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Planning for the Perfect Storm: Regulation of Commodities Trading in Agricultural Products

May 23, 2011
Today, as fuel prices go up, and food prices increase, we are all well aware of the risk of social unrest and civil strife. The world needs affordable food, for a growing population, in a natural environment that is increasingly volatile due to climate change. Whether we can meet these needs will depend upon how we evaluate and address the agricultural investment risks and returns and how we regulate investment in agriculture.

Investors are well aware of this opportunity. Blackrock Global Funds in marketing its World Agricultural Fund comments: "The agriculture sector has, to an extent, lagged other parts of the commodity markets. However, the demand fundamentals continue to improve and with inventories in some agricultural commodities at historically low levels, we believe agriculture is a compelling long-term investment. We have identified three powerful drivers of agricultural commodity demand. These are; rising population, rising incomes and the growth of biofuels.With inventories in some agricultural commodities at low levels, these demand drivers are likely to put upward pressure on prices."

In addition to the traditional risks in agriculture we now have a large and growing man made risk. This is the risk that results from the "financialization" of food commodities. The free market system combined with international trade and international finance enables wondrous technology and a standard of living beyond compare in some parts of the world enabled by investments attracted by the risk reward trade off. But the dark side of these free markets could be viewed to be financial speculation on food facilitated by un-regulated or loosely regulated markets.

An interesting question that is facing us is whether it is morally and ethically correct to "speculate" on food? Is it correct to allow un-controlled and un-regulated profit seeking to withhold grain supplies in a period of shortage? Is the way we account for profits in the scenario correct when we do not charge the private sectors profit and loss statement with the costs of social unrest, riots, wars and the like? Should we do anything to ensure this profit seeking is moderated and regulated? Do we truly believe that "Greed is Good?", as the character Gordon Geko in the movie Wall Street said. Have we not just seen and experienced the result of poor regulation and oversight on the world economy. Can we afford to take this risk with our food?

Fortunately there are already calls for regulation of financial speculation in commodities and thus food commodities. But the requisite legislation and regulation is far from implementation. There is "a pressing need for new measures of transparency and regulation to deal with speculation on agricultural commodity futures markets," said Jacques Diouf, Director-General of FAO.

In the report World Economic Situation and Prospects 2011 published by the UN it is noted as follows: "The traditional function of the commodity exchanges has been to facilitate price discovery and allow for the transfer of price risk from producers and consumers to other agents that are prepared to assume such risk. But these functions have become impaired by the growing “financialization of commodity trading."

In the article "How Institutional Investors Are Driving Up Food And Energy Prices" by Michael W. Masters and Adam K. White, CFA ed. Institute for Agriculture and Trade Policy, the authors note that: "When Physical Hedgers dominate the commodities futures marketplace, prices accurately reflect the supply and demand realities that physical consumers and producers are experiencing in their businesses. When Speculators become the dominant force, prices can become un-tethered from supply and demand, reaching irrationally exuberant heights."

Federal Reserve Bank of St. Louis in an article “What Explains the Growth in Commodity Derivatives? By Parantap Basu and William T. Gavin, ed. Institute for Agriculture and Trade Policy, documents: "During the past decade, many institutional portfolio managers added commodity derivatives as an asset class to their portfolios. This addition was part of a larger shift in portfolio strategy away from traditional equity investment and toward derivatives based on assets such as real estate and commodities. This trading was directly related to the search for higher yields in a low interest rate environment. The growth was both in organized exchanges and over-the counter (OTC) trading, but the gross market value of OTC trading was an order of magnitude greater. This growth is important to note because a critical factor in the recent crisis was counterparty failure in OT C trading of mortgage derivatives."

In this regard we need to consider the issue of investment in agriculture in our deliberations on Making Finance Work for Africa. We should seek to assist governments, producers, and consumers to regulate their Commodities Exchanges and Over the Counter Markets to ensure that they function to enable price discovery, facilitate agricultural trade and financial hedging, and to ensure that "speculation" is driven out of the food commodities market. If we do not do this - we increase the financial, social, political, and economic risks in fragile states and emerging nations alike and we do so at our peril.

The author has worked in the areas of agriculture investment and development including value chain financing for over ten years in Africa and Asia. He is currently involved in researching and implementing, as well as training on, risk mitigation tools to enhance the flow of funding to agriculture production and processing with a focus on Small and Medium Enterprises in agricultural value chains in emerging markets.

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