Adventures in Global Finance [Part III]

From Derivatives to Rice Riots

To understand why the price of rice can double virtually overnight, we need to understand what kind of weird financial mechanisms have sprouted up in the past couple of decades.

The world is full of many complex, new "financial instruments."

(Could one say that as a musical instrument is used to play music, a financial instrument is used to finance something? It may or may not be analogous -- I can tell you simply that a financial instrument is "any funding medium".)

There are two main categories of financial instruments:
-- cash (like in loans, deposits, stocks) and
-- derivatives (which derive value from some other financial instrument or variable).



What's the biggest market in the world?

It's not the bond market (selling of debt/credit) -- that's worth about $45 trillion.
It's not the stock market -- that's worth about $51 trillion.
And it's not actual goods & services -- the world gross domestic product is about $50 trillion.

The biggest market in the world is in derivatives: at least $681 trillion & growing.


Derivatives are financial instruments or contracts with values that are linked to, or derived from, the performance of underlying financial instruments, interest rates, currency exchange rates, or indexes. In a simplified sense, a derivative links its holder to the risks and rewards of owning an underlying financial instrument without actually owning the financial instrument. -- FDIC web site


The main types of derivatives are futures and options. These are contracts to buy a certain good on a certain date for a certain price -- or for the option to buy that good on a certain date for a certain price.

from Wikipedia: A futures contract gives the holder the obligation to buy or sell, which differs from an options contract, which gives the holder the right, but not the obligation. In other words, the owner of an options contract may exercise the contract, but both parties of a "futures contract" must fulfill the contract on the settlement date.



Futures and options are commonly traded on commodities like wheat, oil, metals, pork, orange juice, etc. This kind of trading began in the US during the 19th century to help out wheat farmers -- it helped them ensure that they would get a certain price even if things went unexpectedly with the harvest. But futures trading on non-commodity things, like the interest rate, didn't begin until the 1970s; the rapid growth derivatives trading is even more recent.

Where are derivatives traded? On futures exchanges like the Chicago Mercantile Exchange, and also the NYMEX -- the New York Mercantile Exchange -- where every minute 1200 contracts are bought and sold.



The NYMEX went public in 2006 -- before then, it cost $6 million for a membership to trade there. It's electronic now, but also open outcry; traders have a special sign language they use to trade with. The human hand still has a part in all this.






But it's not just commodities that are traded-- derivatives have grown far beyond that. Futures & options can be traded on interest rates, stock market indexes, foreign currencies, etc. For example, people even trade in weather derivatives (an instrument pioneered by Enron); you can make money by betting on the temperature of a certain number of days. There's a $60 billion a year market in weather derivatives; one can imagine the unpredictability of global warming will increase this gambling market. It seems that many things that have an element of unpredictability or risk can be traded upon-- for these derivatives are basically a trade in risk.

Options, for example, come in flavors of "vanilla options" (the standard kind) and "exotic options", like rainbow options. You can, for example, put an option on an option. I am adding this extraneous information because I find it gruesomely amusing, at the risk of losing my readers, I am sure. But the points I want to make are:

-- Most of the financial activity going on in the world is in this kind of betting; nothing of value is created with these derivatives. For every $1 floating around the productive wold economy of real goods and services, there is an estimated $20 to $50 circulating in the world of pure finance, producing or creating nothing (Charles Derber, qtng. David Korten, Corporate Nation).

-- This is a new situation: it is only in the last decade that futures trading was deregulated, and that vital commodities really became speculative investments.



OK: believe it or not, that was just the beginning: the background necessary for this story.


Some questions to delve into:

What are the implications of these "exotic global speculative instruments" on our financial system?

As Charles Derber explains in his book Corporate Nation, we have moved into a state of 'finance capitalism', which is "dominated by financial rather than nonfinanical corporations and reifies the pursuit of money gains over the making of useful products ... Capital becomes a paper commodity increasingly unrelated to production, and the profitability of stock markets and finanical corporations becomes increasingly disconnected from the real economy." Still, the eventual implications of this are yet unknown -- experts are unsure of how it will play out, since it is after all an uncontrolled, improvisational experiment. So let's move to another question...


How will financial speculators somewhere affect our ability to eat?

This second question is more answerable. Let's look at the role of derivatives trading in the current food price crisis. For this, I'll refer you to an excellent Globe & Mail article published on 31 May, "The Byzantine World of Food Pricing" (cover page, business section), which I'll summarize and quote from below:

In the past few decades, pension funds became a common way for people to save for retirement. They produce a massive influx of cash into stuff like commodities-- you can invest in a fund that either tracks the commodity index as a whole, or funds that buy a specific "basket" of commodities. People like you & me wouldn't normally want to buy oil or orange juice in these quantities, but under this system, it seems like a good way to diversify your portfolio-- especially if the stock market is uncertain.

But it was only in very recent years that the amount of fund money in commodity indexes shot up-- from 13 billion in 2003 to 260 billion in 2008.

Why? Because until recently, there were restrictions on how commodity trading was regulated.

(For a miniature review...)

In a forward contract, the buyer and seller agree to the price of a commodity and a fixed date for delivery. A farmer enters into a forward contract with a food company by promising to deliver a certain amount of grain on a certain date at a certain price. ... A futures contract is the same basic agreement, but it trades on exchange, and the buyer rarely -- if ever -- takes delivery of the commodities. Instead, futures contracts are used mainly by farmers for hedging and by investors for speculating. These contracts have historically been regulated.

However . . .

Beginning with the energy market, regulators made a series of far-reaching decisions that gradually loosened oversight of complex commodity derivatives and created loopholes for large speculators, allowing them to trade virtually unlimited amounts of corn, wheat, and other food futures. Only now, nearly two decades later, are the full consequences of those decisions being felt.

Basically, there was a legal case in 1990 that decided that some kinds of futures contracts should be classified as "forward contracts" and thus be outside of regulation by the Commodity Futures Trading Commission. (Wendy Gramm, wife of Republican senator Phil Gramm, was the chairmon of the CFTC and made this policy). Rewriting the rules on how these contracts were policed gave birth to a "new frontier of commodity trading, enabling financial speculators to buy and sell complex derivatives away from the prying eyes of regulators and exchanges."

So, first financial speculators -- and then investment banks, armed with your retirement money -- swooped into the province of farmers. As Manitoba farmer Ian Wishart said: "The commodity market was designed to provide a forward pricing tool to protect ourselves ... not to provide an opportunity for someone else to make profits."

In 1991, after the rules were altered, a bank requested exemption from speculative trading limits (because it was using a middleman to get around the rules). It was granted, which allowed all kinds of funds to enter commodities trading. Later, in 2000, more exemptions from the commodity trading limits were introduced (including one for the electronic trading of energy contracts, "the Enron loophole.")

Why might it be a bad idea (not for you per se, but for the world) for you to have some of your retirement savings in a commodity fund?

Many in the food industry compalined that these index funds don't behave like traditional speculators in commodity markets. Unlike hedge funds, which actively buy and sell contracts, and make bets on price increases and decreases, index funds are passive investors. They take positions in various commodities and hang on for extended periods, betting that prices will continue to go up. Critics claim that this has resulted in a kind of hoarding, and that the market no longer reacts the way it should to supply and demand factors.

Are there benefits to speculation in the commodity markets? Many say yes: speculators increase liquidity in the market, and as trader Mack Frankfurter explains, "the function of speculators is required to facilitate the hedging utility and price discovery mechanisms" [citation]. However, many of those who support speculation believe that it should be regulated.



Will a revamping of the derivatives-trading system solve the food crisis?

It may help, though rising oil costs have played a part in rising food prices. (But not that big a part-- yet). So have rising population levels, ethanol, increased wealth in China & India, etc-- still, none of those factors explain how the price of wheat doubles in a year. Recently, we have seen riots over food prices in scores of countries, and rationing in Russia and Pakistan. Reconsidering how commodity speculation is handled could make the markets more stable. There is still enough food to go around-- the problem is that many poor people can't afford it.


What can you and I do?

For one, cut back on meat (animals consume grain people could eat), and eat locally.

Many people are coming to a common answer: grow your own food. Backyard gardens will probably come back into fashion, and supply a greater part of our food source again.

And, we should probably not invest in commodities, and take political action to get these derivatives regulated again. It's a humanitarian issue.



I'll close with an excerpt from a blog entry in the RGE Finance and Markets Monitor:

Two or three generations ago, most of us would have been directly involved in food production as a hedge against food insecurity. My parents’ generation kept a garden in the back yard, putting to me to work each summer to raise corn, tomatoes, cucumbers and other fresh foods for the table, sending me to pick berries and fruits in season from our own and the neighbours’ bushes and trees. My grandparents’ generation kept chickens as well as a garden behind their house in the middle of a large industrial city. The garden and chickens helped my mother survive the Great Depression at a time when my father suffered stunted growth from rickets. My great-grandparents’ generation were almost entirely farmers working the land.

Today global agriculture is dominated by eight multi-national corporations. The policies promoted by successive governments and international institutions including the IMF, World Bank and WTO have aimed at undermining local production, distributed commercial networks, and diverse local markets in favour of mass production, streamlined supply chains and concentrated global market pricing.

As with other areas of our lives, the policies of “free market fundamentalism”, as George Soros styles it, have not diminished risks but increased them. My children are hostages to food insecurity, as are yours and billions of others. A disruption in global food supplies or surge in prices that puts food staples beyond the reach of many low income or middle-class families cannot be offset from the back garden. The exposure of food to pricing in markets open to manipulation and excess speculation puts the lives of millions at risk.

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In the final episode in this series, we'll look at derivatives trading in the housing market, as well as inflation, and put all of this information together into best guesses on what we can expect in the future of global finance (and, therefore, our economic lives).

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footnote: If you're not convinced that some gardening is for you, check out this great piece in The Guardian, "Don't Give Up". It has to do with gardening and climate change... which reminds me that I haven't even gone into oil derivatives trading and energy prices. There are only so many hours in a day. Let it be known that the commodity market in oil suffers from similar problems as with food commodities-- though with oil, there is definitely a supply-and-demand issue at work.