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Derivatives (including commodity derivatives)

Food Commodities Speculation – Report by UN Special Rapporteur on Right to Food

The UN Special Rapporteur on the Right to Food produced a briefing note in September 2010 looking at the impact of speculation on the volatility of prices of basic food commodities and possible solutions. The backdrop for this briefing was the food price crisis of 2008. The briefing describes some of the most relevant impacts of the crisis, pointing out that as a result of the crisis the number of people in poverty rose by 130-150 million and that 40 million people were driven into hunger and deprivation. The brunt of these impacts, the brief points out, was borne by the world’s poorest developing countries, the Low Income Food Deficit Countries (LIFDC’s).  In trying to determine the causes of this volatility, the briefing noted that the increased volatility had gone back to right around 2005, and started looking right around that period for possible explanations. Two of the major reasons often used to explain the price and volatility increases were: (1) supply and demand fundamentals and (2) per capita income growth in China, India, and other countries. However, after analyzing the numbers, the briefing found that these explanations were inadequate to fully explain the dramatic shifts.

The briefing identified speculation as one of the major causes responsible for the increases in volatility. Wheat prices, for example, fluctuated way too wildly within limited time frames to be explained by other factors like supply and demand. The briefing even refers to a Lehman Brothers report (published just before their bankruptcy) that showed the index fund speculation had increased by 1900 per cent between 2003 and March 2008. With respect to speculation in agriculture, the brief divides speculation into two categories. The first it calls “traditional speculation” which is useful as it allows for price discovery based on market fundamentals. The second, momentum based speculation, is the type which is dangerous according to this report. This type of speculation can create speculative bubbles and its effect on the commodities index fund in particular is to create a vicious circle of upward spiraling prices (called “contango”) where speculators can drive prices up by virtually hoarding futures contracts. Another major cause identified by the briefing is the deregulation of the OTC (Ove-the-Counter) derivatives market in 2000. This action led to a massive spike in futures and options traded globally on commodity exchanges between 2002-2008 (5x increase) as a result of the influx of non-traditional, mostly institutional and speculative, investors into the commodities market. This served to further enhance the problems created by momentum based speculation by making it easy to do.

The briefing then provides a summary of the existing policy responses to this problem as well as laying out some of its own suggestions. The US policy response was included in the Dodd-Frank legislation, which included provisions directing that limits be placed on the number of agricultural commodities that can be held by one trader as well as placing limits on the aggregate number or amount of positions may be held by one person in a month. The brief found that while these provisions were useful, more was needed and that the watered down version of the “Volcker Rule” was not enough to accomplish what its original form was intended to. As for the EU provisions, the briefing found that proposed regulations, such as imposing mandatory reporting and clearing, were not strong enough to solve the problems.

The brief suggests possible improvements for regulations and international cooperation, which it narrows down into five specific policy recommendations: (1) Comprehensive reform of all derivatives trading is necessary, starting with registration and clearing of OTC derivatives, (2) Regulating bodies should carefully study and acquire expertise in commodity markets, (3) Access to commodities futures should be restricted, (4) Spot markets should be strengthened to reduce uncertainty and regulated to prevent hording, (5) Physical grain reserves should be created. The brief concludes that while some progress has been made (particularly in the US) more action is needed to address the dangers of speculation in basic foodstuffs.

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