Food markets used to work
At least according to last month’s UNCTAD report on the information content and price formation in agricultural commodity markets. Until recently, spot and futures markets were closely aligned. The futures market was larger and more liquid, and also offered speculators the ability to take the other side of legitimate hedging trades. Since most traders (with some exceptions) were specialists in one or a few crops, they were generally well-informed. This resulted in a widespread acceptance of futures market as the source of price discovery, a pattern confirmed by a recent study which found that futures prices have Granger caused spot price returns (and volatility) more or less consistently.
OTC commodity index swaps are a very clever way around the CFMA
The Commodity Futures Modernization Act of 2000 carved out agricultural commodities as the one area not allowed to move off-exchange in light of their unique role of price discovery in global food markets. Swap dealers appear to have gotten around this by moving only the index swaps off-exchange, presumably (though I would have to check to confirm this) by arguing that index swaps are not agricultural commodities but rather more diversified financial instruments of the kind the CFMA explicitly allowed to move to the OTC markets.
Dealers then hedge their swap commitments by going long the index constituents in the futures markets. They have been able to do this in such scale due to a change in the laws governing position limits in 1991, which allowed size limit exemptions for financial hedging that had previously been available only to physical market hedging (for more on this, see this 2008 CFTC staff report). These exemptions were further relaxed on a case by case basis, until by 2005 they were effectively universally available to the major investment banks.
The influx of institutional assets into the swaps market (all of which occurred behind an information barrier of opacity) led to distortions in the futures market that in turn distorted their price signals. The source of much of the confusion about the first leg of the food crisis in 2007/2008 appears to me to have been related to the range of interpretations of these signals – those who believed they continued to provide Spence equilibrium signals about fundamentals clung to that belief, while others (generally those directly involved in spot markets) believed otherwise.
Some of the most eloquent (and largely ignored) comments on the impact of these distortions have come from traditional market participants such as farmers and commercial intermediaries, such as the following in a 2009 Senate committee report on wheat prices:
Participants in the grain industry have complained loudly about the soaring prices and breakdowns in the market. “Anyone who tells you they’ve seen something like this is a liar,” said an official of the Farmers Trading Company of South Dakota. An official at cereal-maker Kellogg observed, “The costs for commodities including grains and energy used to manufacture and distribute our products continues to increase dramatically.” “I can’t honestly sit here and tell who is determining the price of grain,” said one Illinois farmer, “I’ve lost confidence in the Chicago Board of Trade.” “I don’t know how anyone goes about hedging in markets as volatile as this,” said the president of MGP Ingredients which provides flour, wheat protein, and other grain products to food producers. “These markets are behaving in ways we have never seen,” said a senior official from Sara Lee. A grain elevator manager warned, “Eventually, those costs are going to come out of the pockets of the American consumer.”
These comments echo those of Tom Buis in a similar Senate hearing one year earlier (the same hearing that produced the much better-known Masters testimony). Buis was at the time the president of the National Farmers Union, and his testimony included a number of cases like the following:
Remarks from CFTC officials that the activity in the market is responding to fundamentals is frustrating, at minimum because some farmers have been precluded from utilizing financial risk management tools. I have heard from numerous farmers that they can no longer forward price their commodities for delivery after harvest any more than 60 days in advance. As you can imagine, it is very frustrating for farmers who are paying record amounts in input costs to produce a crop, but cannot capitalize on the higher commodity prices to protect their financial risk. Meanwhile, we continue to read newspaper articles or watch television reports that say farmers are getting rich because of the record high commodity prices, which could not be further from the truth.
I have heard from numerous farmers and grain elevators around the country, including one Kansas grain elevator that contracted wheat from farmers for delivery after harvest last fall at $7.00 per bushel. When the speculative money poured into the futures market and prices skyrocketed to record highs this winter, that Kansas grain elevator was forced to pay $0.60 per bushel in margin calls, totaling $600,000 per day. It does not take long with margin calls such as these, for local elevators to reach their credit limit and stop offering contracts to farmers. The market intended to provide producers a risk management tool was not functioning.
It would be reductive to argue that these distortions were the sole cause of the crisis (such complex systems rarely have a single cause) but it would be equally foolish in my view to deny their role given the centrality of futures markets to the entire global commodity chain.
I think the food crisis offers a particularly apt setting for testing Luhmann’s theories on systems, risk and information, and will be writing more on this after I return from the conference next week.
And one other thing: I realize this has been obvious for some time, but after wading through documents about that sorry period again, it’s clearer than ever to me that Brooksley Born should be running the SEC.