MIFID position limits: size matters

For European regulators, beginning work on a methodology for calculating commodity derivatives position limits must feel like entering a rabbit hole, where each turn leads to more choices and more tunnels, each leading further and further into the depths of the warren.

To give that some perspective, the European Securities and Markets Authority (ESMA) is required under the revised Markets in Financial Instruments Directive (MIFID II) to draw up a calculation methodology for position limits on physically-settled and cash-settled commodity derivatives, but must consider several separate factors when developing the framework. Each of those, in turn, involve additional considerations, potentially involving further analysis to arrive at the appropriate position limits for each commodity.

Take market size as an example. This is a critical factor, and underpins much of MIFID II regime for commodities. But there is much more to this than meets the eye – not least, what is meant by the term ‘market size’, and how can it best be measured?

In a discussion paper published on May 22, ESMA suggests using deliverable supply in the underlying commodity as the basis for setting position limits on physically settled spot contracts, and possibly other derivatives contracts too. Under one option proposed by ESMA, position limits would be set as a percentage of deliverable supply.

As a first step, it recommends national competent authorities use the data on deliverable supply from the trading venue, and then potentially adjust that to reflect any capacity constraints at certain delivery locations, the accuracy of supply estimates and any expected variations (for instance, due to seasonality). ESMA also recognises that some markets are global, and will require consideration of worldwide dynamics to determine a realistic estimate of deliverable supply.

That last step, however, will prove difficult. There is no shortage of data sources available, but very few, if any, provide a complete and accurate picture of global supply. The US Geological Survey, for instance, provides an estimate of mine production and reserves of rare earth materials, but contains no data on African or South American reserves or production, with the exception of Brazil. (What it does show, though, is that China accounts for more than 90% of reported worldwide production and 39% of reserves, and restricts exports to approximately one third of production.) A more comprehensive global or even regional report on the deliverable supply of rare earths is not expected any time soon.

The Group of 20 leaders are aware of the lack of transparency in physical commodity markets and support a project by the Joint Organisation Data Initiative (JODI) to improve the availability and reliability of data. So far, however, JODI is limited to oil and natural gas, and no similar initiative exits for agricultural commodities, which are arguably most at risk from geopolitical and climatic shocks. This would require those countries in dominant positions – Ivory Coast for cocoa, Brazil for coffee and sugar, Thailand for rice – to share data.

Obtaining an accurate estimate of deliverable supply is clearly important prerequisite for the proposed position-limit regime. Getting it wrong, based on an incorrect assessment of market size, could – as ESMA acknowledges – harm the price discovery process, create barriers to market development, and ultimately result in higher volatility and price spikes.

As such, the industry stands ready to help regulators measure the deliverable supply of those commodities underlying derivatives contracts subject to the position limits. This effort will also require the help of sectorial regulators (for instance, energy regulators for natural gas and power) and market operators.

There is still plenty of debate on whether position limits will actually do what regulators think they will do and curb “excessive market volatility”. But it’s in no-one’s interests for position limits to be calculated on a flawed basis.

Bad weather and expensive bacon

Too bad we can’t apply limits to weather shocks!

Shoppers will have noticed some worrying changes to the cost of their groceries in recent months, with the prices of some supermarket favourites – coffee, orange juice, bacon – rising rapidly this year. But this might be just the start of a sustained increase in prices, at least for those commodities produced in countries that are subject to climate and/or geopolitical shocks.

The signs don’t look good, with the combination of an expected weather patterns, the developing Ukraine crisis and animal disease combining to reduce supply and push up prices.

It’s a far cry from just one year ago, when good weather conditions led to record production of corn in the US and wheat in Asia. The bumper harvests in 2013 caused prices in those crops to fall dramatically.

So what is happening now?

For one thing, weather forecasters are predicting an El Nino weather pattern later this year, which causes higher temperatures across the globe, increased rainfall in some countries and drought in others.

The effects can be dramatic. The last significant El Nino in 1997-98 cost approximately $3 billion dollars in agricultural damage in the US, according to an analysis conducted by Texas A&M University. As the Financial Times notes, a new El Nino would likely lead to price increases in coffee, sugar, cocoa and orange juice due to expected droughts in Brazil and West Africa. However, cereals could be affected too, pushing up the cost of animal feed and therefore the price of meat.

That’s on top of the current crisis in Ukraine, which could force the price of wheat up, as well as disrupt natural gas supplies.

Meanwhile, a mysterious virus is killing pigs in the US, which will have a significant impact on pork prices.

A similar mix of events has occurred in the past, most notably in the mid-eighteenth century, when a mini ice age in Europe combined with epidemics and the disastrous seven years’ war (the very first in history that took the form of a global conflict covering Europe, partially Asia and Canada) led European countries to famine and a deep economic and social crisis.

Fortunately, this isn’t the eighteenth century, and commodity producers, suppliers and end-users can use commodity derivatives and other capital markets instruments to mitigate climatic and geopolitical shocks. A liquid and efficient commodity derivatives market may prove critical in helping participants to hedge their exposures to high commodity prices in 2014.

No doubt, some commentators will look at the price rises, and point the finger at financial investors using derivatives as a means of gaining exposure to commodities and generating returns. It may even give greater impetus to the push for position limits.

It’s true there may be investor activity in agricultural derivatives, but it’s not obvious position limits will prevent the rise in prices, given they are being driven by fundamental factors. In fact, limiting the size and liquidity of any market is unlikely to reduce volatility.

Applying limits to climatic shocks or geopolitical shocks is unfortunately not possible…too bad.

Regulations a driver of change, not a response

Big, sweeping changes to any established market run the risk of unintended consequences, particularly when those changes result from multiple pieces of legislation and regulation, often written independently of each other and introduced more or less at the same time. The UK’s Financial Conduct Authority (FCA) now thinks it might have spotted some in the commodity markets, warning in a report published at the end of last month about the impact a retreat by investment banks may have on market liquidity and transparency.

None of this will come as any surprise to commodity derivatives users. Several banks have scaled back or pulled out entirely from physical commodity markets over the past year or so – a move that some have attributed to new regulations – and industry participants have been warning about the affect this may have on market dynamics for some time.

The regulatory changes are coming from several directions: the Dodd-Frank Act and Volcker rule in the US; the European Market Infrastructure Regulation, revised Markets in Financial Instruments Directive and Market Abuse Regulation in the European Union; and the Basel III capital and liquidity rules. And additional changes could be on the way, with the US Federal Reserve Board releasing an advance notice of proposed rule-making in January that could impose tougher restrictions on US financial holding companies trading physical commodities.

While stressing that it believes these measures are necessary and appropriate, the FCA notes the balance in commodity market participation is changing, with banks playing less of a role and other participants – specifically, commodity trading firms – taking up some of the slack. This comes with some potential challenges. For one thing, these firms tend to operate outside the UK, which could pose a challenge to the FCA’s market supervision.

More to the point, however, the FCA acknowledges that regulation has actually become a driver of market change, rather than being a response to it. The new market reality could mean fewer market participants, less liquidity, less customer choice, less transparency, competitive inequality and high barriers to entry. That’s not an ideal scenario for anyone – including the FCA. A comment towards the end of the paper perhaps sums it up best: the legislation has been implemented in response to decisions taken by the Group of 20 nations in 2009, but “markets have changed since then and the risks now are less about growing markets and a rising tide of speculative activity and more about a lack of liquidity and a retreat by classes of participants”.

So, what’s the way forward? It seems unlikely the regulatory to-do list will change any time soon, but it opens the door to new debate about the changes in commodities markets, and raises the very legitimate question of whether this is where we want to be.

Rain falls, crops increase; prices fall, then what?

For agriculture commodities, droughts mean no water, no crops, and price increases driven by scarcity. That was the scenario in 2012 in the US with drought-ravaged corn production. 2013 was another story.  The Wall Street Journal reported  that thanks to good weather conditions, “production in the US, the world’s biggest grower and exporter of the grain, surged to a record of 13.989 billion bushels” (the year before, due to droughts, US production was 30% below this level).

green corn field

What was the result of this “bumper crop” of corn? Chicago Board of Trade corn futures fell by 40% in 2013, making corn the worst performer of the S&P GSCI index of 24 commodities due to lower prices.

In Asia, rain was abundant in the first half of 2013 as well, and rice prices fell. Thailand 5% rice, for instance, ended the first week of January at around $420 per ton, down about $130 per ton from a year ago (during that period, the Thai baht was stable at around 32.75 baht per U.S. dollar).

Two similar stories – an excess of supply in an agricultural commodity in 2013 creates a drop in prices. But in Thailand, the impact of one fundamental rice price driver (weather) was followed by another: political policy. The Wall Street Journal revealed that in June 2013 Thailand’s National Rice Policy Committee decided to boost “the price at which the government buys rice from local producers” by 25% to “help farmers and drive up rural incomes.”

The government thought it would increase not only local but global rice prices by stockpiling grains of rice. Instead, the article highlights, “other exporters such as India and Vietnam stepped in to fill the gap in the market. India knocked Thailand off its perch as the world’s biggest seller of the grain.”

And what was financial market participants’ role in all of this? Their participation in commodity derivatives played a positive role in the first scenario ‒ they enabled corn producers to hedge against price declines that are normally associated with abundant crop production.  Unfortunately, though, in Thailand producers can’t access an effective rice derivatives  market, and that limited their ability to hedge against the price decline.

Supply shocks cause price shocks: how commodities policy can address the issue

If one wants to improve global food security in a sustainable manner, one needs an appropriate diagnosis of the food crises of 2008 and 2011. The popular diagnosis that futures market operations by index funds were responsible for catastrophic price increases is – to the best of our knowledge – wrong. Instead, the dramatic price increases experienced in recent years were caused by shocks and structural developments in the real economy and intensified by political coordination failures.”

Thus reads the main conclusion of Hungermakers? – Why futures markets activities by index funds are promoting the common good, a report recently published by four German researchers from Martin-Luther University of Halle-Wittenberg and the Leibniz Institute for Agricultural Development in Central and Eastern Europe in Halle*. Some observations included in this report are very instructive: for instance, when people claim with alarm that wheat (CBOT) prices increased by 159% between January 2006 and April 2008 because index funds were strongly engaged, they should remember that in the same time rice prices increased by 168% − and that index funds are not involved in rice markets.

The authors consider a future where world population is projected to be about 9.3 billion in 2050. In addition to demand for fruits and cereals, the consumption of meat will increase, boosting the demand for agricultural commodities, especially animal feed. The researchers list three policy recommendations:

  • Sustainably increasing the production of agricultural commodities through research funding, know-how transfers and more investment, both private and public;
  • Prevention of government policies that are detrimental to markets, such as protectionist policies (export bans) and the subsidisation of bio-energy (the report shows how the use of croplands for subsidised biofuels led to a dramatic decline in stocks of wheat, rice, soya and corn from 2002 to 2008);
  • Appropriate regulation of commodity futures markets. The European Market Infrastructure Regulation (EMIR) will increase information efficiency of the futures markets, the authors say, but the application of strict position limits under MiFID or ban of index funds from the agricultural futures markets would impair the functionality of agricultural markets. The authors conclude that “Governments should avoid such mistakes in the interest of the hungry”.

This study illustrates that policymakers need to consider whether financial investors are not only not detrimental to food security, but in fact serve as a cornerstone of coordinated efforts to meet the world’s future needs.  In the professors’ own words, “Global food security will not be improved by introducing entry barriers for futures markets.”

* Prof. Dr. Ingo Pies and Matthias Georg Will from Martin-Luther University of Halle-Wittenberg and Prof. Dr. Sören Prehn and Thomas Glauben from the Leibniz Institut für Agrarentwicklung in Mittel und Osteuropa (Agricultural Development in Central and Eastern Europe) of Halle.

Denkanstöße (Food for Thought)

October 16 was World Food Day, and it probably won’t come as a shock that a number of activist groups chose the occasion to publicly protest in Frankfurt for their causes. It was, however, a pleasant surprise to see an in-depth and balanced article on the protests and the underlying issues in a German-language article in the October 12 Frankfurter Allgemeine Zeitung (read our unofficial English translation here).

The critics insist that food shortages are due to financialization of the physical commodity markets. As the article’s author, Dennis Kremer, explains:

“To put it bluntly, the allegations are that up there in the boardrooms of the financial institutions they are making big money at the expense of the world’s poorest; and in the face of more than 840 million people who are starving – who would not find this abominable?”

Indeed. But Kremer proceeds to deftly unpack – and refute – the allegations. He starts by discussing a pair of agricultural economists (Thomas Glauben and Sören Prehn) and a financial ethicist (Ingo Pies) who have carried out and continue to undertake studies which thus far have reached a very different conclusion. The researchers:

“…make statements that all those against speculation must find difficult to stomach: The strong presence of the investors on the agricultural markets is not an evil, but a blessing.”

Let’s look at one of the activists’ main targets: Exchange Traded Funds (ETFs). There have been massive inflows of cash into ETFs over the last decade, a period that saw the price of corn almost triple.  Has the former caused the latter? Glauben and Pies say no:

“In a new, as yet unpublished, study they have been examining whether there really is a link between the new strength of the index funds and the price rises among foodstuffs. The surprising result is that there is not the slightest link. Rather it demonstrates much the opposite: according to the study, the presence of such funds has helped curb even greater price rises.” [emphasis ours]

How can this be? Glad you asked:

 “…the higher demand for futures market securities is actually good for farmers because a higher demand for the funds conversely signifies that more farmers can insure themselves with financial futures against a drastic reduction in agricultural prices, and at more favourable terms. A simple market-based logic is behind this: the greater the range of insurance options available (i.e. the capital in the index funds), the lower the premiums the insured (the farmers) have to pay.”

So the existence of the futures market, transmitting clear price signals, makes the supply and demand process more efficient, and limits volatility. Ultimately, it gives farmers the security to take risks in cultivation or land use which can result in higher crop yields in the medium term – and more food for everyone overall.

Stabilizing the price at the pump

How commodity derivatives mitigate physical price volatility

The average person may not be able to recite the hundreds of economic figures announced daily in newspapers, on TV and online. But there’s one exception to that rule: It seems almost everyone knows how much he has to pay for a litre or a gallon of gasoline. This price, like the price of a barrel of oil, seems central to many people’s lives.

Indeed, in 2008, when the G20 began addressing commodity prices, oil was on everyone’s mind. The price of a barrel of Brent had run from $98 in January to $158 in July, and then plummeted to $35 in December, all in the same year. The July peak provoked significant increases in local fuel prices, particularly in countries where taxation on fuel is low.

The consequences of this shock were comparable to the energy crisis that occurred in the wake of Islamic revolution in Iran in 1979. When the Shah of Iran fled his country early that year, the subsequent disruption of Iranian oil supply (suspension of exports) caused panic in Western countries, even though the other OPEC nations tried to mitigate the effects through increasing their own production. In reaction, the US effected a phased deregulation of oil prices starting on April 5, 1979, when the average price of crude oil was $15.85 per barrel. The price of crude oil rose to $39.50 per barrel over the next 12 months − the all-time highest real price until March 7, 2008.

Oil price shocks provoking economic and social crisis is not a new phenomenon, but countries can, and have, taken steps to alleviate the associated volatility.

In 2009, Mexico (an oil exporting country that depends on the commodity for 40 percent of government revenues) used derivatives to hedge against price decreases. At the time, the governor of the Central Bank of Mexico, Agustin Carstens, stated that derivatives, “when used responsibly,” are “very useful.” In 2013, Ghana, another exporter, used derivatives the same way as Mexico did in 2009.

Also this year, for the first time in history, as reported in the Financial Times this month, a sovereign oil importing country, Morocco, turned to the financial markets and to derivatives to hedge its consumption.

What the Moroccan government is pursuing is very simple: preventing an unexpected, uncontrolled rise in fuel costs. They are doing this by purchasing options for diesel that grant the right to buy fuel at a predetermined price for the rest of the year. If prices drop, Morocco can purchase diesel at lower prices in physical markets; if prices go up, the option enables Morocco to buy diesel at the option price which will be lower than the physical market price.

Corporates that consume oil in the ordinary course of their industrial activities have used options on a daily basis since the mid-eighties. But this is the first time that a sovereign state has entered into commodity derivatives transactions to limit price volatility for end-consumers, for the people in the street.

These people, who are so aware of the cost of gasoline, may be surprised to learn that the rising price of oil does not mean higher prices at the petrol pump. They deserve to know that in this case, commodity derivatives are being used to preserve affordable fuel for consumers.

The essential role of banks for physical commodities

A new report reiterates that commodity producers, suppliers and end-users need banks to finance projects and hedge their risks.

Meetings between the European Institutions have restarted in Europe about the Markets in Financial Instruments Directive (MiFID) which aims to regulate, among other things, the functioning of commodity derivatives markets.

At the margins of these meetings, there was intense NGO activism with regard to commodities speculation and mass emailing of policy makers and influencers in Brussels inviting them to join them in a demonstration outside the European Parliament. Before this demonstration, they had gathered a petition of more than 30,000 citizens’ signatures against food speculation.

Their logic is pretty simple: increasing positions taken by financial players in commodity derivatives markets trigger commodity prices to the detriment of the poorest population which struggle to access food. Therefore financial firms should get out of the commodities markets.

However, a growing pile of research reports shows that the development of commodity derivatives markets does not in itself trigger higher prices but on the contrary helps mitigate the shocks that are really affecting physical commodity markets (such as climate shocks, disruption of the supply chain caused by political events such as civil wars etc.).

The latest report was released by the research company IHS and is entitled The role of banks in physical commodities. It states that:

“If the banks were not participating in physical commodity markets, their ability to serve clients with risk management and financing services would suffer. It is not at all clear who could replace them.”

But still, NGOs say that banks look guilty and they demand decisive actions. And surely, since this report was commissioned by an industry group, it will not make them change their mind.

Now, the question is: do we still want an argument between a prosecutor (the NGOs) and a defender (the banks)? Or is there another way forward? And shall we accept that evidence is ignored simply because it is provided by the defender?

There surely are hard facts and economic evidence which representatives of the industry (bankers, investors, and corporates), policymakers, regulators and NGOs would agree upon: for instance, that agriculture production has to double within the next thirty years in order to feed 9 billion people by 2050. Also, that about $80 billion per year needs to be invested in production infrastructures, transportation networks and storage facilities within the same period to enable such shift in agriculture production and supply.

Commodity producers, commodity suppliers, commodity end-users always reiterate that they need banks to finance their projects and to provide them with hedging financial instruments. Every market participant agrees that transparency in physical markets should be enhanced, that regulators should have the right to intervene to address disorderly markets.

The past five years, and in particular 2008 and 2009, were chaotic in both physical commodity markets and financial markets (whatever the asset class). Have we ever heard industrial firms, producers, suppliers and end-users calling for getting the banks out of these markets? No.

Is there any independent academic research suggesting that we should get banks out of these markets? No.

For four years the industry has called for a constructive dialogue, based on evidence and facts, around the best way to enable commodities production and supply to meet the ever-growing demand.

The IHS report, rather than a “defense” commissioned by Wall Street, should be seen as a call for a reasoned consideration of the full role that banks play in commodities markets.

China’s commodity slowdown chills prices

Renowned economist Daniel Yergin recently had an opinion piece, China’s Big Commodity Chill, in The Wall Street Journal that’s worth a read for
anyone who wants to know what really drives price changes. You may know Yergin from his book The Prize: The Epic Quest for Oil, Money and Power, a number-one bestseller and Pulitzer Prize winner.

Yergin’s article discusses the effects of the end of the commodities “supercycle” that has been driven by that country’s rapid industrialization and urbanization. Yergin states that China’s economy grew two and a half times in the last decade, and at the beginning:

“The world’s commodity-supply system, accustomed to excess capacity and weaker demand for its products, was not ready. Something had to give, and that something was price. Commodity prices took off at a breathtaking pace. There was a stumble at the beginning of the recession in late 2008. Then, as Beijing’s massive stimulus kicked in, China’s economy roared back and so did the hunger for commodities.”

A sample of how that excess demand affected prices:

“Copper prices reached their peak in 2011—six times higher than in 2003. China was consuming about 40% of the world’s copper, up from less than 20% in 2003.”

When a huge new customer increases demand but it takes years to add supply – you can’t open a copper mine overnight — prices are going to rise.

More recently, China’s growth rate has moderated.  The country is beginning to move from an export-driven model (which requires lots of commodity inputs) to a model more reliant on domestic consumption for growth. And thus, there will be fewer commodity purchases by China:

“China will still be the biggest market for industrial commodities—but without the same accelerating growth in demand. Meanwhile, global production capacity has been greatly expanded to service the supercycle. Just as China did so much to fuel the supercycle, so its slowdown, more than anything else, is what has brought the supercycle to an end. The change is registered in prices.”

How, exactly?

“Copper prices are down 30% from their 2011 peak, iron ore 32%. Overall, the IHS non-oil commodity index is down 27% since 2008.”

Similar things have happened with oil:

“A decade ago, the general expectation was that oil prices would stay in the $20-$28 a barrel range. Or lower. At an OPEC meeting in February 2004, one oil minister warned that “The price can fall, and there is no bottom to it.” But then demand started to rise, and oil prices took off. China alone accounts for 60% of the growth in world oil demand between 2003 and 2012. China is overtaking the U.S. as the world’s largest oil importer. But oil prices were also driven up by the “aggregate disruption” in the last decade from a number of diverse countries, including Iraq, Venezuela, Nigeria and the U.S. (after Hurricanes Rita and Katrina).”

So there was added demand from China, and disruptions in supply from major producers that continue to the current day. The result?

“Oil prices today, in a general range of $105 to $110 per barrel, are more than four times higher than they were a decade ago.”

Yergin essentially reiterates an important fact:  Fundamentals drive prices. If demand is high, and supply is limited, prices rise. Demand from China, whether running hot or cold, has an outsize effect on commodity prices, and that will be worth keeping in mind whenever we see headlines about abrupt changes in prices in the years to come.

Banks and commodity activities

A recent article in the Financial Times takes a hard look at some of the issues related to the commodity-related activities of major banks.  The piece is noteworthy for two reasons.

First, it finds that there are some significant flaws in arguments used to support a ban on banks holding physical commodities.

Second, and of more direct interest to us, it indicates the prevalence of misperceptions that plague the broader debate over the “financialization” of commodity markets and its purported impact on commodity prices.

It’s important that this debate be grounded in facts, and not rhetoric, so that markets can function effectively for all of us.

See the FT piece here (subscription may be required).