Posted on June 7, 2008 on the IUF’s Private Equity Buyout Watch
Deregulation and the systematic exploitation of US regulatory loopholes have facilitated a recent surge in speculative investment in commodity markets, much of it by institutional investors including pension funds. The influx is one of the driving forces behind the hyperinflation of basic food staples.
Financializing Food: Deregulation, Commodity Markets and the Rising Cost of Food
A May 31 article by Sinclair Stewart And Paul Waldie in the Toronto Globe and Mail (Feeding frenzy) describes how deregulation and the systematic exploitation of US regulatory loopholes have facilitated a recent surge in speculative investment in commodity markets, much of it by institutional investors including pension funds. The influx is one of the driving forces behind the hyperinflation of basic food staples.
“These funds”, write the authors, “Have plowed tens of billions of dollars into agricultural commodities as a way to diversify their assets and improve returns for their investors. The amount of fund money invested in commodity indexes has climbed from just $13-billion (U.S.) in 2003 to a staggering $260-billion in March 2008, according to calculations based on regulatory filings. Michael Masters, a veteran U.S. hedge fund manager, warned a Senate hearing this month that this number could easily quadruple to $1-trillion, if pension funds allocate a greater portion of their portfolio to commodities, as some consultants suggest they are poised to do. Because agricultural markets are small – relative to stock markets – the amount of cash pouring in gives these funds substantial clout. Mr. Masters estimated that that these big institutional investors control enough wheat futures to supply the needs of American consumers for the next two years, and blamed the “demand shock” from these recent entrants to the commodities markets as arguably the primary factor behind the sudden take-off in food prices.
“If immediate action is not taken, food and energy prices will rise higher still,” he told the hearing. “This could have catastrophic economic effects on millions of already stressed U.S. consumers. It literally could mean starvation for millions of the world’s poor.”
The authors trace the progressive loosening of regulatory requirements which has made possible the enormous influx of money, much of it fleeing the meltdown in the market for mortgage-backed securities and the wider fallout, including big leveraged buyouts.
“Beginning with the energy market, regulators made a series of far-reaching decisions that gradually loosened oversight of complex commodity derivatives and created loopholes for large speculators, allowing them to trade virtually unlimited amounts of corn, wheat and other food futures.”
The key breakthroughs for investors came in the energy futures market, establishing general precedents for all commodity trades (including food). In 1989, the US Commodity Futures Trading Commission (CFTC) issued a policy paper declaring that it would not regulate “swap deals” – commodity purchases involved financial intermediaries (typically banks) and the dealers. This was followed by a 1990 declaration by the CFTC that it would consider oil trading on the Brent Market as “forward contracts” (a contract in which the buyer ultimately takes delivery of the commodity) rather than “futures contracts” (in which the buyer rarely takes delivery, but uses the contract for purely speculative purposes). Futures contracts had traditionally been regulated, in order to curb speculation and volatility in key markets; forward contracts are not regulated. The ruling meant that oil futures trading was to be treated as outside the scope of CFTC regulation.
“The CFTC’s embrace of a narrow definition of a futures contract built on the regulator’s earlier promise that it would not police swap transactions. Together, these moves opened up a new frontier of commodity trading, enabling financial speculators to buy and sell complex derivatives away from the prying eyes of regulators and exchanges.”
Expanding beyond the energy market into other commodities, institutional investors began diversifying into food. As the authors describe the chronology of deregulation, “It wasn’t long before this infusion of money hit another regulatory snag. For almost 75 years, the CFTC has imposed limits on how much of certain agricultural commodities, including wheat, cotton, soybean, soybean meal, corn, and oats, can be traded by non-commercial players – that is, investors who are not part of the food industry. So-called “commercial hedgers,” like farmers or food processors, can trade unlimited amounts in order to manage their risk.”
“The limits were designed to prevent manipulation and distortion in what are relatively small markets, and at the same time to allow for a small amount of speculative activity, in order to provide liquidity for trading.
“For decades, the restrictions didn’t pose much of a problem. And then, in 1991, as new money began pouring in, the playing field suddenly shifted.
“Emboldened by the CFTC’s laissez-faire approach, a bank approached the regulator and, for the first time, requested an exemption from speculative trading limits in an agricultural commodity.
“The unnamed bank was acting as a “swap dealer” for a pension fund: Essentially, it was a middleman who helped the pension fund get exposure to commodities. A spokesman for the regulator declined to identify the bank or the pension plan, citing confidentiality requirements.”
The CFTC granted an exemption, ruling through a particularly tortuous logic that the swap dealer was for practical purposes no different than a food industry “commercial hedger”, and therefore exempt from regulation – and regulatory limits on the size of the investment. The decision, however, was a one-time affair rather than a change in the rules. Investors need assurance that the exemption would become precedent, so in 1992 Congress passed legislation empowering the CFTC to determine what kinds of derivatives could be treated as forward contracts. Regulation was further loosed through new legislation in 2000 which established new exemptions, including virtual trading in energy futures contracts – the “Enron loophole”.
Freed of regulatory limits and requirements, pension funds increasingly turned to food commodity markets, The Ontario Teachers’ Pension fund, which began with a modest investment in 1997, now has some USD 3 billion invested. With rising investor activity and increasing demand, prices became to rise: “Between 2000 and 2007, the price of wheat increased 147 per cent on the Chicago Board of Trade. Over the same period, corn increased 79 per cent and soybeans 72 per cent. In the past year, in particular, the price moves have been dramatic. The CFTC’s moves to deregulate the sector, meanwhile, only inspired calls for more deregulation. As more funds piled in, stoking demand for agricultural futures contracts, speculators began clamouring for more flexibility with trading limits.”
Always eager to abandon its mandate of regulating in the public interest, the CFTC in 2005 expanded trading limits on the amount of wheat, corn, oats and soybeans that traders could buy or sell at any one time on the futures markets.
In 2006, Deutsche Bank and an (undisclosed) fund asked to be exempted from all trading limits. The regulatory authorities assured them that there would be no penalties for exceeding the limits.
More recently, the CFTC has proposed full regulatory exemption for index and pension funds, which would allow them to invest directly In the face of rising criticism, the same arguments produced in defense of the buyout binge are being adduced: the funds are “bringing liquidity” to the market, and generalizing risk.
From another point of view, it has been estimated that every percent point increase in the price of food pushes an additional 16 million people into hunger.
In its briefing paper for the World Food Summit held June 3-5 in Rome, the FAO devoted two perfunctory paragraphs to the influence of financial markets in pushing upwards the cost of staple food commodities in its “assessment of recent developments”, and had nothing to say on the matter in its concluding “policy options”. Regulating financial markets, it seems, is not a policy option in the face of mass starvation.