Not one to mince words, commodities-analyst-turned-commentator John Kemp declares the financial crisis and commodity market gyrations has disproved three tenets of commodities regulation:
- Speculation has emerged as a factor in its own right, he says, even though most analysts insist this is not possible.
- Manipulation is possible, he writes, citing examples such as hedge fund Amaranth, which held more than half of the open interest in natural gas contracts when it collapsed in 2006.
- And settlement failures in the US government bond market highlight how vulnerable smaller commodity markets are to liquidity problems and large positions.
Why is this a problem?
Excessive volatility undermines the function of price signals by making it harder for producers and consumers to differentiate real long-term signals from the mass of short-term movements (”noise”). It imposes real costs in terms of resource misallocation when producers and consumers get it wrong, and these costs are non-trivial.
What should be done? Both the ‘structural’ approach of US regulation and the ‘behavioural’ approach of the UK have proved ineffective.
A new consensus, Kemp says, will have to be forged with an agreement on the how these markets work. Regulators should be particularly concerned with how smaller niche markets can be used to manipulate larger markets:
The recent report on commodity market regulation by the International Organisation of Securities Commissions (IOSCO) admitted positions in unregulated over-the-counter (OTC) markets could, in principle, influence prices on regulated public exchanges, and called for greater information and oversight on positions in these markets.
So far the focus has been on soliciting greater information about OTC trading on larger markets such as oil and natural gas. But a case could be made that regulators should also concentrate on smaller markets (such as carbon) many of which are traded OTC and where linkages to larger markets such as power may make them more important than their size suggests.
Conceptual problems in commodity regulation (Reuters, 11/05/09)