefits along with a lot of long-term pain? In the United States the public debate about excessive speculation on the commodity futures market has started. Politicians and regulators are being pushed and prodded to actually do something. And financial investors should also be aware of their role. Let us be alert. The credit crisis has shown us what harm ‘financial innovation’ can do when disconnected from the real economy.
Koert Jansen, fund manager Triodos Sustainable Trade Fund, Zeist, the Netherlands