Agricultural derivatives markets allow farmers and food processors (so-called ‘commercial parties’) to reduce their exposure to the risk of price fluctuations (‘hedging’). This is an important function in agricultural markets, where prices can fluctuate heavily. Food derivatives markets also play an important role in ‘price discovery’: futures prices are used in determining the prices in the physical (‘spot’) market and in making investment decisions. For derivatives markets to work well, some financial speculation is often welcome to provide liquidity, making it easier for commercial parties to find a counterpart for their desired trade. Over the last decade, however, purely financial speculation in commodity derivatives markets, including derivatives of food commodities, has increased dramatically. Total commodity assets, invested mostly through derivatives, have grown within a decade from a negligible amount to less than US$100 billion in 2005 and more than US$400 billion at the time of writing. As a result, financial speculators have become the dominant party in many agricultural derivatives markets, holding the majority of the contracts, whereas this was 10-20% before 2000.In this period the price volatility in futures and spot markets has intensified unprecedentedly, with food prices reaching record levels in 2008 and 2011. As people in the poorest nations spend up to 80% of their income on food (compared to only 10% in developed countries), rising food prices directly increase poverty and undernourishment for millions of people. After declining for many decades, the number of undernourished people has in recent years started to rise again. Children can suffer the consequences of even temporary undernourishment for the rest of their lives. Increased volatility has also caused the cost of hedging to rise. Farmers and food processors therefore find themselves exposed to ever larger price risks. This means that farmers are less likely to increase the food supply in response to the incentive of higher food prices. What role does the dramatically increased financial speculation play in this higher volatility? In recent years, world food markets have also been affected by other fundamental changes and shocks, such as the increased use of crops for energy production, extreme weather events and a strong rise in demand. The issue of food security is clearly not about commodity derivatives markets alone. However, an increasing number of studies show that the increased financial investment in commodity derivatives is also contributing to the volatility in futures and spot markets, and hence to the recent price hikes. Thus the unprecedented financial speculation we are seeing today can be labeled ‘excessive speculation’, as defined in US law, undermining the orderly working of derivatives markets instead of contributing to it. Weighing the evidence, we conclude that increased speculation does more harm than good. Financial speculation brings no clear advantages and high food prices have a devastating impact on the most vulnerable. With food prices on the rise again, governments must act decisively to prevent a recurrence of the situation in 2008. The precautionary principle, as enshrined in the Lisbon Treaty of the European Union, states that public action is warranted when there is sound evidence that harm can be prevented, as is the case here with regard to the Universal Human Right to affordable food. Especially in this field with such little information on both the levels and kind of speculation going on and the real supply and demand, waiting for full clarity on causal relationships would be irresponsible.The now excessive speculation should be brought back to the level where it was before 2000. This can be done through increasing not only the transparency of physical food markets and food derivatives markets, but also the capacity and expertise of regulators to process this information, as well as enforcing more stringent price- and position limits. A financial transaction tax would further reduce speculation. The EU has a special responsibility here as it is lagging the US in terms of both transparency and regulation. The US has much experience in regulating food derivatives markets. It is also in the US that the most far-reaching regulation, with regard to the transparency of all commodity derivatives trade and to stricter position limits, have been introduced. A strong and knowledgeable regulator is wholly absent from the EU, and it seems to be as yet unwilling to impose the strict position limits introduced in the US. The EU’s delay and its potentially weaker regulation undermine the global effort to restore the normal functioning of commodity derivatives markets. The discussion of the MiFID regulation and directive in the European Parliament and European Council in the beginning of 2012 is an excellent opportunity for the EU to play its part in reforming this essential part of the global financial system.
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Feb 21, 2012
Open Access