Global Commodities Markets After Financialisation

Markets are in constant flux and commodities markets are no exception. Their market structure has evolved at an incredible pace over the past decade. Size and interconnection, fuelled by easy access to financial leverage, have made top commodities trading houses ‘too-physical-to-fail’. Greater transparency of physical holdings, greater scrutiny in intra-day futures volumes, management of conflicts of interest, oversight on the functioning of international benchmarks and strong cross-border coordination among national supervisors are the indispensable policy toolkit in the new complex market environment.

Whether the commodities super-cycle is fading away and authorities are cornering financial institutions for their physical holdings, the financial system has irreversibly changed the structure of commodities markets. The strengthening interaction of commodities markets with the financial system over the last decade is commonly referred to as ‘financialisation’, i.e. returns from commodities are increasingly pooled with returns from pure financial assets (‘pooling effect’). This process has been driven by three important market developments: soaring international trade, easier access to international finance and new technological developments in trading infrastructure. The expansion of international trade across all commodities markets, supported by regional trade liberalisation and important WTO commitments, has coincided with the economic expansion of emerging markets, such as China and Brazil, and their growing participation in these markets, which boosted exports both in value and size.

Growth of exports value ($bn) and size, 2001-11

Value ($bn)

Size

2001

2011

CAGR

2001

2011

Units

Crude oil

340.1

1,475

16%

38,262.1

38,854

kbbl/day

Natural Gas

82.4

368.5

16%

553.46

1073.32

bcum

Iron ore

14.8

180

28%

493.1

1,072.9

mn/tonnes

Wheat

19.1

47.6

10%

105.92

150.4

mn/tonnes

Aluminium*

16

38.1

9%

11.1

15.87

mn/tonnes

Corn

6.7

34.1

18%

74.67

117.03

mn/tonnes

Coffee

5.4

28.6

18%

5.45

6.81

mn/tonnes

Sugar

4

17.8

16%

21.11

31.12

mn/tonnes

Soybean oil

2.9

11.1

14%

8.25

8.52

mn/tonnes

Cocoa

2.6

8.8

13%

2.47

2.96

mn/tones

Source: Author’s calculation from World Bank, USDA, ABREE, BP, OPEC, FAO. Note: *Data on exports are estimates.

Due to accommodating monetary policies and financial deregulation, the high returns generated by growing international trade fuelled by demand emanating from emerging industrial economies have attracted the interest of financial institutions hoarding cash for what has been commonly perceived as an anti-cyclical asset class. More interaction with the financial system also means easier access to financial leverage by commodities firms, and in particular by trading companies. The financial system has been therefore instrumental in the development of international trade.

The combined effects in the last decade of international trade, monetary policies, and technological developments in market infrastructure have also made physical markets more interconnected among them and the financial system, which has increased pro-cyclicality of commodities returns. This is confirmed by the statistically significant relationships with financial indexes for key commodities prices from the early 2000s in particular, when the combined effect of these three structural developments materialised.

Link between commodities prices and financial indexes before and after 2002

Before 2002 After 2002 Whole sample Models
Crude oil No Yes No ARCH
Natural Gas No No No ARIMA, Granger
Aluminium No Yes Yes** ARCH, OLS
Copper No Yes No ARCH, OLS
Wheat No Yes No ARIMA, OLS
Corn No Yes No OLS
Soybean oil No Yes Yes ARCH, OLS
Cocoa Yes* Yes* Yes* OLS
Coffee No Yes* No OLS

Note: **both ways, *Rejection at 10% level. Data up to 2011/2012. Front-month futures and cash forward prices.

Source: Author’s calculations.

The new market structure thus intensifies the magnitude of non-financial and financial shocks, even if they take place in smalls region of the world. The fallouts of government actions, such as export bans, or temporary supply cuts spread very rapidly across the globe. But this is also a sign of efficiency. Market fundamentals are also more sustainable, as the fast transmission of information creates market pressures that lead participants to deal with underlying market structure issues, while making distortive price subsidies expensive measures. Index investing has hardly driven prices up, but often provided useful liquidity to support the astonishing growth of hedging tools through electronic futures trading platforms. Yet, technological developments such as remote access and new trading technologies (e.g., algorithmic trading) have boosted futures markets volumes and have built up strong connectivity among commodities markets order books, which has improved quality of price formation. Despite problems with delivery systems that are unable to match the characteristics of underlying physical markets, such as for aluminium cash forwards on the London Metal Exchange, benchmark prices today incorporate more and higher quality information and are thus more resilient to informational shocks than ever.

A world of fragmented and inefficient commodities markets is a memory of the past, but internationalisation and interconnection also means concentration of international trading in a handful of global companies and market infrastructures, which have to remain accountable for their actions and fully transparent in the aggregate size of their physical holdings. Trading houses that have acquired significant physical holdings horizontally across commodities markets and access to cheap financial leverage should not endanger security of commodities supply. Should one of the top trading houses collapse, however, the supply security across diverse commodities markets in different countries could be under threat. Recent experience with financial markets reminds us the importance of designing a sound and transparent system of incentives for the market structure to marginalise short-term opportunistic behaviours stemming from size and interconnection.

Together with greater surveillance over complex algorithmic trading practices embedded in high intra-day volumes, which can potentially cause herding behaviours or hide manipulation attempts, market oversight is also undergoing structural changes. Commodities markets are cross-border in nature, whether they involve a physical forward or a futures contract traded on an infrastructure that offers delivery across all key regions of the world. Information-sharing and supervisory coordination on market participants and infrastructure (e.g. delivery rules) are key tasks to ensure effective supervision over potential manipulative behaviours in both physical and futures markets. So far IOSCO has acted as a catalyst of positive developments in international coordination and perhaps should be granted even more room for manoeuvre in the near future. As evidence does not corroborate the thesis that general categories of non-commercial traders are distorting commodities price formation mechanisms,[1] a general ban or excessive regulatory burdens on categories of traders or trading practices that are not manipulative per se, driven by a fragmented supervisory framework, would only affect liquidity of benchmark prices. However, greater transparency of global commodities markets should be a top priority. Conflicts of interests, for instance, between the ownership of market infrastructures and/or ownership of physical/futures/other financial holdings of market participants need to be appropriately identified, disclosed, and ultimately managed by the parties involved under the coordinated international supervision of competent authorities. Insufficient information about market incentives may otherwise feed policy responses that would push the clock back to a time of nationally ring-fenced and highly subsidised commodities markets, with their negative implications for innovation and long-term sustainability. Nobody misses those times, not anymore.



[1] On top of a growing body of literature, our empirical analysis for a highly financialised futures contract such as WTI (through a vector error correction model), both with data on open interest from old CFTC legacy reports and new COT report from 2006, confirms that commercial futures (short) positions drive non-commercial (long) positions in the long-term. More attention must be drawn onto intra-day volumes, instead.

For more information, please see Valiante, D. (2013), “Price Formation in Commodities Markets: Financialisation and beyond”, Task Force Report, CEPS Paperback, Brussels. Draft available at http://www.ceps.eu/book/price-formation-commodities-markets-financialisation-and-beyond.

3 Responses to "Global Commodities Markets After Financialisation"

  1. jackstraw   July 27, 2013 at 8:11 pm

    interesting and fun article to read. i've always thought financialization had to do with housing, cars…consumer stocks..with commodities as an ancillary beneficiary. certainly the need for such a mass quantity of base material (you left off the big one namely coal) i think has always been overdone in my view. there are so many substitution effects that can be created…well, let's just say economic nationalism never really leaves a nation.

  2. zermatgr   August 28, 2013 at 10:37 am

    In case you would like an alternative view on the topic:
    http://www.growmark.com/sites/Files/Documents/Chi