The financial reform legislation focused on systemic risk and protection of consumers of financial products. Congress steered clear of trading behavior which is abusive or otherwise simply harmful to the public. Perhaps this unfinished business will be addressed in round two of reform, assuming Congress has the stamina. Until then, it is up to the regulatory agencies as they implement the new law.
Fueled by information technology and deregulation, trading volumes have exploded in the last decade. The categories of commodities and financial instruments actively traded have multiplied geometrically, as more products are "derivitized" by banks and hedge funds. There are derivatives on prices for most components of a typical household's budget, everything from corn and wheat to gasoline and electricity.
What are the implications for American consumers as they shop for groceries, fill up at the pump and heat and air condition their homes? Those consumers, pounded senseless by predatory credit cards, unemployment and underwater mortgages, remember the price spikes and volatile markets of 2007/08.
And how were the poor populations of the developing world affected? From 2005 to 2008, the real cost of food increased to the highest levels since 1845, according to the Economist. Wheat more than doubled in price. Real people went hungry. An additional quarter of a billion people were relegated to the "food insecure" category by international agencies in 2008. The UN believes that American derivatives markets contributed to this crisis.
We owe these people an honest answer.
With the blind faith of religious zealots, the leading thinkers in and out of government came to believe that unfettered trading markets are bound to maintain efficient and fair price equilibrium. Alan Greenspan, the high priest, was generous enough to share this doctrine in his memoirs and other writings.
Events suggest that this faith was misguided. Efficient markets are large, transparent and liquid. Inefficiencies are quickly squeezed out as traders react to take advantage. However, sophisticated traders have successfully segmented all markets by creating specialized derivative instruments and strategies. They prosper in less efficient environments of their own creation. The trading markets are by no means perfectly efficient.
Faith is resistant even to factual evidence. Self-proclaimed reformers still focus on the good health of the trading firms and curbing their propensity to self inflict wounds. They ignore the possibility that some types of trading are inherently detrimental to the public's welfare.
This is not a video game in which traders get to accumulate bonus pool points in an imaginary environment. Real people experience misery on a wide scale when unintended consequences occur. If futures trading affected prices of food and fuel, the faith of the free market believers is called into question. This possibility must not be dismissed just because it is uncomfortable.
The OECD commissioned research by Professors Scott Irwin (University of Illinois at Urbana-Champaign) and Dwight Sanders (Southern Illinois University Carbondale). It examined "the role of index and swap funds in agricultural and energy markets." Commodities index funds were invented by Goldman Sachs in 1991, but rose to prominence as customer investment increased from $3 billion in 2003 to $260 billion in 2008. Commodities prices rose dramatically during the same period, increasing 71% on average from 2006 to 2008.
Managed by investment banks, index funds pool investor money to buy futures contacts on exchanges. Funds invest exclusively in long positions, so contract values increase as expected commodities prices increase. The futures contracts are allocated among various agricultural and energy commodities in order to reflect overall commodities price movements.
Futures contracts are priced based on market expectation of "spot" prices in "cash markets." The cash market is the purchase and sale on delivery of the actual commodity for a price, referred to as the spot price. Over time, futures contact values fluctuate with changing market expectations regarding future spot prices. As a futures contract expires on the delivery date, the contract's value converges with the actual spot price. (For reasons still not understood, convergence broke down at the height of commodities prices in 2008, just before the financial meltdown. This was and is considered to be exceedingly odd.)
A holder of an expiring future may be required by the exchange to actually make or take delivery of the underlying commodity. The purpose of the index funds was to track futures prices perpetually. Expiration and potential delivery were to be avoided. So, on pre-designated dates prior to the notional delivery month, futures contracts were sold off and replaced by purchases of futures with a later delivery date. This is referred to as the "roll."
The Irwin/Sanders study (labeled "preliminary") generally supports the notion that the index funds did not cause a commodities price bubble. Many believe that the study takes futures trading off the hook for the damage done by the commodities price run-up. It is a great comfort to the true believers in perfect markets. There are academic studies with contrary results. Some have criticized the Irwin/Sanders study's methodology and data sets. I am in no position to dispute the methodology.
But I emphatically question the scope of the study and its failure to answer many questions. To me, it offers no answers to American consumers and hungry children in developing countries.
Here are some of the bases for the study's conclusions and my thoughts on them.
The study found no evidence that investment inflows into the funds caused price increases and volatility. Use of inflows as the purported cause of high spot prices and volatility is a problem. Obviously, when money flowed into funds, futures had to be purchased. But the far more significant issue is the periodic roll into longer-dated futures. Theoretically, at a roll date, the entire fund could be liquidated and reinvested in replacement futures based on subsequent cash market months. Like the Phoenix, the fund dies through liquidation and is recreated through purchases of a new class of futures.
Inflows were significant, but were spaced out over time. Roll dates involved large sales and purchases in the market. Net long positions may not change on a roll date, but there is a lot of market activity in both currently expiring futures and longer-dated ones. The rolls should have been analyzed for causal relationships with spot price and volatility.
The study found that the trading patterns of the funds (i.e., the rolls) were predictable as to time and commodity class. If fund trading had strayed from fundamental values (prices determined primarily by supply and demand dynamics), other market participants would have traded against the funds to force prices toward these values. This phenomenon is a form of arbitrage. The study acknowledges that uninformed and unpredictable trading (referred to as "noise trading") may deter arbitrageurs. The uncertainty and chaos of noise trading increases the risk of trading based on fundamentals. Rational arbitrageurs can experience losses when noise traders randomly and irrationally move the market. The study acknowledges that, if arbitrageurs do not discipline the markets, futures prices can be de-linked from fundamental values and cash markets can be affected.
The roll procedure does appear to be the opposite of noise trading. But the study does not address the possibility that market participants may have employed trading tactics designed to take advantage of the pre-programmed need to roll large quantities of futures contracts across time periods on specified dates. It is widely believed that this happened. (I would be flabbergasted if it did not). Index fund investors complained publicly about losses experienced on rolls during 2008. Tactical counter-trading could well have been the cause.
Traders using tactics were behaving rationally. But they based their behavior on futures contract supply and demand. They were unconcerned with fundamental value. Tactical counter-trading, de-linked from fundamental values, could deter arbitrageurs and influence cash markets, just like noise trading.
The study states: "Lack of convergence between spot and futures prices in certain markets, however, does raise issues a number of issues about the functioning of these markets and the possible role of index funds. Future research is needed to understand better..." The immediate implication of non-convergence was that futures contracts were not useful to real businesses trying to hedge their market price exposures. More importantly, convergence is a fundamental property of futures contracts. It is definitional. The occurrence of this phenomenon during the period prior to the financial meltdown is important evidence that something unusual was happening. Any study of the effect of futures on cash market prices is incomplete without an explanation.
Notably lacking from the study is consideration of the possibility that high futures prices and volatility may have affected fundamental values. Commodities producers and wholesale buyers must hedge their price risk using futures. In high price and/or volatile markets, they have to post higher margin in order to hedge. During 2007/08, price levels and volatility in commodities markets were unprecedentedly high. Hedgers' operating costs and risks increased as a result. In fact, agricultural and energy hedgers panicked during this period because they could not arrange sufficient financing to post collateral. Costs and risks change fundamental values. That change feeds back into the expectations driving futures markets and the cycle repeats. Prices can spiral upward.
The study cites factors related to supply and demand that influenced prices during the period. (It is curious that the study did not discuss the onset of the US recession in 2007, which presumably dampened demand.) It also observes that prices of many commodities other than those traded by index funds increased.
Perhaps futures market trading had nothing to do with the real market prices for products, even though large increases in fund activity coincided with abnormally high prices and volatility. However, the issue is so important that skepticism of conventional beliefs, not faith in the perfection of free markets, is appropriate for any study of the issue. The American public and a hungry world deserve at least that much.
Wallace C. Turbeville is the former CEO of VMAC LLC and a former Vice President of Goldman, Sachs & Co.