Financialization of Commodities

The financialization of Commodities can be termed as the growing integration of financial and physical commodity markets over the last decade.

The deregulation of commodity and Financial markets coupled with swift technological advancement (e.g., computerized trading based on algorithms) and financial innovation (e.g., commodity index funds) have facilitated the entry of big financial players into both physical commodity markets and commodity derivatives markets.

Financial Players In Commodity Market

The key Financial players (non-commercial participants) in the commodity futures markets are very diverse. They include investment banks, merchant banks, swap dealers, insurance companies, hedge funds, mutual funds, private equity funds, pension funds, and other large institutional investors. 

Financial players look at commodities as a separate asset class or as part of a tangible assets allocation. 

The traditional asset classes include equities, bonds, fixed-income securities, property, and cash.

Financial players add commodity derivatives to their investment portfolio, i.e., the pool of money they invest, as part of a strategy to diversify their portfolio. 

Why Invest in Commodity

Commodities are added as "other asset class." Investment in commodities is seen as a balancing effect on the portfolio. It acts as a price risk management tool to avoid the prices of all the assets in a portfolio from going down or to hedge against inflation.

Gold is often considered a hedge against inflation in India. 

Financial players can leave commodity markets with fewer opportunities to profit from speculative trading.

Investment banks and hedge funds have developed various kinds of financial instruments for other investors to trade in or be exposed to commodity derivatives markets, including complex OTC derivatives and commodity (index) funds that track the prices of commodity futures. 

Players might also trade in commodity derivatives using their capital ('proprietary trading') rather than earning fees and commissions from processing trades.

The non-commercial futures positions have become the most significant component of futures markets.

According to a staff report by Commodity Futures Trading Commission (CFTC) in the US, institutional investors' value of index-related commodities futures investments grew from $15 billion in 2003 to over $200 billion in mid-2008.

The CFTC data published in 2011 reveals that the vast majority of trading volume in the key US futures markets – more than 80 per cent in many contracts – is day trading (or trading in calendar spreads). Only 14 per cent of long positions and 13 per cent of temporary jobs in the crude oil market (NYMEX West Texas Intermediate grade contracts) were held by producers, merchants, processors, and other commodity users.

Trading by different players (hedgers, speculators, and others) can affect the price formation and determine market prices in a futures market.

Suppose there are more buyers in the futures market (say, speculators) than sellers (say, hedgers). In that case, an excessive speculative buying of futures contracts is likely to increase the price of contracts. 

In this case, prices will no longer be determined only by the give and take between supply and demand as related to the physical commodity markets. 

It is not easy to undertake in-depth research due to the non-availability of data, as OTC trading is dull and can potentially influence the trading on exchanges.

The US Senate Permanent Subcommittee on Investigations issued a report in 2006 showing how the injection of billions of dollars from speculation into the commodity futures markets had contributed to rising energy prices.

The large influx of speculative investments in these markets had altered the traditional relationships between futures prices and supplies of energy commodities, particularly crude oil.

In 2007, the Subcommittee released another report highlighting how excessive speculation by Amaranth Advisors (a hedge fund) distorted natural gas prices and contributed to higher costs for natural gas consumers.

In its 2009 report on the wheat market, the Subcommittee stated that a large amount of commodity index trading due to speculative purchases of index instruments has contributed to "unreasonable fluctuations" and "unwarranted changes" in the price of wheat futures contracts in the US.

A 2013 study based on a dataset of Commodity-Linked Notes (a financial product linked to commodity derivatives prices) in the US found that speculative investors own cause significant price changes in the underlying futures markets and, therefore, provide direct evidence of the impact of "financial" investment on commodity futures prices.

The dramatic rise and fall in oil and agricultural commodities prices during 2006-08 generated a heated debate in global policy circles. 

Several policy measures were recommended to improve the regulation and supervision of commodity derivatives markets. 

Amendments in OTC derivatives markets were made. 

The mandatory clearing of standardized OTC derivatives by central counterparties (CCPs)

The requirements for bilateral margin posting in nonstandard OTC contracts

Regulated OTC derivatives are to be traded on the exchanges. 

Having one CCP precise massive amounts of OTC contracts may not be the best solution because a CCP may also fail for various reasons, including default by many prominent members and losses on the collateral value received.

In 2011, G20 agriculture ministers agreed to share reliable data on agricultural markets to ensure transparency in agricultural financial markets (including the OTC derivatives). 

They also called for greater collaboration between physical and financial regulators to improve the functioning of markets.