I loudly applaud the CFTC’s efforts to tighten commodity trading regulations, but I think that Washington still doesn’t fully understand the root cause of today’s speculative commodity and financial markets.
It’s not about position limits. It’s about credit flowing to financial speculation instead of toward productive use.
It is difficult for any oversight agency to try to maintain fair markets so long as there are easily accessible opaque trading avenues. As opposed to the text book “speculator” who openly declares him or herself as such, today’s hedge funds are masters of circumventing required transparency.
Commodity speculators have and will easily get around CFTC reporting requirements because the CFTC only oversees the public commodity markets. Washington doesn’t seem to realise that the non-public markets might actually be a bigger haven for speculators.
Here is a rather dramatic example.
The Bank for International Settlements (BIS) provides data on commodity-related swaps and derivatives positions on global bank balance sheets. Over the past several years, the value of these swaps ballooned to historic levels as the bull market in commodities matured.
One might suggest that the growth in these over-the-counter (OTC) commodity contracts was simply a reflection of extraordinary global growth and “de-coupling” (no one, of course, would mention the extraordinary growth of the hedge fund industry!). Unfortunately, the data do not support that the growth in OTC commodity-related derivatives was caused by anything related to fundamentals.
Historically, the notional values of these commodity-related bank balances were equal to about 40-50% of the total sales of all publicly traded materials and energy companies in the world. However, during 2007/2008’s exponential increase in commodity prices, commodity-related bank balances rose to over 200% of total global commodity-related sales. If one hedges more than one uses, then one is, by definition, speculating. Keep in mind that these data only account for OTC commodity derivatives on bank balance sheets, and do not include any exchange traded instruments.
These data raise a couple of questions germane to the recent CFTC announcement:
First, why aren’t the Fed and the Treasury Department involved in the discussions about commodity-related transactions? These BIS data reflect positions on global bank balance sheets. Anyone want to bet whether some folks in Washington might be somewhat upset if they found out the bank holding companies that just received TARP funds were entering into swap agreements that caused the price of oil to increase?
Second, won’t the CFTC’s proposals simply push more trading to the opaque swaps market? If a hedge fund enters into a swap agreement with a bank, and the bank hedges that exposure on an exchange, the bank correctly lists itself as a “commercial” (i.e., non-speculator/non-hedge fund) user of the commodity markets. If a hedge fund traded directly on the exchange, then it would have to list as a “non-commercial” (i.e., speculator). Thus, setting tighter position limits on exchanges might have a negligible effect on curtailing commodity speculation because speculators could still potentially circumvent the more stringent requirements by using the OTC markets.
Washington seems to be going about this the wrong way. Excess credit fuels speculation. We had the biggest credit bubble of our lifetimes, and eventually saw a huge commodity bubble.
There should be no witch hunt for evil speculators. Speculation is a necessary part of any financial market. One has to admit though that the extreme speculation associated with this decade’s “bubble” environment was not healthy for the overall economy. Bubbles and excess speculation cause tremendous misallocation of economic resources.
Washington should make sure that if credit is going to flow again, then it flows towards productive use in the real economy, and not into commodity and financial market speculation. The CFTC should be applauded for its efforts however fruitless they may ultimately be, but Washington as a whole still needs to better understand the insidious link between credit and speculation.
Richard Bernstein is CEO of Richard Bernstein Capital Management. He was previously the Chief Investment Strategist and Head of the Investment Strategy Group at Merrill Lynch. He has written two books on investing: Navigate The Noise: Investing In The New Age Of Media And Hype and Style Investing: Unique Insight Into Equity Management.
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