Problem: influx of assets into soft commodity derivatives is increasing volatility and imposing costs for producers and food companies.
Solution: treat commodity hedging as a utility public service. Financial players would state their purpose as hedgers or speculators, with different regulatory regimes applying to each. Regulators could vary the mix and capture rents for the public benefit.
In early 2008 the price of wheat more than doubled, shooting food prices up around the world. But when wheat prices leapt 50% this summer after crop failures in Russia, bread makers had learned their lesson (according to this FT article from 6 Aug) and were well hedged. Food prices shouldn’t be quite so volatile this time.
Thanks to the banks writing socially-useful commodity futures, thousands of farmers can insure against price falls when the harvest is good, and food companies (and ultimately consumers) can insure against price rises when crops fail.
Agricultural hedges are usually written over 12-18 months, long enough to cover a season of bad weather but short enough for underlying demand changes to feed through, for example so population changes can still drive agricultural land use.
In steady years, the hedgers earn a margin for their role as insurers, which they squirrel away against bad years more easily than a farmer or baker could. Theoretically, as more of both sides of the market become hedged, the smaller the net risk for hedgers in the middle and the cheaper their services should become.
So why is commodity hedging still so profitable? The Armajaro STS Commodities Fund, which “invests in liquid exchange traded commodity derivatives”, makes 25% a year for its investors. Perhaps that’s because it is one of the funds managed by “Chocfinger”, aka the GBP 3.4m a year commodity trader Anthony Ward, who cornered the cocoa market earlier this year.
The huge recent influx of money into commodity ETFs and commodity hedge funds is clearly having an effect. Deutsche Bank estimates that commodity investments in the US doubled in 2009 to more than $22bn, or $73bn if you include precious metals.
This has a range of ill effects. In the words of Paul Woolley, of the LSE's Centre for the Study of Capital Market Disfunction: "Before the middle of the last decade the prices of individual commodities could be explained by the supply and demand from producers and consumers. With the flood of passive and active investment funds going into commodities from 2005 onwards, prices have been increasingly driven by fund inflows rather than fundamental factors. Prices no longer provide a reliable signal to producers or consumers. More damagingly, commodity prices have a direct impact on consumer price indices and the role of central banks in controlling inflation is made doubly difficult now that commodity prices are subject to volatile fund flows from investors."
In other words, when the balance of speculative and commercial investors gets out of kilter, prices don’t behave as they should. In trader-speak, rising future prices create “contango” losses for ETF investors as monthly contracts are rolled over, or “backwardation” if it goes the other way.
Farmers aren't interested in such jargon. They see that high prices hurt consumers and low prices hurt growers. High volatility hurts them both and, as it's a zero-sum game, speculative profits must come from farmers or bakers somewhere along the line. So what is the policy response?
One idea is to tax short-term contracts, as Angus Cunningham proposes with his differentiated speculative Financial Transactions Tax, or dsFTT. This serves as a proxy for speculative activity, on the basis that if producers normally use 12-18 month contracts, anyone trading a 1-week or 1-month futures contract is probably a speculator.
That may often be the case with securities, but agricultural commodities are a bit different. If a producer needs a short-term contract there’s a good chance he really needs it: perhaps a food company extending its hedge as prices spike, or a farmer trying to secure a minimum price for an unexpectedly big harvest as prices fall away. For soft commodity derivatives, a FTT on short-term contracts could have a nasty side-effect of penalising producers, making it less effective as a speculative curb and hard to implement.
Another approach is to limit the ratio of hedging derivatives to the underlying commodity on a one-to-one basis, on the grounds that any excess hedging must be speculative. However, a simple correlation may be unrealistic since some hedges will never be exercised, while outputs will always differ from expectations. It’s also hard to make sure that the right people buy the hedges; if speculators corner the market in futures before producers get a chance, any limit would be self-defeating.
A third option is simply to tax all derivatives as part of a general financial transaction tax, as proposed by the Robin Hood Campaign. This could raise large sums from farmers, food companies, consumers and speculators alike. It would dampen speculation a bit, but its non-discriminating nature means it could end up mostly as a tax on food and farming.
A fourth option is the utility-style regulation mentioned at the top of this post. The idea is to put all commodity derivatives on exchange and issue licenses to financial players, who must opt to be either hedgers or speculators, with different regimes for each.
Hedgers could write as many contracts as they like provided their profits stay within a set percentage of turnover, as with water companies and electricity suppliers. Their profit could be set at a fixed percentage of the value of contracts written (set to give a fair return on capital but no more), with any surplus taxed at a 100% marginal rate. This would set an upper limit to the amount society needs to pay for price stability in commodities that are prone to weather disruption.
To maximise their profits, hedgers would need to contract with as many producers and users as possible, spreading their protection from price shocks as far as possible. In return, hedgers might be asked to maintain a low ratio of derivatives to underlying commodities, and accept duties towards producers and consumers such as equality of treatment and fair dealing. They would have a clear economic purpose in providing price stability and spreading risk, at a reasonable cost. Any behaviour inconsistent with that could lead to them losing their hedger's license and being re-categorised as a speculator.
Speculators would be allowed to operate freely, writing contracts for anyone in any quantity just as they do now. However, they would be subject to a new financial transaction tax that licensed hedgers would be exempt from, and they would have to buy their speculator's licenses at auction. They might also be given higher capital and margin requirements to reflect systemic risk.
The idea would face a few difficulties: speculators could register offshore; putting commercial OTC contracts onto exchanges would increase producers' margin costs; laissez-faire and vested interests could make implementation difficult; a new regulator might be needed and might set the hedging profit level badly; and regulation could cause a disruptive outflow of commodity investments.
But it would have advantages over the current system. If price volatility increases, the regulator could simply bump up the FTT until the level of speculative trading falls back to a suitable level. Meanwhile, speculators' profits would be taxed through the auction process, returning economic rent to the public purse. And traders would still be free to trade as boring hedgers or high-rolling speculators, as long as they accept the risks and duties of each.