Originally Published: 5/21/2008
THE COMMODITIES MARKETS
By The Issue Wonk
Given the price of crude oil and the food shortage, I thought it was time to look at the commodities markets where these things are traded. I don’t need to point out the cost of gas, but I should remind you that food prices have skyrocketed, in some cases 80%.1 While some things, like regional upheavals as in the Middle East and climate change, can effect the supply of these products, it is more likely the speculation of traders that drives prices up. Regarding escalating food prices, Gordon said:
. . . policymakers are scrambling to point fingers at a litany of culprits – everything from climate change, high oil prices, a weak dollar and the biofuels boom, to meat eaters in China. All of these factors have played a part in the current crisis, but the blame game is also allowing one culprit – the principle protagonist in this story – to get away with not even a mention. It’s a character you might have heard of recently for its role in that little unfortunate sub-prime mortgage mess. That’s right, deregulation.1
Regulation of Commodities Markets
Commodities markets are the markets where products are exchanged, or traded, including food, energy (including oil), metals, and various agricultural products. (Here’s a list of the various commodities markets and a list of items traded and where they are traded.) Products are traded either with Spot Trading, where delivery takes place immediately or almost immediately, or Futures Trading, where the parties agree to exchange a certain quantity of a commodity at a fixed future date for a price fixed at the time of the agreement.
The Commodities Exchange Act (CEA) was passed in 1936 to regulate futures trading and commodity trading, requiring that all such trading be conducted on organized exchanges.2 It replaced the Grain Futures Act of 1922 and extended regulation to other items, replacing the term “grain” with “commodity.” CEA sought to facilitate honest and fair practices and to restrain fraud, excessive speculation, and manipulation in commodity exchanges. It established the Commodity Exchange Commission and delegated day-to-day regulatory duties to the secretary of Agriculture. The secretary, in turn, established the Commodity Exchange Administration to undertake these regulatory responsibilities. Substantial amendments in 1974 transferred regulatory authority to a newly created, 5-member Commodity Futures Trading Commission (CFTC). Since federal oversight of futures began in the 1920s, regulation has expanded beyond traditional futures contracts in agricultural products to futures in many other markets, such as energy commodities, government securities, and foreign currencies.”3
Commodity Futures Modernization Act
The Commodity Futures Modernization Act (CFMA) was passed in 2000 in large part to allow for the creation of U.S. exchanges for a new sort of derivative security4 called the single-stock future.5 It also deregulated over-the-counter (OTC) derivatives trading by exempting them from coverage of the CEA and it lifted anti-fraud and anti-manipulation authority from these derivatives markets and reduced the regulation, especially the transparency, of futures and options. It also legalized single stock futures.6 This opened the door for massive amounts of trading in the futures markets.
CFMA was largely the brainchild of corporations wanting to enter the futures markets. “Enron Corp. used its vast web of political connections to win December 2000 passage of commodities trading legislation that helped the company shield its energy trading activities from government scrutiny . . .”7
As the futures markets have grown, the ability of federal regulators to police them for fraud and manipulation has been shrinking. Loopholes abound that Congress has failed to remedy. “The oldest of these is the so-called Enron loophole, an 11th hour addition to the Commodity Futures Modernization Act of 2000 that gave an exemption to private energy-trading markets, like the one operated by Enron before its scandalous collapse in 2001. Regulators later accused Enron traders of using this exempt market to victimize a vast number of utility customers by manipulating electricity prices in California.”8
In addition, there is also an exemption for commercial markets. “What lawmakers did not anticipate was that one of the exempt markets, the Intercontinental Exchange, known as the ICE and based in Atlanta, would become a hub for trading in a product that mirrors the natural gas futures contract trading on the regulated New York Mercantile Exchange. In 2006, traders at a hedge fund used the ICE’s look-alike contract as part of what regulators later asserted was a scheme to manipulate natural gas prices, again at great cost to users. The fund denied the accusation, and civil litigation is pending.”8
That case persuaded the CFTC that it needed more authority to police these exempt markets, at least when they help set commodity prices. But, again, Congress has done nothing.
The courts have also played a role. There have been 3 lawsuits where judges have determined that federal law limits CFTC’s ability to fight fraud involving both over-the-counter markets and foreign currency contracts. “The commission has filed appeals, but a far quicker remedy would be for Congress simply to revise the laws, as the commission requests.”8
Finally, CFMA set up conflicts with futures exchanges. The exchanges are largely self-regulatory. The CFTC did not want a system like the New York Stock Exchange where its self-regulatory units were spun off into an independent agency, now called the Financial Industry Regulatory Authority. The CFTC Act,
the product of some intense lobbying, radically changed the agency’s approach, putting into effect a principles-based system rather than one based on rules. Under the act, futures exchanges have to comply with 8 “designation criterion” and 18 core principles. Users refer to this as a “lighter touch” approach – one far more favorable to them.9
Walt Lukken, the acting chair of the CFTC, said that CFMA gave the futures market the flexibility it required to foster innovation. “While the CFTC monitors whether a core principle is ultimately met, the exchanges, with their hands-on experience, are given discretion to tailor their rules to their special circumstances.”9 (For a real eye-opening experience, read CFTC’s proposals for de-regulation.) What has resulted are for-profit exchanges with responsibilities to their shareholders benefiting from ignoring their regulatory infractions, particularly those that generate substantial income.8
And, the CFTC is “widely considered weaker than its securities market counterpart.”9
The futures commission has a staff of fewer than 500, a 2006 budget of less than $100 million, and like the SEC, a revolving door of leadership inherent to its political nature. But compared with the SEC, the futures regulator has smaller resources: The SEC’s 2006 estimated budget is $888 million, and roughly 3,700 people work there, about 2,000 of them investigating companies and seeking to bring cases against them.9
The growth of the commodities exchanges, and the problems that ensue, are well demonstrated by the CME Group. In October 2006 the Chicago Mercantile Exchange bought the Chicago Board of Trade, “creating one of the world’s largest financial markets”9 trading in futures and derivatives. The combined entity is called the CME Group. According to Anderson, “It is unclear . . . whether the Commodity Futures Trading Commission . . . can effectively regulate the beast created.”9
With regard to the food markets, Gordon said:
The impact of all this deregulation was to replace local market access for the majority of small producers with global market access for a few global producers. Thanks to non-existent anti-trust enforcement and rampant vertical integration, we’ve reached a level of concentration in our global agriculture system that would make Standard Oil blush. Three companies – Cargill, Archer Daniels Midland, and Bugne – control the vast majority of global grain trading, while Monsanto controls more than 1/5th of the global market in seeds. Consumers from Sioux City to Soweto are more and more dependent on fewer and fewer producers. By eliminating the breadth and diversity of the system, we’ve eliminated its ability to withstand shock or manipulation.1
Shock comes from natural disasters. Manipulation comes from investors in the market. We can’t control one. We should be controlling the other.
1 Gordon, Gretchen. The Food Crisis: Global Markets and Deregulation Strike Again. OrganicConsumers.org, April 18, 2008.
2 The Securities and Exchange Commission (SEC) regulates the trade of stocks. Some stock exchanges list bonds, but generally bonds are traded by bond houses and commercial banks. “The bond market is primarily institutional, with commercial banks as the primary investors. It is not heavily regulated, and there is no federal agency dedicated to overseeing the bond market other than the SEC.” See Reference for Business
3 Answers.com. Commodities Exchange Act.
4 Derivatives are financial instruments whose values change, such as futures, options, etc. For more information, see Wikipedia.
5 Single-stock futures are futures contracts with the asset being one particular stock, usually in batches of 100. When purchased, the share rights and dividends are not transferred. Since they are futures contracts, they are traded on margin, thus offering leverage. They were disallowed from any exchange listing in the 1980s because the Commodity Futures Trading Commission and the U.S. Securities and Exchange Commission were unable to decide which would have the regulatory authority over them. The Commodity Futures Modernization Act of 2000 allowed the 2 agencies to have joint jurisdiction. For more information, see Wikipedia.
6 Dodd, Randall. Key Regulatory Evens, and Key Regulatory Institutions, in the United States. Financial Policy Forum, March 20, 2006.
7 Public Citizen. Electricity, Commodities Deregulation Allowed Enron to Loot Billions from Lenders, Shareholders, Employees and Consumers. Public Citizen, December 21, 2001.
8 Henriques, Diana B. Commodities: Latest Boom, Plentiful Risk. The New York Times, March 20, 2008.
9 Anderson, Jenny. An 8,000-Pound Gorilla, With Little Oversight. The New York Times, October 20, 2006.
© The Issue Wonk, 2008