Calming Proposals for Volatile Ag Markets

Calmer seas could be on the horizon for the volatile North American agricultural futures markets, which have seen dramatic price swings and massive trade volumes over the past year. Faced with complaints that futures prices were out of tune with cash bids in the countryside, and that the markets were lacking transparency, the U.S. Commodity Futures Trading Commission [CFTC] - the government regulator watching over the futures trade - announced some initiatives June 3 that could help steady the rocking boat.

The increasing use of agricultural products to produce fuel (such as corn for ethanol, or soybeans for biodiesel), the rising demand for food from countries with expanding economies (such as China and India), together with some of the tightest international stocks of grains and oilseeds in decades, helped drive futures prices for corn, wheat, soybeans and other commodities higher over the past year. Adding fuel to that fire, however, was a substantial flood of speculative money from investors who were not traditional players in the agricultural markets.

While speculators have always been a factor in the agricultural markets, the so-called index funds are a relatively new player in recent years, as they diversify out of the equity and fixed-income markets and into agricultural commodities. Index funds usually comprise large pools of money from corporate and government pension funds, sovereign wealth funds and institutional investors. Rather than play both sides of the market, the index funds are usually only on the long side of the trade, gobbling up large positions with a seemingly insatiable appetite.

Eponymous Term

They are aptly called index funds because they trade various commodity indexes, such as those named after the Commodity Research Bureau, Standard & Poor's and Goldman Sachs. They'll buy futures of each commodity in the index at the same proportion as the commodity is found in the index. For example, if canola is 2% of the CRB index, then the index funds would be long the equivalent amount of Winnipeg canola futures.

Some recent estimates have the long-only index funds holding positions of about $180 billion to as much as $260 billion across all commodities. By comparison, the index funds were holding a stake closer to $13 billion in the agricultural futures markets only five years ago.

The CFTC only began tracking the index fund movements in the agricultural future markets in their weekly Commitments of Traders reports in January 2007. At that time, as an example, the index funds were holding 364,320 long positions in Chicago Board of Trade corn futures, or 17.2% of the total volumes in the commodity. As of May 27, 2008, that total was sitting at 470,044, or 22.3% of the total open interest.

The complaint amongst many traders has been that the sheer size of the index fund money distorts prices by exaggerating the futures' values compared with what the actual physical commodities are being sold for in the country. It's made life difficult for longtime grain traders and analysts who are accustomed to basing their market predictions on fundamental factors such as the weather, available supplies and export demand, and on technicals - charts displaying such things as moving averages and support and resistance levels.

Grain companies, who use the futures market as a hedging tool, were also upset that the soaring futures prices caused their margin fees to increase, making hedging that much more difficult.

As a result of the higher margin calls, more transactions are taking place as agricultural swaps. Swaps - or over-the-counter trades - allow two parties to tailor a transaction to their own specific needs, and may include commodities or other financial instruments that are not offered at any exchange. There is currently no transparency in the markets when it comes to swaps, which largely escape regulatory attention.

During hearings last month in Washington, D.C., the CFTC was criticized for inadequately monitoring the impact of speculative investors on commodity markets. The chairman of the Senate Homeland Security and Government Affairs Committee, Joseph Lieberman, said May 20 that he is pondering legislation limiting the participation of large institutional investors in commodity markets.

CFTC regulators tried to assure U.S. lawmakers that commodity index funds and other speculative investors were not the reason for record high prices for energy and agricultural commodities. But the CFTC appears to be reconsidering its stance, or at least is seeking more assurances that the commodity markets are working properly.

The CFTC's new policy initiatives are expected to bring some additional transparency to the agriculture markets, but are also creating some nervousness amongst traders as they wait on further details as to how the proposals will actually be implemented.

Some of the market initiatives include:

A review of trader reporting and classification, with the intent of developing a proposal that would require more detailed information from index traders and swap dealers.

The withdrawal of proposed rulemakings that would have increased the speculative position limits on certain agricultural futures contracts.
The creation of greater risk management choices for farmers and agribusinesses, including the clearing of agricultural swaps.

An investigation into the February/March 2008 run-up in cotton futures markets. (Cotton futures rallied in line with grains, oilseeds and other agricultural commodities, despite the fact that there was no fundamental reason for them to do so - a sign to some market players of the disruptive nature of the fund money).
Efforts to work with agricultural lenders to help facilitate a better understanding of the financing issues faced by agricultural market participants, thus dealing with some of the issues tied to higher margins.

Additional studies into coming up with solutions for improving the relationship between the futures and cash markets and determining margins and daily price limits, among other things.

Overall, analysts don't expect the CFTC to impose any regulations that would seriously hurt investment opportunities in the agricultural markets. Rather, most participants seem to be of the opinion that the CFTC will move slowly when it comes to implementing any of their initiatives.