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REGULATING EXCESSIVE SPECULATION: COMMODITY DERIVATIVES AND THE GLOBAL FOOD CRISIS

Published online by Cambridge University Press:  26 April 2017

Anna Chadwick
Anna Chadwick*
Affiliation:
Max Weber Fellow, European University Institute, [email protected].
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Abstract

Evidence suggests that commodity derivatives speculation contributed to extraordinary patterns of grain price volatility that led to a global food crisis in 2007–11. People in countries throughout the world are increasingly dependent on international commodity markets for access to food. Almost everywhere, now, the value of food is determined by a single condensed symbol of its worth—its price. Persuaded of the need to ensure that this measure of value is not put at risk of distortion in the pursuit of financial profit, governments in the US and in the EU are now implementing new regulations designed to curb ‘excessive’ levels of speculation in derivative markets. Carrying out an analysis of these regulatory measures, the article demonstrates that both sets of reforms suffer from a critical limitation: They are predicated on an inaccurate understanding of how activity in commodity derivative markets can impact on underlying food prices. If the new regulations for commodity derivative markets are not up to the task, as this article argues that they are not, a more fundamental revision of global economic structures may be required if the basic needs of human beings are not to be subsumed to the interests of financial capital in the years to come.

Keywords

commodity derivativesDodd FrankEMIR-MiFID IIfinancial regulationfood insecurity
Type
Articles
Information
International & Comparative Law Quarterly , Volume 66 , Issue 3 , July 2017 , pp. 625 - 655
Copyright
Copyright © British Institute of International and Comparative Law 2017 

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References

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11 ibid.

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31 For an overview of contemporary futures trading see ‘A Trader's Guide to Futures’ <www.cmegroup.com/education/files/a-traders-guide-to-futures.pdf>.

32 Swaps were first invented in 1981 to facilitate a deal between IBM and the World Bank. They are a species of derivative that enable parties to exchange future cash flows, allowing parties to ‘swap’ their respective advantages in different markets for mutual benefit. However, ‘swaps’ is a common name given to all OTC derivatives. ‘IBM in Deal on Currency’ New York Times (18 August 1981).

33 A commodity swap is a contract where two sides of the deal agree to exchange cash flows, which are dependent on the price of an underlying commodity.

34 Index funds are designed to give investors a return based on a mathematical formula aggregated from the values assigned to a specified basket of commodities including non-food commodities such as fuels and metals.

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37 Michael Greenberger speaking at the High Level Thematic Debate on Addressing Excessive Price Volatility in Food and Related Financial and Commercial Markets, United Nations, New York, on Wednesday 11 April 2012 <www.unmultimedia.org/tv/webcast/2012/04/general-assembly-thematic-debate-on-addressing-excessive-price-volatility-in-food-and-related-financial-and-commodity-markets.html>.

38 The UK Financial Services Authority (FSA) estimated that, as of 2007, approximately 80 billion dollars of capital from pension funds globally was invested in commodities. E Doyle, J Hill and I Jack, ‘Growth in Commodity Investment: Risks and Challenges for Commodity Market Participants’ <www.fsa.gov.uk/pubs/other/commodity_invest.pdf> 23.

39 M O'Brien, ‘Everything You Need to Know about High-Frequency Trading’ The Atlantic (11 April 2014) <www.theatlantic.com/business/archive/2014/04/everything-you-need-to-know-about-high-frequency-trading/360411/>.

40 Jones, ‘The Great Hunger Lottery’ (n 30) 9.

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43 The role of financial deregulation in precipitating the financialization of commodity futures markets has been discussed by a number of commentators. While these scholars are correct to argue that changes in the law were instrumental in bringing about growth of the OTC derivatives market, it is inaccurate to suggest that all of the changes amounted to ‘deregulation’. Derivatives can be understood as a form of regulation in themselves, and the OTC market depends on an intricate network of contracts, legal techniques, and courts in order to function. A more compelling analysis is that financial regulations were not so much removed but rather recalibrated during the 1990s and 2000s. For an account of the legal changes made to allow for the emergence of the OTC market see Stout, LA, ‘Derivatives and the Legal Origin of the 2008 Credit Crisis’ (2011) 1 HBLR 1 Google Scholar and Tett, G, Fool's Gold: How Unrestrained Greed Corrupted a Dream, Shattered Global Markets and Unleashed a Catastrophe (Abacus 2010) 26–47 Google Scholar. For scholarship that problematizes the discourse on ‘deregulation’ see Vogel, S, Freer Markets, More Rules: Regulatory Reform in Advanced Industrial Countries (Cornell University Press 1996)Google Scholar.

44 Stout ibid, 11–15.

45 Under section 63, the FSA 1986 offered OTC trading an enforceability guarantee in the UK.

46 Tett (n 43); Stout (n 43)

47 Commodity Futures Modernization Act 2000.

48 J Ghosh, ‘The Commodity Price Rollercoaster’ (2008) World Development Movement Report 5.

49 Ghosh, J, ‘The Unnatural Coupling: Food and Global Finance’ (2010) 10 Journal of Agrarian Change 1 CrossRefGoogle Scholar.

50 P Wahl, ‘Food Speculation as the Main Factor of the Price Bubble in 2008’ (2009) World Economy, Ecology & Development Briefing Paper 11.

51 ibid.

52 Ghosh, ‘The Unnatural Coupling’ (n 49).

53 Economists at UNCTAD have highlighted that the prices of many commodities including metals, agriculture and energy commodities are ‘clearly moving today in tandem’, when, prior to the development of derivative products such as commodity index funds, this was not the case. UNCTAD ‘Don't Blame the Physical Markets’ (n 42) 2.

54 Jones, ‘The Great Hunger Lottery’ (n 30) 4.

55 Deutsche Bank recently justified its decision to continue investing in commodity derivatives arguing that ‘there is no convincing evidence that the products we offer have a de-stabilizing impact on prices and cause more people to go hungry’. Deutsche Bank, ‘Our position: The Key Questions and Answers’ <https://www.db.com/cr/en/concrete-current-questions-and-answers-may-2014.htm>.

56 P Krugman, ‘Speculative Nonsense Once Again’ The New York Times (23 June 2008).

57 The theory that financial markets are ‘informationally efficient’ is known as the ‘efficient markets hypothesis’. Fama, E, ‘Efficient Capital Markets: A Review of Theory and Empirical Work’ (1970) 25 Journal of Finance 2 CrossRefGoogle Scholar.

58 P Krugman, ‘Commodity Prices (Wonkish)’ The New York Times (19 March 2008).

59 Kulkarni, B, Commodity Markets and Derivatives (Excel Books 2011) 40Google Scholar.

60 The Institute for Agriculture and Trade Policy (IATP) provides a helpful compendium of much of this work, see B Lilliston and A Ranallo (eds), ‘Excessive Speculation in Agriculture Commodities: Selected Writings from 2008–2011’ (2011) IATP Report.

61 The Granger Causality test is a test developed by Nobel prize-winning econometrician, Clive Granger, and has been acclaimed for developing a rigorous way of establishing when correlations might have a causal link. Granger, C, ‘Investigating causal relations by econometric models and cross-spectral methods’ (1969) 37 Econometrica 424 CrossRefGoogle Scholar.

62 M Lagi et al., ‘The Food Crises: A Quantitative Model of Food Prices Including Speculators and Ethanol Conversion’ (2011) NECSI Report.

63 ibid 2.

64 G20 governments made a specific pledge at the G20 forum in Pittsburgh in 2009 to improve the regulation of financial and commodity markets in order to address excessive commodity price volatility. See ‘G20 Leaders Statement: The Pittsburgh Summit’ 24–25 September 2009, Pittsburgh, Preamble <www.g20.utoronto.ca/2009/2009communique0925.html>.

65 ibid.

66 ibid.

67 ibid.

68 The Dodd Frank Wall Street Reform and Consumer Protection Act of 2010 Pub.L. 111–203, H.R. 4173 (Dodd Frank).

69 The Regulation (EU) No 648/2012 of the European Parliament and of the Council of 4 July 2012 on OTC derivatives, central counter-parties (CCPs) and trade repositories (TRs) (EMIR).

70 Directive 2014/65/EU of the European Parliament and of the Council of 15 May 2014 on markets in financial instruments and amending Directive 2002/92/EC and Directive 2011/61/EU Text with EEA relevance (MiFID II).

71 In the US this falls to either the Commodity Futures Trading Commission (CFTC) or the Securities and Exchange Commission (SEC) depending on how a given instrument is classified. In Europe, the task has been allocated to the European Securities and Markets Authority (ESMA), a new regulatory body established to oversee financial stability and investment practices in the EU.

72 Dodd Frank act section 737, Stat 4173, 1620–31.

73 CFTC, ‘Aggregation, Position Limits for Futures and Swaps’ Proposed Rule: 17 CFR Part 151 (RIN 3038–AD82 77) Federal Register (FR 31767 // PDF Version) <www.cftc.gov/LawRegulation/DoddFrankAct/Rulemakings/DF_26_PosLimits/index.htm> 31768.

74 CFTC, ‘Fact Sheet: Proposed Regulations on Position Limits for Derivatives’ <www.cftc.gov/LawRegulation/DoddFrankAct/Rulemakings/PositionLimitsforDerivatives/index.htm>.

75 For non-spot-month contracts the limits will be set at 10 per cent of open interest in the first 25,000 contracts and 2.5 per cent thereafter. CFTC, ‘Q & A – Position Limits for Derivatives’ <www.cftc.gov/idc/groups/public/@newsroom/documents/file/pl_qa.pdf> 2.

76 Positions on non-spot month contracts are yet to be decided. ESMA, ‘Consultation Paper – Annex B Regulatory technical standards (RTS) on MiFID II/MiFIR’ <www.esma.europa.eu/system/files/2014-1570_cp_mifid_ii_part_2.pdf> 381–399, RTS 29 and RTS 30.

77 ibid 385.

78 In practice this would mean that no position limit is higher or lower than 40 per cent of deliverable supply. ibid 385.

79 B Lewis and H Jones, ‘EU Told Rules on Commodity Price Speculation Risk Losing Their Teeth’ Reuters (21 May 2015) <http://uk.reuters.com/article/2015/05/21/eu-regulation-commodities-idUKL5N0YC35Y20150521>.

80 The relevant provision of the Glass–Steagall Act can be found in the Banking Act of 1933 Sections 16, 20, 21, 32, 12, USC.

81 Dodd Frank Act section 619, 124 Stat 1376, 1620-31.

82 J Mont, ‘European Commission Proposes EU Version of Volcker Rule’ Compliance Week (29 January 2014) <https://www.complianceweek.com/blogs/global-glimpses/european-commission-proposes-eu-version-of-volcker-rule#.VYF5PfNwbGh>.

83 European Commission, ‘Proposal for a Regulation of the European Parliament and of the Council on Structural Measures Improving the Resilience of EU Credit Institutions’ art 9, 13 COM (2014) 43 final.

84 Art 4(1) EMIR; Dodd–Frank Act section 723. A central counterparty is an entity that ‘interposes itself’, in one or more markets, between counterparties to the contracts traded, becoming ‘the buyer to every seller and the seller to every buyer’ guaranteeing the performance of contracts. European Central Bank/Eurosystem, ‘Glossary of Terms Related to Payment, Clearing and Settlement Systems’ (December 2009) 4.

85 Whereas the execution of an OTC trade involves ‘variation’ margin—pledging a sum of money to act as a buffer against daily market movements—additional payments in the form of ‘initial’ margin are involved in centrally cleared transactions. JP Braithwaite, ‘Private Law and the Public Sector's Central Counterparty Prescription for the Derivatives Markets’ (2011) LSE Law, Society and Economy Working Papers 2/2011, 18.

86 Art 2(1) EMIR.

87 Dodd Frank only requires reports from larger banks and financial institutions that deal in large volumes of derivatives. P Gibbon, ‘Commodity Derivatives: Financialization and Regulatory Reform’ (2013) Danish Institute for International Studies Working Paper, 18.

88 ESMA, ‘Final Report: ESMA's Technical Advice to the Commission on MiFID II and MiFIR’ (19 December 2014) ESMA/2014/1569, 429, paras 2–3; ‘CFTC Market Surveillance’ CFTC website, <www.cftc.gov/IndustryOversight/MarketSurveillance/CFTCMarketSurveillanceProgram/index.htm>.

89 CFTC, Regulation Automated Trading, RIN 3038-AD52 17 CFR Pts 1, 38, 40 and 170 <www.cftc.gov/idc/groups/public/@newsroom/documents/file/federalregister112415.pdf>.

90 N Mathews and J Robison, ‘CFTC Proposes “Regulation AT” on Automated Trading’ Derivatives in Review (18 December 2015) <http://blogs.orrick.com/derivatives/2015/12/18/cftc-proposes-regulation-at-on-automated-trading/>.

91 ‘MiFID II Update: HFT Crackdown, Speculative Position Limits, and Investor Protection’ Finance Magnates (17 January 2014) <www.financemagnates.com/forex/regulation/update-on-mifid-ii-hft-crackdown-trading-systems-position-limits-and-investor-protection/>.

92 ibid.

93 The threshold for commodity derivatives for non-financial counterparties is 3 billion euros. ESMA, ‘EMIR Review Report no. 1: Review on the Use of OTC Derivatives by Non-Financial Counterparties’ ESMA/2015/1251 (13 August 2015) <https://www.esma.europa.eu/sites/default/files/library/2015/11/esma-2015-1251_-_emir_review_report_no.1_on_non_financial_firms.pdf>. This rule functions as a parallel to the de minimis exemption granted to commercial and small financial market participants in the US.

94 CFTC, ‘Final Rules Regarding Further Defining “Swap Dealer,” “Major Swap Participant” and “Eligible Contract Participant’ <www.cftc.gov/LawRegulation/DoddFrankAct/Rulemakings/DF_2_Definitions/index.htm>; ESMA, ‘Consultation Paper MiFID II/MiFIR’’ (19 December 2014) ESMA/2014/1570, 503-4.”

95 In order to claim such an exemption, the aggregate gross notional amount of the swaps that the person enters into over the prior 12 months in connection with dealing activities must not exceed $3 billion. Similar provisions enacted under EMIR allow financial counterparties to bypass central clearing up to a threshold volume of 3 billion euros of commodity derivatives.

96 Deloitte, ‘An Interpretation of the ‘‘Hedge or Mitigate Risk’’ Criteria and the Impact to Compliance with the Dodd-Frank Act’ (Deloitte Development 2012) <http://deloitte.wsj.com/riskandcompliance/files/2013/05/Dodd-Frank_Hedge_Mitigate.pdf> 6.

97 ibid 5.

98 ibid.

99 CFTC, ‘Final Rules Regarding Further Defining “Swap Dealer,” “Major Swap Participant” and “Eligible Contract Participant”’ <www.cftc.gov/LawRegulation/DoddFrankAct/Rulemakings/DF_2_Definitions/index.htm> 4.

100 ibid.

101 ESMA (n 93)

102 World Development Movement, ‘Back to Fundamentals: Why Position Limits Are Needed to Help Prevent Food Price Hikes’ (2012) Report, 18.

103 K Hansen-Kuhn and S Suppan, ‘Speculation Update: Progress Report on US Commodity Market Reforms’ (2012) IATP Report <www.iatp.org/documents/speculation-update-progress-report-on-us-commodity-market-reforms>.

104 For a table providing an overview of some small points of difference between the two regimes see C Staritz and K Küblböck, ‘Re-Regulation of Commodity Derivative Markets – Critical Assessment of Current Reform Proposals in the EU and the US’ (2013) Austrian Research Foundation for International Development Report 17–18.

105 Several countries have indicated that they are waiting for regulatory provisions in the US and in Europe to be refined before they finalize their own regimes of reform. See Financial Stability Board, ‘OTC Derivatives Market Reforms: Third Progress Report on Implementation’ (15 June 2012) <www.fsb.org/wp-content/uploads/r_120615.pdf> 1.

106 Hansen-Kuhn and Suppan (n 103).

107 CFRC website <http://comments.cftc.gov/PublicComments/CommentList.aspx?id=965>.

108 D Samardi, ‘Financiers Attack EU Rules against Food Speculation’ (15 July 2015) <www.euractiv.com/sections/development-policy/financiers-attack-eu-rules-against-food-speculation-316315>.

109 ibid.

110 As The Economist has noted: ‘[a]nticipating the Volcker rule, bank departments previously using the word “proprietary” have been dropped, renamed or quietly shifted to sheltered corners’. ‘Too Big Not to Fail’ The Economist (18 February 2012).

111 ‘Regulating Derivatives: Teething Problems’ The Economist (22 January 2014).

112 Global Justice Now, ‘Food Speculation Open Letter’ <http://www.globaljustice.org.uk/food-speculation-open-letter>.

113 Bart Chilton, Commissioner of the Commodity Futures Trading Commission, addressing a potential ‘race to the bottom’ in the absence of internationally harmonized rules for the global derivatives market, B Chilton, ‘Stopping Stammering: Overcoming Obstacles in Financial Regulatory Reform’ Address before the Goldman Sachs Global Commodity Conference, 28 March 2011, <www.ctfc.gov/pressroom/speechestestimony/opachilton-43.html>; Awrey, D, ‘Complexity, Innovation and the Regulation of Modern Financial Markets’ (2012) 2 HarvBusLRev 235 Google Scholar, 289.

114 Interagency Report (n 9)

115 NECSI (n 63)

116 See references at (n 30).

117 For a discussion of the semantic and conceptual issues that stem from the identification of a given practice as ‘speculative’ see Szado, E, ‘Defining Speculation: The First Step toward a Rational Dialogue’ (2011) 14 Journal of Alternative Investments 1 CrossRefGoogle Scholar.

118 J Clapp, Food (Polity Press 2012) 142.

119 See ‘Macro-Hedge’ Investopedia <http://www.investopedia.com/terms/m/macrohedge.asp>.

120 S Murphy, D Burch and J Clapp, ‘Cereal Secrets: The World's Largest Grain Traders and Global Agriculture’ (2012) Oxfam Research Report 29.

121 ‘Challenges for Regulators: Financial Players in the (Food) Commodity Derivatives Markets’ (2012) SOMO Report 5.

122 Dodd–Frank Wall Street Reform and Consumer Protection Act, section 737, ‘Position Limits’ (2)(A) Establishment of Limitations.

123 For a discussion of the implications of this judgment, see Williams, JW, ‘Dodging Dodd–Frank: Excessive Speculation, Commodities Markets, and the Burden of Proof’ (2015) 37(1–2) Law & Policy 131 CrossRefGoogle Scholar.

124 J Farchy and J Blas, ‘CFTC Urged to Act on Position Limits’ Financial Times (1 October 2012).

125 T Arbit, ‘Market Participants Weigh in Regarding CFTC's Re-proposed Position Limits Rules’ <www.regulationtomorrow.com/us/market-participants-weigh-in-regarding-cftcs-re-proposed-position-limits-rules/> (2 September 2014) Financial Services: Regulation Tomorrow.

126 ‘The Speculators Win a Round’ The New York Times (14 October 2012).

127 Stout Legal Origin (n 43) 11.

128 Grain Futures Act of 1922; Commodity Exchange Act 1936.

129 Staritz and Küblböck (n 104) 15.

130 O De Schutter, ‘Food Commodities Speculation and Food Price Crises: Regulation to Reduce the Risks of Price Volatility’ (2010) Briefing Note 02, 3.

131 UNCTAD, ‘Price Formation in Financialized Commodity Markets: The Role of Information’ (2011) UNCTAD Report, 21.

132 Robert Shiller won a Nobel Prize for his work on speculative bubbles in the 1990s in which he demonstrated how ‘feedback loops’ created by traders adopting positions informed by the behaviour of other traders could drive prices away from fundamentals and result in market volatility. Shiller, RJ, Irrational Exuberance (Princeton University Press 2015)CrossRefGoogle Scholar.

133 Investing ‘long’ means investing in the expectation that an asset is going to rise in value.

134 Rogers, J, Hot Commodities: How Anyone Can Invest Profitably in the World's Best Market (John Wiley & Sons 2007) 58Google Scholar.

135 J Wilson, ‘Wall Street Grain Hoarding Brings Farmers, Consumers near Ruin’ Bloomberg News (28 April 2008) <http://www.infiniteunknown.net/2008/04/30/wall-street-grain-hoarding-brings-farmers-consumers-near-ruin/>.

136 FoodWatch, ‘The Hunger Makers: How Deutsche Bank, Goldman Sachs and Other Financial Institutions Are Speculating with Food at the Expense of the Poorest’ FoodWatch Report (2011) 24.

137 UNCTAD (n 131).

138 Dow, S, ‘The Psychology of Financial Markets: Keynes, Minsky and Emotional finance’ in Papadimitriou, G and Wray (eds), The Elgar Companion to Hyman Minsky (Edward Elgar Publishing 2010) 246Google Scholar.

139 Rosenberg, GD and Massari, JR, ‘Regulation through Substitution as Policy Tool: Swap Futurization under Dodd–Frank’ (2013) 667 ColumBusLRev 729 Google Scholar.

140 Hochfelder, D, ‘‘‘Where the Common People Could Speculate”: The Ticker, Bucket Shops, and the Origins of Popular Participation in Financial Markets, 1880–1920’ (2006) 93(2) JAmHist 351 Google Scholar.

141 ibid.

142 Staritz and Küblböck (n 104) 14.

143 Bjerga (n 35) 18.

144 A Kittrell, ‘New App Streamlines Grain Trading’ <www.agriculture.com/news/technology/new-app-streamlines-grain-trading_6-ar17557>.

145 Shiller (n 132).

146 ibid.

147 IATP, Better Markets, Inc. and other critics of speculation argue that the CFTC should ban index funds because even if their components are regulated, they still correlate and move prices in otherwise uncorrelated commodities. Hansen-Kuhn and Suppan (n 103).

148 Posner, EA and Weyl, GE, ‘An FDA for Financial Innovation: Applying the Insurable Interest Doctrine to 21st century Financial Markets’ (2012) 107 NWULRev 1307 Google Scholar; Omarova, ST, ‘License to Deal: Mandatory Approval of Complex Financial Products’ (2012) 90 WASHULRev 63 Google Scholar.

149 Derivatives were first coined as ‘financial weapons of mass destruction by the investor, Warren Buffet in 2003. ‘Buffett warns on investment ‘‘time bomb’’’ BBC News (4 March 2003) <http://news.bbc.co.uk/1/hi/2817995.stm>.

150 A tax on short-term financial transactions was first proposed by James Tobin in 1972. Tobin suggested that a tax on all spot conversions of one currency into another, proportional to the size of the transaction, could serve to curb levels of volatility in currency trading. Interviewed in 2001, he suggested it might be levied at 0.5 per cent. See ‘They Are Misusing My Name’ Speigel Online International (9 March 2011) <www.spiegel.de/international/spiegel/english-summaries-a-154539.html>.

151 HLTF (n 4).

152 Interagency Report (n 9) para 76.

153 O De Schutter, ‘Final Report: The Transformative Potential of the Right to Food’ (2014) Report of the Special Rapporteur on the Right to Food, A/HRC/25/57, 10–11.

154 S Murphy, ‘Grain Reserves: A Smart Climate Adaption Policy’ in Lilliston and Ranallo (n 60) 18.

155 Helleiner, E, ‘Explaining the Globalization of Financial Markets: Bringing States Back In’ (1995) 2 Review of International Political Economy 2 CrossRefGoogle Scholar.

156 Awrey (n 113).