Pick a chart in the agricultural world (say, wheat) and it's obvious that something's going on. With wheat rising so fast they're resetting the circuit breakers, the conventional wisdom lays the blame on the growth of exchange-traded funds [ETFs] and other passive commodity indexes: Investors are buying long, and staying long, and that's skewing the market.
With this as background, consider the November proposal by the Commodity Futures Trading Commission [CFTC] on increasing the levels for speculative position limits in agricultural futures. The public comment period ended in late January, and sources have told us that comments seem to have been overwhelmingly negative. The proposed rule limit would increase single month and all-month speculative position limits (the number of contracts a "trader" can hold) for most agricultural commodities.
On the surface, there's a valid reason for concern. Increasing the speculative position limits would theoretically leave the market open to increased risk of big firms coming in and cornering the market in say, wheat futures. Virtually everyone we talked to in the grain industry believes that speculative money has already played a large role in the all-time high prices that many grains, such as wheat and corn, have been experiencing in the past year. If true, then increasing the trading limits would let in more noncommercial money—possibly to the detriment of companies who use futures for their "legitimate" purpose, as a hedging tool to decrease business risk.
Grain processors use hedging as a way to spread out their risk—they purchase futures contracts in order to lock in prices for grain that they will need in the coming months. When investors play, they almost exclusively hold long-only positions, and thus bid up those contracts. Grain processors end up paying more than they (theoretically) would have if these financial players weren't in the market. After all, even though a futures contract is derivative of an underlying good, it is in and of itself a good subject to demand pressures. So in this time of rising spot prices, not only are the futures going up, but the whole curve is shifting up.
Higher prices lead to higher margin requirements. The National Grain and Feed Association—an industry group made up of a wide range of grain industry participants from people dealing with physical storage and processing of grain to commodity brokers, banks and transportation companies—recently released a number of statements highlighting the possible problems associated with the proposed rule changes.
"Such traditional hedgers have seen a dramatic increase in recent months in the amount of money needed to finance margin requirements on outstanding futures contracts."
"In this environment, the marketplace is ill-equipped to efficiently absorb more investment capital and perform its core function of serving as an efficient tool for businesses hedging physical grain purchases, particularly when virtually all of that investment capital is long-only and a large share of open interest essentially is 'not for sale' for long periods of time."
"The lack of convergence between cash and futures markets during the delivery period, in conjunction with rapidly rising commodity values, has created huge borrowing needs and financial risks and exposure for the grain-buying industry," the NGFA said in a statement submitted to the CFTC. "As banks have begun to question hedging performance in futures positions, borrowing lines have been stretched to the limit or beyond…Cash basis levels [the difference between futures and cash market prices for a specific commodity] are widening to reflect much higher financing costs—to the extent financing is even available—that now are being forced into the system."
"Both the overall confidence in the [futures] market and the livelihood and business structure of the cash grain industry are at stake."
Four different ways of saying “the sky is falling,” which, if you’re someone who has to buy grain for a living, it must indeed seem to be.
What happens to a market when the people who physically store the commodity and need it for their business are unable to compete with the big bucks from Wall Street? These are not huge oil conglomerates that have become accustomed to an environment of rapid price changes driven by politics. The grain markets, while volatile, have historically been much more a traditional hedging market, and less a financial battleground. If you're on the buy side of wheat, it must seem like a whole new world out there.
On The Other Hand
But wait a minute. Pretty much everyone can see (even me, and I'm far from the smartest money in the game) that the grain market fundamentals are tight. Between the effects of biofuels on crop planting and usage, increased demand for feed grains to satisfy increased demand for beef and poultry, and adverse weather shocks elsewhere on global crops such as wheat, it is no wonder that we are seeing prices at all-time highs.
If this were really the result of all these ETFs buying into rising prices, we'd expect to see it in the exchange numbers, right? But check out the Commitment of Traders reports [COT] for the last year. This is the data that's supposed to tell us exactly this.
If it is indeed the influx of Wall Street money that is responsible for the rise in prices, you would expect to see an increase in holdings and/or the numbers of index traders participating in the market. It isn't there—at least not in these stats. The percentage of open interest these "index traders" have been holding has stayed roughly the same since the COT started splitting out the information in a supplemental report in January 2007.
Ok, so what's an index trader? Well, in a rare moment of clarity, CFTC calls them folks who "managed funds, pension funds, and other investors that are generally seeking exposure to a broad index of commodity prices as an asset class in an unleveraged and passively managed manner." They also toss in firms that engaged in derivative trading (swaps really) based on broad indexes, for whom a particular contract is just part of a big-picture strategy. You'd expect this to be the lair in which the bogeyman is living. Well …
… the truth is, bullpucky. The real growth—in numbers of participants—in the markets has been commercial traders. Commercial traders are the ones who are supposedly doing legitimate hedging. The number of "index traders" has remained the same in the past year.
In other words, the long, passive money has stayed pretty much the same no matter how you look at it, either as a percentage of the market, or as a number-of-players.
Of course, the CFTC doesn't give us juicy details. They don't specify who exactly those noncommercial traders are, and it could well be that some traders are being captured in the wrong category—which is what many in the industry think is happening. But until the stats are fixed, we won't know for sure. The rise in participation for commercial traders is logical—with prices and the market behaving as it has been, it is in the commercial traders' best interests to be part of the market. In fact, you'd expect the commercial traders to be the savviest folks in the virtual pits: After all, they've got the closest thing to inside information. They actually have to use the stuff.
What Happens Now?
If the CFTC decides not to implement the proposed rule change, what happens? Will there be a limit to the number of direct exposure ETFs that can operate in the market? Will funds participating in these trades have to cap how much money they allow into the fund, limiting the size of the funds? Or will funds find a way around the categorization as "index traders" and invest in the market anyway? Is this a market that is working efficiently? Or are there changes to be made?
Here's the thing: Derivatives are messy. They're difficult to monitor, make decisions about and establish policy for. That's why we have so much regulation in futures already. Call me a head-in-the-sand free-marketeer, but I'm of the opinion that letting the market make these decisions will, in the long run, be the right call. Properly constructed, the delivery-arbitrage mechanism in futures should, in the long run, take care of excess financial participation. That may not make someone with a grain silo sleep better at night, but at the end of the day, it's probably the right thing to do.
Of course, none of us rule the world. Inside sources say that the comments the CFTC received were overwhelmingly negative on the proposed changes, and that a decision to raise the caps would be a long time coming. So it looks like status quo for the time being.