A new vision for agriculture
momagri, movement for a world agricultural organization, is a think tank chaired by Pierre Pagesse.
It brings together, managers from the agricultural world and important people from external perspectives,
such as health, development, strategy and defense. Its objective is to promote regulation
of agricultural markets by creating new evaluation tools, such as economic models and indicators,
and by drawing up proposals for an agricultural and international food policy.
CNUCED
  Editorial  
  Report on price formation in financialized commodity markets

United Nations Conference on Trade and Development (UNCTAD)

Since the mid-2000s, commodity prices have been marked by an upward trend and increased volatility. The reasons most commonly advanced by experts include the reported market fundamentals shift that is rooted in the combination of climate hazards, biofuel development and economic growth of developing countries.

These different factors, however, are not enough to explain the structural volatility observed in agricultural markets, and even less the recent progression of agricultural prices. Consequently, other issues must be included in the scope of the study, particularly the increasing financialization of agricultural markets, whose impact on price volatility is indisputable but multifaceted. With this goal in mind, the United Nations Conference on Trade and Development (UNCTAD) has published a report1 on price formation in financialized commodity markets in June 2011.

We encourage you to read the report that brings significant elements concerning the complex links between the financilization of agricultural markets and agricultural price volatility. We are publishing below an excerpt of the report, which principally illustrates the issues that might be generated by increased financialization of agricultural markets, and outlines UNCTAD’s recommendations––strengthening transparency on physical markets to limit uncertainties, improving information flows on commodity trading and access to such data, tightening regulation concerning financial players by capping position volume for instance, and lastly, implementing direct measures to stabilize commodity prices.

Momagri Editorial Board




What is problematic about financialization?

“The importance of financialization has increased significantly since about 2004, as reflected in rising volumes of financial investments in commodity derivatives markets – both at exchanges and over the counter (OTC). This phenomenon is a serious concern, because the activities of financial participants tend to drive commodity prices away from levels justified by market fundamentals, with negative effects both on producers and consumers. The role of information flows is crucial for price developments in commodity derivatives markets.”

[…]

“The financialization of commodity trading has made the functioning of commodity exchanges controversial. Their traditional functions have been to facilitate price discovery and allow the transfer of price risk from producers and consumers to other agents that are prepared to assume the price risk. These functions are impaired to the extent that trading by financial investors increases price volatility and drives prices away from levels that would be determined by physical commodity supply and demand relationships.

As a result, commodity price developments no longer merely reflect changes in fundamentals; they also become subject to influences from financial markets. Consequently, market participants with a commercial interest in physical commodities (i.e. producers, merchants and consumers) face greater uncertainty about the reliability of signals emanating from commodity exchanges. Thus, managing the risk of market positions and making storage, investment and trading decisions become more complex. This may discourage long-term hedging by commercial users. Moreover, with greater price volatility, hedging becomes more expensive, and perhaps unaffordable for developing-country users, as well as riskier.”

The efficient market hypothesis does not hold in commodity futures markets, leading to herd behavior and price bubble

“Traditionally, the so-called efficient market hypothesis (EMH) is assumed to hold in financial markets, including in commodity derivatives markets and especially in futures markets, which are the focus of this study. The EMH postulates that all publicly available information is immediately reflected in prices. In its strong form, the EMH contends that even private information – available only to individual market participants – is reflected in the price through the effects of the transactions of the persons in possession of the information. If the EMH were to apply, commodity price developments would reflect nothing but information on fundamentals.

However, this study shows that the EMH does not apply to the present commodity futures markets. Market participants also make trading decisions based on factors that are totally unrelated to the respective commodity, such as portfolio considerations, or they may be following a trend. Therefore, it is difficult for other agents in the market to discern whether or not their transactions are based on information about fundamentals, which in any case is sometimes difficult to obtain and not always reliable. Trading decisions are thus taken in an environment of considerable uncertainty. In such a situation, it is rational to follow other participants’ trading decisions. A wide range of motivations leads traders to engage in this so-called “intentional herding” on a perfectly rational basis, the most important one being imitation in situations where traders believe that they can glean market information by observing the behaviour of other agents.

In an environment of herd behaviour there are limits to arbitrage. Acting against the majority, even if justified by fundamentals, may result in large losses, often of borrowed money. It may therefore be rational for market participants to ignore their own information and follow the trend. This is what many financial players do by default, basing their trading decisions purely on the behaviour of price series (algorithmic trading), which can lead to a commodity price bubble.”

Results of the field survey confirm that the role of financial investors has become more important, leading to increased volatility

“To complement the theoretical and empirical findings 22 interviews were conducted with various commodity market participants, ranging from physical traders to financial investors, but also including a broker, representatives of a price reporting firm and two consultants. The interviewees agreed that the role of financial investors has become more important in recent years. Due to their financial strength, they can move prices in the short term. This leads to increased volatility, which may harm markets and drive hedgers with an interest in physical commodities away from commodity derivatives markets. The increased volatility results in more margin calls and thus higher financing requirements. Although all interviewees stressed the role of fundamentals in medium- to long-term commodity price formation, they conceded that substantial price distortions and herding effects could occur in the short term due to the participation of financial investors. This is also reflected in the responses of several interviewees, who said they paid increasing attention to financial market information.”

“The main conclusion of the interviewed commodity market players was that market transparency needed to be increased. For the United States, this refers especially to the OTC market. In Europe, there is, in general, a greater lack of transparency than in the United States. The adoption of reporting in Europe, similar to that provided by the Commodity Futures Trading Commission (CFTC) – the institution mandated to regulate and oversee commodity futures trading in the United States – in its weekly Commitments of Traders reports would be a big step in the right direction, but more information should also be required about the OTC business.”

Policy considerations and recommendations

“The analysis clearly shows that information flows play a vital role in commodity price developments. The market distortions described above are closely related to the fact that market participants make decisions under conditions of substantial uncertainty. Therefore policy responses to improve market functioning should concentrate on the following issues:

    • Increased transparency with respect to fundamentals. Although a variety of sources of information currently exist, there is substantial uncertainty in terms of data quality and timeliness, particularly with respect to inventories.

    • Increased transparency in the exchanges and OTC markets themselves. More information should be made available with regard to position-taking and categories of market participants in commodity derivatives markets. This applies in particular to commodity trading in Europe, where transparency lags significantly behind that in United States exchanges. Improved transparency is important not only for market participants but also for regulators, who can only intervene if they know what is happening in the market.

    • Tighter regulation of financial players. Tighter rules internationally would be an optimal scenario, so that regulatory migration could be avoided. Given that the size of financial players’ involvement has a substantial impact on price developments, position limits aimed at restraining the engagement of financial investors in commodity markets may be indispensable in the medium to long run. As appropriate levels are not easy to determine, a first step might consist of position points at which traders would be required to provide additional information. In addition, proprietary trading by financial institutions that are involved in hedging transactions of their clients could be prohibited because of conflicts of interest.

    • Beyond this kind of “soft regulation”, a number of direct commodity price stabilization measures should be considered. As governments and international institutions have access to the same kind of information as the market participants, the establishment of a government-administered virtual reserve mechanism and the possibility of allowing governments’ direct intervention in the physical and the financial markets need to be considered. In financialized commodity markets, as in currency markets, intervention may even help market participants to better recognize the fundamentals.

    • The introduction of a transaction tax system could generally slow down the activities of financial investors in commodity markets. All these measures deserve serious political consideration, even if some of the more sophisticated schemes among them may prove difficult to implement quickly.”


1 “Price formation in financialized commodity markets, The role of information”, January 2011, http://www.unctad.org/en/docs/gds20111_en.pdf
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Paris, 29 July 2014