On December 2, 2011, two of Wall Street’s top lobby groups launched an assault on a newly reinstated “position limits” regulation, which aims to curb speculation in commodity futures markets–and a key factor behind rising food prices–in the first ever case brought against the Commodity Future Trading Commission (CFTC).
The two lobby groups, the Security Industry and Financial Markets Association and the International Swaps and Derivatives Association have challenged the extremely controversial position limits rule, which the CFTC passed in a narrow 3-2 vote this October. Wall Street has recruited the lawfirm of Gibson, Dunn & Crutcher, whose lawyers Miguel Estrada (among Bush’s counsel in Bush v. Gore) and Eugene Scalia (who overturned a Securities and Exchange Commission rule earlier this year) are determined to hold the scepter of market regulation at bay.
The rule caps the total future interest of a given commodity (such as wheat, corn, soy, etc.) a market participant can hold, aimed at preventing “excessive speculation” in those markets. Position limit supporters argue that their absence in recent years has led to price volatility and price spikes, such as the 2008 food crisis that plunged millions of the world’s most vulnerable people deeper into abject poverty, and rising oil prices which in turn drive up the price of food.
Why Position Limits?
Commodity futures exchanges are stocked with two types of traders: Hedgers and speculators. Farmers have long accepted hedging in commodity futures as a way of hedging risk, by selling off future interests (the earliest derivative contracts) in those commodities the burden of production is shared and the farmer ensured a fair price. But wherever futures exchanges were established the threat of speculation was always near.
Japan was home to the first futures exchange in Osaka in the 1730s, however the action of speculators led to famine and food riots, and over time strict controls were developed to protect both farmers and consumers. Recognition of commodity futures speculation prompted the U.S. Commodity Exchange Act 1936, and position limits were established for 28 commodities markets.
By the early 90s free trade ideology had exposed much of the Third World to cheap agribusiness exports. Secret exemptions from position limits for a new Goldman Sachs commodity index fund were allowed on the rationale that they too constituted bona fide hedging. Sixteen other large institutional investors soon received the same exemption. By 2004, cracks started to show in the housing market, and investors began moving money into commodities, spawning an enormous, unregulated and extremely profitable “shadow market.”
By purchasing huge amounts of imaginary wheat, corn, rice or any other commodity and sitting on the contracts for long enough to create an artificial price shock, these enormous “noise” investors were able to impact the price of future contracts to such an extent that real prices followed suit. One congressional staffer estimated that by 2008 80 percent of the market was made up by speculators.
As huge amounts of money entered these markets price volatility went critical. Real prices of Third World staple foods saw unprecedented rises–between 2005 and 2008 maize nearly tripled, wheat increased by 127 percent and rice by 170 percent. Food riots erupted in Mozambique and Haiti, killing hundreds. The 2007-08 food crisis drove 40 million people to hunger a further 20 million to extreme poverty. In 2010 these spikes returned, peaking in early 2011. In 2010 Goldman Sachs is estimated to have made $1 billion from these dangerous gambles.
There are other relevant factors influencing these graphic price spikes, such as biofuel subsidies, crop shortfalls from natural disasters and climate change, and increasing demand, especially for resource-intensive food. The financial industry attributes the crisis to these traditional “supply and demand fundamentals,” and their complaint highlights these fundamentals as driving price volatility. However, despite the vocal protestations of lobby groups in Washington and their vociferous report writing, a growing body of academic literature has observed the dynamic at work.
A Battle of Ideas
The current complaint alleges that the CFTC misinterpreted the existing law, mistaken in believing it was required to institute position limits. Comments from former Commissioner Michael V. Dunn (who stepped down in October) demonstrate this confusion, claiming that although he couldn’t logically justify passing position limits, he believed he was bound to it. Wall Street argues the limits are required only “as appropriate” if “necessary to diminish, eliminate, or prevent” “any undue and unnecessary burden on interstate commerce” caused by “[e]xcessive speculation.” First you must prove the limits’ necessity, and then establish limits as appropriate.
Industry claims that position limits are unnecessary because there is “no empirical basis to conclude excessive speculation had burdened modern markets in any way,” citing evidence from CME Group (which owns and operates large derivatives and futures) that “virtually unanimous academic agreement that commodity price changes have been driven by fundamental market conditions, not speculation.” Industry argues that ensuring market liquidity is critical to ensure “price discovery” functions are maintained, and that the CFTC failed to present a reasoned analysis, locking them out of the rule-making process. Further, it claims the CFTC didn’t carry out an adequate cost-benefit analysis, as restructuring would cost $100 million.
The claim of “virtually unanimous academic agreement” is somewhat specious, rather demonstrating the power of the financial lobby to shape the debate. The Sunlight Foundation counted over 13,000 comment letters to the CFTC regarding the rule. Chief Commissioner Gary Gensler estimated that it has prompted approximately 1,000 CFTC meetings, and the “vast majority are from large financial institutions.” A voluminous body of reports issued by financial firms and their legal teams eloquently condemn market regulation in a way that farmers and consumers simply cannot compete with. Data from The Center for Responsive Politics indicates that in 2011 alone lobbying firms have issued 175 separate reports on commodities.
Still, a wide cross-section of academics, activists, non-governmental organizations, former traders and international institutions have argued that excessive speculation, and not market fundamentals, causes commodity price spikes. The World Bank conjectures that index fund activity “…played a key role during the 2008 spike … [a]nd we find no evidence that alleged stronger demand by emerging economies has had any effect on world prices”. UNCTAD states that “financial investment in commodity trading appears to have caused commodity futures exchanges to function in such a way that prices may deviate, at least in the short run, quite far from levels that would reliably reflect fundamental supply and demand factors.” Nongovernmental organizations, such as the Institute for Agriculture and Trade Policy, the World Development Movement and Oxfam have joined others include the IMF, U.S. Senate, the UN FAO, the UN Special Rapporteur on the Right to Food, and rockstar economists such as Jayati Ghosh, Paul Krugman and Nouriel Roubini to highlight of the connection.
Does Liquidity Ensure Price Stability?
The industry’s central argument is the claim that greater market liquidity helps the process of “price discovery.” A recent working paper from the Political Economy Research Institute argues that this position doesn’t take into account the role of investor psychology in determining asset prices, including a “strong desire to accept evidence that could earn traders lots of money.”
Beyond observing “a strong and obvious correlation between the increase in liquidity in these commodity futures markets and the rapid rise of prices in spot markets,” they argue that price volatility was relatively steady prior to the market liquidity bubble witnessed in the 2000s. They conclude that the industry’s position cannot be supported by the “strong and consistent descriptive evidence in support of the need to limit the huge increases in trading volumes on futures markets through effective regulations.”
The System on Trial
Cases like this hold many hurdles, as the poorest and most aggrieved victims of this dangerous trading have no practical power to mount a credible legal challenge against the financial industry’s endless resources. The revolving door between New York and Washington, D.C is such that the majority of its commissioners have held high-ranking spots in financial firms, cheering on or indeed overseeing the deregulation of commodity futures in the first place. The CFTC itself has no broader interest in Third World hunger, but recognizes that excessive speculation can burden interstate commerce.
Still, the message on commodity futures speculation is spreading and increasingly appears as a key lever of hunger and social unrest in our time. Research has linked conflict and revolution in the Middle East and North Africa to food price spikes (Egypt, for example, is the world’s biggest importer of wheat). It is an issue on which both farmers and consumers have a stake in, as the profits Wall Street makes from commodities futures gambling eats into their livelihoods.
This is the opportunity to that crack down on legitimate corporate profiteering–to put the system on trial–and the battle to control the dialogue is well and truly on. To countervail the voices of financial lobbyists, the Occupy movement has made it a key demand building popular power around the issue. Wall Street will not give up their profits easily, yet the power of people too hungry to listen to market liquidity mumbojumbo could prove a formidable barrier. If this power can be channeled, the CFTC’s first lawsuit might not be the one-sided battle it first appears to be.