Not a Game, Speculation vs Food Security: Regulating financial markets to grow a better future

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Food prices are a matter of life and death to many in the developing world. Financial markets that should be helping food growers and processors to manage their risk and set prices have become a potential threat to global food security. Deregulated and secretive agricultural commodity derivatives markets have attracted huge sums of speculative money, and there is growing evidence that they deliver distorted and unpredictable food prices. Financial speculation can play an important role to help food producers and end users manage risks, but in light of the harm that excessive speculation may cause to millions, action is required now to address the problem. This briefing explains what has gone wrong with financial markets and what could be done to fix them.
  Oxfam Issue Briefing 3 October 2011 Not a game speculation vs food security REGULATING FINANCIAL MARKETS TO GROW A BETTER FUTURE   Food prices are a matter of life and death to many in the developing world. Financial markets that should be helping food growers and processors to manage their risk and set prices have become a potential threat to global food security. Deregulated and secretive agricultural commodity derivatives markets have attracted huge sums of speculative money, and there is growing evidence that they deliver distorted and unpredictable food prices. Financial speculation can play an important role to help food producers and end users manage risks, but in light of the harm that excessive speculation may cause to millions, action is required now to address the problem. This briefing explains what has gone wrong with financial markets and what the United States, the European Union and other G20 members should do to fix them. A NEW REALITY REQUIRING NEW RULES FINANCIALIZED FOOD MARKETS Food and finance: not a game Few things seem more remote from the real world of agriculture than financial traders working in the skyscrapers of Chicago, New York, London or Paris.  And yet ever more of the financial products they buy and sell are linked to the food we eat. They are derived from underlying agricultural commodities such as wheat, corn, soybean or sugar. Historically these so-called „derivatives‟ were designed as an innovative way of dealing with the risky business of growing and selling food. 2  However, the balance has shifted, and transactions on markets in agricultural derivatives are increasingly made without reference to the dynamics of markets in actual food. Banks have used new types of derivatives to attract players  –  pension funds, hedge funds, sovereign wealth funds  –  which invest without any interest in the underlying agricultural commodities. Multinational agricultural commodity traders, which have long controlled the global grain trade, have developed new business lines selling financial services to profit from this new trend. Agricultural derivatives, which used to be closely linked to the realities of buying and selling food, have now become highly „financialized‟.   At the same time, agricultural markets have become increasingly unpredictable. High and volatile food prices have caused two global food price crises in three years. Both crises had dramatic consequences in many poor countries: increased hunger, conflict and instability. The 2008 spike in food prices pushed 100 million people into poverty, and by 2009 the number of people hungry passed one billion. The World Bank estimates that 44 million more people fell below the poverty line in the last half of 2010 as prices climbed back to levels close to the 2008 peak. 3   „ The modern trader is playing the most sophisticated, dynamic, immersive game in the world. … The difference here being, of course, that it's all real. Those flickering prices the trader attends to are not just big, but bloody, too. ‟ 1 James Somers, The Atlantic Monthly  , May 2011    2 LOSERS Food price spikes hit the poorest hardest Poor people can spend up to 75 per cent of their income on food and often depend on food assistance. High and volatile prices hit these people hardest. 4  Governments and aid agencies dependent on imports from international markets find their food aid budgets support fewer hungry people. The multiple strategies that poor people adopted in response to the food price crises have had lasting effects by forcing people to change their diets, to sell productive assets, to incur debt, to withdraw children from school, to marry early and to migrate to areas where food might be available. Women have been at increased risk of domestic violence and children at risk of stunting and arrested cognitive development. 5  Financialization of agricultural derivatives means that they are no longer working, as initially intended, to help food producers, processors and end users deal with the vagaries of physical markets. Even worse, there is an emerging case for the existence of a link between increased speculation 6  and higher volatility and, in some cases, higher prices in physical markets in food. The precise impact of speculation on food prices today remains disputed and cannot currently be proven, not least because of the lack of transparency of financial markets. 7  However, this should not preclude action on the basis of legitimate and well-founded concerns. The response to food price volatility will need to be comprehensive, and must include actions ranging from tackling climate change and extreme weather events, to removing government policies diverting food into (bio)fuel, to regulating the ability of large food producing countries to slap on export bans when prices go up. And because food price volatility can be a matter of life and death, a precautionary approach must be taken to speculating on agricultural commodities. Governments must act, domestically and together through multilateral mechanisms, to prevent harm by curbing excessive speculation through greater transparency and regulation. New rules required: will the US, EU and G20 deliver? New rules are needed to deal with the new reality of financialized markets in agricultural derivatives to allow them to work for their most important stakeholders: food producers and consumers. The battle between those in favour of effective regulation and those with a vested interest in the status quo  –  including the powerful exchanges, investment banks and food trading companies 8    –  is raging in the United States 9  and the European Union. Meanwhile, France is attempting to forge a consensus on the need to regulate at G20 level. When President Obama signed the Dodd  – Frank Wall Street Reform and Consumer Protection Act into law in 2010, 10  the United States took the lead in turning back deregulation and reforming financial markets. The Dodd  – Frank  Act directs the regulatory agency in charge of commodity derivatives markets, the Commodity Futures Trade Commission (CFTC), to issue regulations that cap the size of bets that can be made in the „ futures ‟ 11  market and the number of futures contracts a market player may ho ld („position limits‟)  in order to diminish, eliminate or prevent excessive speculation „ as appropriate ‟ . 12  Disputes over the interpretation of this mandate  –  with strong opposition from banks, hedge funds and traders  –  is creating uncertainty about its full implementation. The CFTC is tasked with resolving these disputes; their ruling will determine to what extent the Act will help to effectively regulate excessive speculation. The EU has lagged behind in its efforts to regulate commodity derivatives markets. The fate of the European Markets Infrastructure Regulation (EMIR), which aims to increase transparency by moving over-the-counter (OTC) derivatives onto exchanges, remains to be decided by the European  3 Parliament and the Council. A reform of the legislation regulating exchange-traded derivatives, the Markets in Financial Instruments Directive (MiFID), has been announced by the European Commission and is likely to include position limits. However, European governments are divided over the merits of such measures and could block them. French president Sarkozy has made regulation of commodity speculation one of the top priorities of the 2011 French presidency of the G20. Agriculture ministers have called for more transparency and better regulation, 13  but it remains to be seen if a consensus will emerge at the level of finance ministers and heads of state. Failure to agree on the need for new rules would put into question the central role the G20 claims to play in international economic cooperation. WHAT FINANCIAL MARKETS SHOULD DELIVER TO FOOD MARKETS Markets in agricultural derivatives were designed to make food markets work better. When they do, people all along the food chain, from farmers to food processers to consumers, should benefit. Hedging risk: making prices predictable and income reliable  Agricultural markets are inherently risky because they depend on factors as capricious as sunshine and rainfall. They are very inflexible or inelastic: price spikes are not effectively transmitted into less demand or higher production. Even if prices increase suddenly, people often continue to eat the same foods: appropriate substitutes are not readily available. And producers need at least a season to plant and harvest more food. This can expose producers and buyers to significant price risk. One way for them to offset or „hedge‟ this risk is to enter into a market where others will guarantee their prices at a defined point in the future. These others are speculators who take a gamble that prices on the market will be higher than the price they have guaranteed  –  they may win or they may lose, but they are willing and able to take that risk in order to make a profit. Buyers and sellers are willing to pay a premium to hedge their risk, making their costs or their income more predictable. Medium- and large-scale players on the food markets, including developing country governments and humanitarian agencies, sometimes use hedging instruments because reliable prices are crucial to their ability to plan and to invest. 14  Hedging also helps to prevent the cost of risk-taking from filtering down to the price consumers pay for the food they eat. Hedging instruments, if properly designed and adapted, may work for some small- and medium-scale producers. However, the most vulnerable producers will not be able to use financial markets to hedge production risk  –  they will need other, better adapted risk-management tools. Price discovery: setting the right price Those buying and selling agricultural commodities often refer to prices on derivatives markets. For example, the grain futures prices quoted by the Chicago Mercantile Exchange, the world‟s largest exchange of agricultural commodity derivatives, tend to be incorporated directly into grain trade contracts all over the world. The reason for this is that food market players often lack information on production, stocks, demand and other fundamentals. Well-functioning financial markets help to overcome this. In theory, each speculator comes to market with a little bit of information and acts on it by buying and selling. These multiple transactions bring the price close to the intersection of supply and demand. In this way, financial markets help „price discovery‟ in agricultural markets. In other words they play a role in setting the right price for food. 15    4 Liquidity: oiling the wheels of the market Cash flow problems are a major issue for participants in agricultural markets.  Agricultural commodities are sold in bulk, rather than in small quantities. Prices can spike before the new harvest reaches the market and plummet when a bumper harvest is sold. But market participants can facilitate transactions out of season by buying or selling derivatives linked to future delivery of physical food. Speculators who monitor market dynamics and buy or sell financial instruments in between harvests bring „ liquidity ‟ to financial and physical agricultural markets. This means that they make money move around and allow assets to be bought and sold throughout the year without causing too big a movement in the price and with minimum loss of value. 16   FINANCIAL MARKETS HAVE TURNED AGAINST FOOD MARKETS During the 2008 food price crisis, hedging became too expensive or simply impossible for many farmers and intermediaries in the USA. 18  Less research has been done in other markets, but the same dynamic applies, particularly for intermediaries in third countries using US agricultural derivatives markets to hedge risk. Meanwhile poor people in countries like Bangladesh, Indonesia, Kenya, and Zambia are hit hardest by the high and volatile food prices. 19  Speculators themselves acknowledge that something is wrong with commodity derivatives markets. 20  Financial markets are no longer delivering for food markets; they have turned against them. What has gone wrong? Deregulated and secretive financial markets In the USA, pressure from the finance lobby, led by powerful organizations like the International Swaps and Derivatives Association (ISDA), led to the Commodity Futures Modernization Act of 2000. This law took away essential safeguards that had protected agricultural derivatives from misuse. New market players with no commercial interest in food markets were allowed in. The powers of regulating authorities were curtailed, and the trade in derivatives through private contracts made outside of organized exchanges (the over-the-counter  –  OTC  –  market) was allowed to boom without oversight. In the EU, derivatives markets had been growing since deregulation in the 1980s, but were much smaller in size and played a much less important role. Scant reporting and the expansion of the secretive OTC derivatives market means that commodity derivatives markets are often operating in the dark. Lack of information makes them inefficient and increases the chances of herding and panic behaviour from investors. When combined with a huge increase in the size and speed of trades, enabled by deregulation and technological and financial innovation, this has meant that, while there has undoubtedly been an explosion in speculative activity, regulators have neither the information to measure its real impact nor the tools to control it. WINNERS Large banks and funds cash in on a new ‘  asset class  ’    Banks and hedge funds profit from passive speculation 21  without having to share in the price risk, notably taking advantage of opportunities for arbitrage profits during the „roll - over‟ period  (when one contract is replaced by another). 22  This represents easy pickings for commodities traders employed by the ban ks to make their living off the „dumb money‟ –  the passive investors. 23  Barclays Capital, the investment banking division of Barclays Bank and Europe‟s most important player in the agricultural commodity derivatives market, could have earned as much as €406 m in 2010 from financial speculation on food. 24   „The market is broken … It no longer serves its purpose‟ Wallace Darneille, chief executive of the Plains Cotton Cooperative  Association, one of the biggest cotton producers in the USA, quoted in the New York Times , 5 May 2011 17   
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