Financialization and Structural Change in Commodity Futures Markets
Irwin, Scott H., Sanders, Dwight R., Journal of Agricultural and Applied Economics
The first decade of the 21st century has perhaps witnessed more structural change in commodity futures markets than all previous decades combined. Not only have trading volumes and open interest increased markedly, but this time period also saw historic changes in both trading and participants. The available literature indicates that the irrational and harmful impacts of the structural changes in commodity futures markets over the last decade have been minimal. In particular, there is little evidence that passive index investment caused a massive bubble in commodity futures prices. There is intriguing evidence of several other rational and beneficial impacts of the structural changes over the last decade. In particular, the expanding market participation may have decreased risk premiums, and hence, the cost of hedging, reduced price volatility, and better integrated commodity markets with financial markets.
Key Words: bubble, commodity, futures markets, index funds, prices, speculation
JEL Classifications: D84, G12, G13, G14, Q13, Q41
Since their modern inception in Chicago during the 1850s, dozens of commodity futures contracts have been launched and countless alterations have been made to the relatively few contracts that have survived over time. Nonetheless, the basic structure of the markets has been remarkably stable over time - a trader from the latter part of the 19th century magically transported to the trading pits of the waning years of the 20th century might have been surprised by the size of the commodity futures markets but not by the way trading was conducted or the main types of participants.1 This stability was not fated to last however.
The first decade of the 21st century has arguably witnessed more structural change in commodity futures markets than all previous decades combined. Not only have trading volumes and open interest increased markedly, but this time period also saw historic changes in both trading and participants. Commodity futures markets transitioned from a primarily telephone/open outcry trading platform to a computer/electronic order matching platform. As a result, market access expanded greatly and trading costs declined. Perhaps not coincidently, the same period saw new financial participants enter the commodity futures arena. Investments that track a commodity index became an accepted alternative investment for institutions and pension funds. The increasing importance of these nontraditional participants has been labeled the "financialization" of commodity futures markets (Domanski and Heath, 2007). Finally, exchange traded funds were introduced that tracked commodity indices or even single futures markets. These changes undoubtedly contributed to the increase in the volume of trade on commodity futures markets.
The structural shifts seen in commodity futures markets during the last decade can impact the marketplace along both rational and irrational avenues. Rational market impacts - such as improved market liquidity and potentially reduced risk premiums - stem from broader market participation and more active trade. Irrational impacts - such as a commodity price bubble - would stem from the markets' inability to adjust to these changes. In this article, we first review recent trends in open interest and volume for important commodity futures markets in agriculture. Next, we examine the forces of structural change within the commodity futures markets driving the trends in market participation over the last decade. Finally, we provide an overview of the literature on rational and irrational market impacts. The emphasis in this part of the paper is on the potential irrational impacts of financialization since this has received the most attention in terms of public policy and academic research.
Trends in Open Interest and Volume
There is little doubt that something happened from 2003-201 1 in the commodity futures markets. For example, combined futures and option (delta-adjusted) open interest in Chicago Board of Trade soybeans over 1995-2002 was relatively stable at an average of 223,000 contracts (Figure l). …