What Explains the Growth in Commodity Derivatives?

Article excerpt

This article documents the massive increase in trading in commodity derivatives over the past decade - growth that far outstrips the growth in commodity production and the need for derivatives to hedge risk by commercial producers and users of commodities. During the past decade, many institutional portfolio managers added commodity derivatives as an asset class to their portfolios. This addition was part of a larger shift in portfolio strategy away from traditional equity investment and toward derivatives based on assets such as real estate and commodities. Institutional investors' use of commodity futures to hedge against stock market risk is a relatively recent phenomenon. Trading in commodity derivatives also increased along with the rapid expansion of trading in all derivative markets. This trading was directly related to the search for higher yields in a low interest rate environment. The growth was both in organized exchanges and over-thecounter (OTC) trading, but the gross market value of OTC trading was an order of magnitude greater. This growth is important to note because a critical factor in the recent crisis was counterparty failure in OTC trading of mortgage derivatives. (JEL G120, G130, G180)

Federal Reserve Bank of St. Louis Review, January/February 2011, 93(1), pp. 37-48.

The recent financial crisis was caused by large financial firms taking on too much risk (leverage) using complicated instruments in opaque trading environments.1 Commodity derivatives trading was one such area. Commodity derivatives include futures and options traded on organized exchanges as well as the forwards and options traded over the counter. Organized exchanges monitor trading of standardized contracts and require margin accounts that protect investors against counterparty risk. The exchange is the counterparty in all trades. Over-the-counter (OTC) trades are bilateral exchanges of customized contracts. Margins are not required and such trading has not been monitored. On July 21, 2010, President Obama signed the Dodd-Frank Wall Street Reform and Consumer Protection Act into law. As of this writing, the regulatory rules have yet to be finalized, but the proposed regulations are intended to limit the use of derivatives by banks and make OTC trading more transparent.

The market failure that led to the recent financial crisis was centered in the opaque, bilateral OTC trading by firms that policymakers at the Federal Reserve and the Treasury considered too big to fail. Because of the potential risks involved, it is important to understand mechanisms that large financial firms can use to exploit the government's safety net. In this article, we document the massive increase in trading in commodity derivatives over the past decade. This growth far outstrips the growth in commodity production and the need for derivatives to hedge risk by commercial producers and users of commodities.

During the past decade, many institutional portfolio managers added commodity derivatives as an asset class to their portfolios. This addition resulted in substantial growth in the use of commodity derivatives - growth out of proportion with the historical levels associated with commercial hedging. This shift was part of a larger change in portfolio strategy away from traditional equity investment and toward derivatives based on assets such as real estate and commodities.

Trading in derivatives does not affect the fundamentals of supply and demand in any obvious way. The derivative trades sum to zero - for every winner there is a loser, for every gain there is an equal loss. Financial firms can write an arbitrarily large number of contracts betting on a future price without necessarily affecting the level of that price. However, an arbitrarily large number of contracts means that there can be an arbitrarily large number of losers. The important policy question is whether the taxpayer is at risk for counterparty failure in OTC trading when some financial firms incur large losses. …