9 August 2009

6 minute read

Abstract

These events have raised questions about whether changes in the composition of traders participating has contributed to movements in commodity prices beyond the effects of market fundamentals.

Evidence suggests the link between futures and cash prices for some commodity markets may have weakened (poor convergence), making it more difficult for traditional traders to use futures markets to manage risk. This report discusses the role and objective of new futures traders compared with those of traditional futures traders and seeks to determine if the composition of traders in futures markets has contributed to convergence problems.

The report examines market activity by focusing on positions of both traditional and new market traders, price levels, price volatility, and volume and open interest trends. Convergence of futures and cash prices is examined, along with implications and prospects for risk management by market participants. The report also discusses the implications for market performance and the regulatory response of the Commodity Futures Trading Commission.

Introduction

Although the traditional role of commodity futures markets is for risk management and price discovery, a new role appears to have emerged: Commodity futures are increasingly used as an asset class in various forms of investment vehicles. Significant amounts of capital have entered the futures market for this purpose.1 The influx of this new capital was partially responsible for the 216-percent increase in average open interest for corn, soybeans, and wheat between January 2004 and June 17, 2008. Since then, the average open interest for the three commodities declined an average 35 percent between June 17, 2008, and April 30, 2009 (table 1 and fig. 1).²

Commodity futures markets and their accompanying derivatives markets have become appealing venues for investors due to widespread electronic trading, the financial integrity of a clearinghouse that alleviates transactions risks, and the ability to leverage investments by requiring only a margin as a performance bond. The costs of purchasing and selling futures contracts as investments in the futures markets are low compared with the costs of investing in other markets.

The large amount of investment capital flowing into agricultural futures markets has prompted increased scrutiny. Industry participants have accused the new traders and new capital of unduly affecting the level of prices and price volatility. Others allege that hundreds of billions of investors’ dollars are swamping the market, and it can no longer serve to assist commercial traders who use the physical commodities to hedge and smooth physical production and/or consumption (Cooper, 2008). These concerns initially arose in the energy markets but were later heard in the agricultural commodity markets. The counterargument to these allegations has rested on the dynamic nature of the commodity markets during recent years. For example, biofuel production, poor growing weather, export controls, emerging economy demand, and increased production costs caused demand growth to outstrip supply growth in various commodities. In addition, low real interest rates and a weak U.S. dollar further fueled higher prices. Because of these and a number of other factors affecting prices, many researchers suggest the need for further research to determine the role of speculative activity upon price levels. Abbott et al. (2008), for example, indicate the following:

While the effects of supply and demand on commodity prices are clear, the effects of changes in the structure of commodity markets, in particular increased speculative activity are not. There is no doubt that the amount of hedge fund and other new monies in the commodity markets has mushroomed. Price volatility has increased, partly due to increased trading volumes. Based on existing research, it is impossible to say whether price levels have been influenced by speculative activity.

Participants within the commodities industry question whether the goals and objectives of the new traders are compatible with the traditional functioning of the futures market. Some analysts suggest that large fund traders are similar to manipulative individual speculators of the past who artificially inflated futures prices and profited from the resulting higher levels. Yet, based on past research in futures markets, there is little evidence that the new traders reduce the quality of price predictions. Carlton (1984) states “Any deterioration in the accuracy of price predictions would attract informed investors who would have an incentive to use their knowledge to earn higher profits and thereby drive the poorly informed from the market by inflicting losses on them.” In 1925, the “Wheat Scandal” was purported to involve speculators who manipulated prices, but upon further review, Petzel (1981) found no such evidence of manipulation: “Charges of manipulation and excessive speculation usually arise during periods of unusual market activity, but they should be subject to careful analysis before action is taken.” Questions have also been raised about the impact of speculators and nontraditional traders on selected performance issues, such as the decoupling (separating) of the futures and cash markets and increased difficulty in managing risk for traditional market players within the futures market.

The changing environment raises additional questions (not all of which are addressed here) about the evolving nature of the commodity futures markets.

If the link between futures prices and cash prices weakens, will futures prices continue to be a useful price discovery or hedging mechanism? Will risk managers be able to offset their cash market price exposures as effectively as they have traditionally done? If not, what alternatives exist for market participants? Can the agricultural futures markets continue to function and serve the objectives of each of its market traders? Are changes in trading rules or contract specifications needed?

This report examines the role and objectives of new futures traders compared with those of traditional futures traders and how new traders may affect market metrics. We will assess changes in market activity by focusing on liquidity, volatility, and the relationship between positions of selected traders’ categories and price levels. Convergence of futures and cash prices will be further examined, along with the implications and prospects for risk management by market participants. We will also highlight the initial regulatory response by the Commodity Futures Trading Commission (CFTC). A glossary is provided at the end of the document for interested readers.

Figure 1: Open interest in CME Group/CBOT: Corn, soybeans, and wheat, weekly, January 4, 2000-April 30, 2009

CME = Chicago Mercantile Exchange; CBOT = Chicago Board of Trade. Source: Commodity Futures Trading Commission, Commitments of Traders Reports, Futures-and-Options Combined Reports, http://www.cftc.gov/marketreports/commitmentsoftraders/cot_historical.html.

Further Reading

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August 2009