Proposals to ban large institutional investors from commodity markets being put forward in the US are misguided, as are similar ideas being discussed by some European politicians.
Institutional investors have deepened and enriched commodity markets, enabling producers and consumers to hedge more efficiently and far further in the future than ever before. Banning them or constraining their participation will only reduce liquidity and hurt market efficiency and won’t cure the problem of rising commodity prices.
Large institutional investors entering the market today are following the trend of rising commodity prices, not leading it. By and large, they are looking at multi-year investments and are not highly active traders. The high volume of trading in commodity markets from financial institutions largely comes from hedge funds, CTAs and investment banks that are actively taking positions in both directions.
Although there may be speculative excess in the prices of some commodities, the great thing about commodity futures, as opposed to purely financial markets, is that ultimately physical supply and demand forces provide a reality check that other anticipatory financial instruments don’t get. When financial bubbles get too big. they get pricked by pins from the physical market. Hence the numerous, substantial corrections that have occurred in several commodity markets including gold, base metals and softs.
Gold is trading in a range below $900, down from more than $1,000 in March; base metals such as lead and zinc have fallen about 50% from their highs last year; and the DJ AIG Agriculture Index only began to recover from its fall in March after severe floods in the US midwest damaged this year’s corn crops.
Commodity prices are high and rising for good reasons, including rising incomes in developing countries, population growth, decades of underinvestment, supply constraints and supply inelasticity – as well as simple scarcity. Investors might be one contributory factor but getting rid of them won’t change the market’s fundamental dynamics and is unlikely to achieve anything except a more inefficient market and lower returns for investors.
That, however, is not to say that there is no room for improved regulatory supervision of commodity markets. Commodity markets have very few rules compared with other financial markets and could probably do with some more, or at least some modernization. Politicians would do better to focus their efforts on helping markets to run more efficiently rather than banning significant sources of liquidity.
