Cause or coincidence?

EXAMINING THE ROLE OF SPECULATORS IN PRICE VOLATILITY

the sharp run-up in commodity prices during 2007 and 2008 set off another round of the ongoing debate over speculators and their role in price volatility. 

Though market volatility has eased somewhat since then, the debate continues. This October, it led the Commodity Futures Trading Commission (CFTC), which regulates US commodity markets like the Chicago Board of Trade and the Chicago Mercantile Exchange, to approve new contract limits on index fund investments — and now there’s debate over the faults or benefits of the CFTC rule.

To make sense of this dispute, it helps to begin with some history.

Commodity markets like the CBOT were created to put sellers of commodities in touch with buyers, and both sides of the current debate agree that some speculators are needed to keep the market going, or, as Cory Martin of the American Bakers Association (ABA) says, “you need someone to provide liquidity, to buy when the bakers aren’t buying and sell when the farmers aren’t selling.”

changing the rules
In recent decades, CFTC rules changed.  By defining index funds as commercial hedgers, the rules exempted them from contract limits and opened the commodity markets to more investment.  Index funds’ stake in commodity markets increased from an estimated $15 billion in 2003 to more than $200 billion in 2008.

Critics like the ABA argue that index funds operate differently than traditional hedgers.

“Unlike the traditional speculator, who often acts as a medium between agricultural producers and end users through buying and selling contracts, index speculators buy and hold contracts by simply rolling their long-only positions to the next spot month,” ABA President Rob MacKie told a CFTC hearing. Translated, “long” contracts are an  ongoing bet that prices will continue to go up, and “rolling” allows index speculators to maintain their same “long” position for an extended period by replacing a set of contracts that are about to expire with another set of long contracts with a later delivery date. 

The result, according to the ABA and other critics, is increased market volatility. 

“The commodity markets were never intended to be an investment opportunity like the stock market,” says the ABA’s Martin.  “We believe that  when index funds began applying stock market tactics to the comparatively small wheat market, it resulted in an incredibly volatile market for the other players.”

At the University of Illinois’ college of agriculture, economist Scott Irwin makes a very different case.

“The argument is that a large wave of investing in commodity index funds overwhelmed the normal supply and demand functioning in these markets and created a price bubble,” explains Irwin.  “But the overwhelming weight of available evidence is inconsistent with a massive bubble.  There’s no smoking gun as yet to link index investing to massive price distortion.” 

A data review by FTI UK Holdings Limited, a London consulting firm, also finds “little causation between speculative positions and prices.

“Just because two data series [speculative investments and commodity prices] move together does not prove that one causes the other,” the FTI study concludes. 

As further support, Irwin cites CFTC Commissioner Michael Dunn’s statement on the issue and the question of restricting commercial hedge fund investment: “Price volatility exists in markets that have position limits and in markets that do not have position limits. Price volatility exists in markets that have substantial participation from index funds and markets that do not have any index fund participation whatsoever. With such a lack of concrete economic evidence, my fear is that, at best, position limits are a cure for a disease that does not exist or at worst, a placebo for one that does.”

Still, the CFTC has voted to set contract limits on index fund investing in commodities.

an industry undecided
The ABA calls the decision “an important step in the right direction to tackle volatility,” citing the limits on index funds’ ability to buy and hold hundreds of thousands of contracts.

Irwin calls the move “the most significant regulatory intervention in commodities markets since the banning of onion futures in 1958.  It’s a shattering of the political consensus on the nature and role of commodity markets.

“It won’t shut down the markets,” he says.  “They will still be useful for discovering price and for managing risk, but they will be more costly to use, and therefore the system as a whole will be less efficient.  Trading will get a little more expensive, and in such huge markets, even a small price change can add up to tens of millions very quickly.”

Meanwhile, the debate rages on, as business columnists like Steven Pearlstein charge that commodities are the latest financial “bubble” about to burst. •