New UNCTAD study charts impact of financial investors on commodity prices

Report says financialization amplifies herding behaviour and creates price bubbles; authors call for greater transparency, tighter regulation, and targeted intervention by market authorities

Geneva, 5 June 2011 - The "financialization" of commodity markets has changed trading behaviour and significantly affects the prices of such basic goods as staple foods, a new UNCTAD study says. The study focuses on how financial investors in commodity markets rely on information related to just a few commonly observable events or on mathematical models, rather than on the physical realities of supply and demand.

The study, titled "Price Formation In Financialized Commodity Markets: The Role Of Information" was prepared by UNCTAD with support from the Chamber of Workers Vienna (Arbeiterkammer Wien).

Its empirical findings, backed up by interviews with market participants, indicate that financialization - reflected in rising volumes of financial investments in commodity derivatives markets - has encouraged herding behaviour through which price determination in commodity markets increasingly follows the logic of financial investment rather than market fundamentals. That can cause damage in the "real" economy, where prices for goods such as food affect health and well-being, especially in less-wealthy countries.

The study further shows how the behaviour of commodity prices, especially oil, over the business cycle has changed fundamentally. In earlier business cycles, commodity prices and equity prices evolved differently, reflecting more clearly the distinct fundamentals underlying different markets. In the most recent business cycle, on the other hand, oil prices surged immediately after the trough of the cycle, even before share prices started to rise. UNCTAD recommends various measures to dampen the adverse effects of financialization, including greater transparency in commodity trading; internationally coordinated regulation of commodity exchanges; and direct intervention by market authorities to deflate price bubbles.

Fundamentals and other factors affecting rising commodity prices

The mid-2000s marked the start of a trend of steeply rising commodity prices, accompanied by increasing volatility in prices. Since mid-2009, and especially since the summer of 2010, global commodity prices have been rising again. These developments coincide with major shifts in commodity market fundamentals, particularly in emerging economies. Fast growth, increasing urbanization, a growing middle class with changing dietary habits, the use of food crops to produce biofuels, and a decline in the growth rates of agricultural production and productivity, have all contributed to upward pressure on food commodity prices.

But UNCTAD argues that the financialization of commodity markets has introduced new forces that affect prices. Traders increasingly follow other participants´ trading decisions. A wide range of motivations leads to this "intentional herding". Uncertainty arising from gaps in market transparency and the effects of equity market developments on commodity prices is central to this behaviour. It may therefore be rational for market participants to imitate the position-taking of others, or simply to follow the trends by basing decisions on an interpretation of historic price series.

Financial markets´ anticipation of global economic recovery seems to have played a disproportionate role in the current bout of commodity price inflation, the study says. The strong impact of financial investors on prices, which UNCTAD calls "the new normal of commodity price determination", can provoke a tightening of monetary policy in spite of the still very low utilization of global industrial capacities. This could recently be observed in China, India and the euro area, the study contends. The fact that monetary policy reacts to price pressure stemming from rising commodity prices, rather than to bottlenecks in industrial production, points to an aspect of the impact of financialization on the real economy that has so far been underestimated, namely sending the wrong signals for effective macroeconomic management.

The mounting evidence

Financial investors´ impacts on commodity prices are revealed through various channels. A number of studies indicate that price bubbles formed in 2007-2008 for such commodities as crude oil and maize. But while index investors were significant price drivers prior to the financial crisis, the importance of money managers (such as hedge funds) has increased since then. Money managers follow an active trading strategy that may build and unwind positions very rapidly, and are the most typical market participants to engage in herd behaviour. There has been a close correlation between price changes and position changes of money managers since 2009, as high as 0.80 in the oil market, UNCTAD says. Prior to the recent price correction, excessive speculation is estimated to have accounted for 20 per cent of the crude oil price.

Cross-market correlations among different commodity markets have also increased recently, indicating that factors other than fundamentals have been driving commodity prices. To illustrate that, an analysis of the reactions of commodity prices to announcements of economic indicators shows that, within minutes of the release of United States unemployment data in 2010, prices reacted similarly across different commodity markets that have little in common. This is not what would be expected to happen in a market where decisions are based purely on fundamentals. While it is true that the oil price should have a strong link with economic activity, and that such activity is reflected in labour market data, unemployment is a lagging indicator that reacts rather late in the cycle. For cocoa, for example, there can hardly be any link between United States employment and world chocolate consumption.

In a more recent example (from the period after the new study was completed), on 5 May 2011, Brent crude oil prices dropped by 8 per cent in a single trading day. While some weak economic data had been issued, no major change in fundamentals had occurred. Rather, some prominent cheerleaders had turned bearish, encouraging other traders to follow suit and triggering computer-based trading that turned a minor initial readjustment of positions into a rout.

The UNCTAD research team complemented its analysis with a survey of various commodity market participants. Traders and investors interviewed by UNCTAD largely agree that substantial price distortions and herding effects occur in the short term due to the participation of financial investors. The survey findings also highlight the growing importance in the market of these investors who, due to their financial strength, can move prices in the short term. This accentuates volatility, which may harm markets and drive hedgers with an interest in physical commodities away from commodity derivatives markets. The increased volatility results in more margin calls and higher financing requirements, the report says.

Transparency, transparency and more transparency

In light of the vital role information flows play in commodity price developments, UNCTAD suggests a number of policy responses to improve market functioning. Among them:

• Increased transparency in physical commodity markets to reduce uncertainty, through enhanced data quality and timeliness, particularly with respect to inventories. This would allow participants to more accurately assess current and future fundamental supply and demand relationships;
• Better flow of and access to information in commodity exchanges, especially regarding position-taking by different categories of market participants in derivatives markets. In particular, measures designed to ensure reporting requirements for trading on European exchanges similar to those enforced in United States exchanges would considerably improve transparency of trading and discourage regulatory migration;
• Tighter regulation of financial players, such as establishing position limits aimed at containing financial investors´ impacts on commodity markets, while proprietary trading by financial institutions that are involved in hedging transactions of their clients could be prohibited because of conflicts of interest. This calls for finding the right balance between being overly restrictive in the imposition of limits on speculative position holdings and being overly lax, including in surveillance; and
• Possible direct commodity price stabilization measures such as occasional targeted interventions by the competent market authorities to deflate price bubbles and help market participants better recognize market fundamentals. As in the case of currency and, more recently, the bond markets, it is possible for a central bank or other appropriate authority to engage in the financial markets as a market maker or as the one institution that is able to shock the market when it overshoots.