For those following the debate on commodity market speculation and its relationship to food price volatility, these are interesting times. Recent months have seen important developments in both the US and the European Union as regulators seek to reform financial markets in a bid to reduce excessive speculation in agricultural commodities. The regulatory outcomes in these jurisdictions will influence whether we end up in a race to the top or a race to the bottom with respect to the rules that govern financial investment in agricultural commodity derivatives.
The US came out of the 2008 food and financial crises with significant momentum to reform its financial market regulations. Although the reform process was long and hard-fought, the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act did in the end call for strong measures to limit speculation in agricultural commodities. It specifically called upon the Commodity Futures Trading Commission (CFTC) to put in place more stringent position limits and more rigorous and transparent reporting of over-the-counter trades, among other things.
The rationale behind limiting the number of commodity futures contracts and related financial swaps that an investor can hold is to reduce the opportunity for manipulation of the market. The purpose of more stringent reporting requirements is to allow regulators to more easily spot and address disruptions to the market. Some two years after the Dodd-Frank bill was passed, these rules are still in the process of being implemented.
Following the adoption of the Dodd-Frank Act, the G20 commissioned the International Organization of Securities Commissions (IOSCO) to provide it with guidance on what globally harmonized financial regulations might look like in this sector. IOSCO produced a report in September 2011 that outlined principles for commodity derivatives regulation and supervision. Its recommendations included the granting of authority to financial regulators to impose position limits on commodity derivatives as a means to prevent market manipulation. The G20 endorsed these principles at its summit in Cannes in November 2011.
Within a month of the G20 endorsement of the principle of position limits, the CFTC was faced with a legal challenge from the International Swaps and Derivatives Association and the Securities Industry and Financial Markets Association over its position limits rules. These groups – which represent a number of financial institutions including JP Morgan, Goldman Sachs and Morgan Stanley, among others – made the case that the rules should not be implemented because the CFTC moved ahead to impose position limits without first determining whether those limits were either ‘necessary’ or ‘appropriate’.
In late September 2012, just weeks before the position limits rule was due to be implemented, the court ruled that the CFTC failed to prove that such rules were ‘necessary’, and as such the rules did not come into place. The CFTC appealed the decision in November, just as it came under attack from yet another lawsuit filed against it by the Chicago Mercantile Exchange over new rules on reporting requirement. The CME suit was later dropped after the CFTC relaxed its expectations for these requirements.
In the meantime, Europe has been debating its own financial market reforms in recent months under the EU Markets in Financial Instruments Directive (MiFID). In late October 2012, the European Parliament voted to adopt amendments that would impose position limits on commodity derivatives, among other things. Civil society groups expressed concern about potential loopholes in the new rules that would allow national authorities to set alternative limits which could weaken their effect. The text is still being finalized and likely won’t be agreed until sometime in 2013, but it seems as though at least some limit on positions, even if weak, will be part of the EU’s financial rules for commodities. These rules will likely come into effect in in 2014.
What a difference a year makes. The EU now appears to ahead of the US in implementing position limits, albeit with some loopholes, when just last year the situation was reversed. But this divergence isn’t likely to last. Uneven rules open room for regulatory arbitrage, which will put pressure on policy makers to minimize divergence. If the ruling on the CFTC appeal is handed down soon, it will likely have an impact on the way in which the EU rules are defined. If the ability of the CFTC to impose position limits is constrained by a requirement to prove their need, the EU may feel pressure to weaken its rules on position limits. If the CFTC wins its appeal, the EU may be more willing to adopt tighter regulations.
There is some irony to the timing of these developments. Some financial institutions are fighting hard to weaken the rules in agricultural commodities trading just as investors are retreating from the sector due to flagging returns. At the same time, other financial institutions, as I noted in this blog post last August, have retreated from the sector due to heavy critique from civil society groups about the impact of their activities. Barclays is the latest bank to announce that it is considering a withdrawal from agricultural commodities investment on account of its reputational risk.
Loosening the regulations on position limits at this point is unlikely to revive investment in the sector. More stringent position limits, on the other hand, will provide regulators with the tools they need to prevent future manipulation of those markets.
