Commodity Futures Exchanges: Historical Evolution and New Realities
By John Baffes. Senior Agriculture Economist. The World Bank
Presentation from the FARMD Annual Conference: Price Volatility and Climate Change, Implications for the Ag-Risk Management Agenda. Zurich, June 9-10, 2011.
Milestones in the evolution of commodity futures exchanges
FARMD (July 2011) | John Baffes tours back through the history of the commodity futures exchange and identifies five periods, which he divides by milestones, to explain its evolution: the early history (17th and 18th century); Information travels faster than commodities (1840-1865); Globalization (1865-1940); post WWII downfall (1940-1970); and the rebirth (1970-2000).
The presenter describes these historical developments as follows:
It has been recognized by several historians that the early history of futures trading goes as far back as 1695, where sporadic trading was taking place in Amsterdam. Later on, the Dojima rice market is credited with the birth of future trading in 1730, which holds many of the characteristics of a modern future exchange. Around 1840, the telegraph and the steamship were two of the mayor milestones that changed the price formation process in futures exchanges. For the first time, and thanks to these inventions, non-local demand and supply were taken into account in the trading activity. The steamship, for instance, reduced the time of shipping from 2 months to 3 weeks, but steam shipping was very expensive, so one of the most valuable thing, that traveled quickly was information.
By the end of the 1800s, there were five commodity exchanges in the world, and these were all connected by transatlantic cable: New York, New Orleans, Liverpool, Havre and Alexandria. It was in this time that these exchanges became global markets, so whatever was happening in Alexandria began influencing New York and New Orleans.
The downfall of exchanges began after War World II. Some exchanges were completely shut down and others diminished their importance. The post war was a period with several government interventions in the agricultural commodities markets. In the United States, for instance, where most of the exchanges had flourished, farm programs made most futures contracts redundant. In Europe, the Common Agricultural Policies had the same effect.
More government interventions damaged the markets even more. The Soviet countries and some Eastern Europe countries with central planning policies did not allow futures trading. Some other strong state control countries, such as China, India and Egypt, prohibited futures trading, with stock holding mechanisms as one of the most damaging government intervention policies for exchanges (See graph in slide #8 of the Power Point presentation).
The re-birth of exchanges occurred in the 1970s. After Breton Woods collapsed, numerous markets were created. Exchange rate and interest rate markets were brought to light. When gold was untied from the dollar, it emerged as an autonomous market. Before 1972, crude oil was priced on the contraction-based arrangements not on market-based arrangements, but after the oil crisis of this year, the oil market emerged.
Close to the end of the century, with the introduction of financial futures, the stakes become high and there is a need for regulation. Therefore, the United States creates the Commodity Futures Trading Commission, a regulatory body that oversees the functioning of futures markets. Prior to this, commodity exchanges were self regulated. In the 1980s/90s, the agricultural policies became more market friendly.
The New Reality
The presenter describes the five factors, which, in his opinion, have shaped the new reality in commodity futures exchanges, as follows:
- The literature: numerous influential authors have written that commodities may be a profitable asset class.
- New players and the financialization of commodities: many funds such as investment, hedge, pension, and sovereign wealth began including commodities in their portfolios in order to diversify their holdings and receive higher returns.
- The financialization of futures exchanges: they changed from member-holding institutions (the equivalent of a Credit Union) to exchange-listed companies (the equivalent of an investment bank).
- Liquidity:low price rates, stimulus packages, government spending, and quantitative easing are not unique to commodities.
- Technology: Electronic tracings, ETFs, index funds, and information technology made commodity investment accessible— also not unique to commodities.
But, does the "new reality" matter after all?
John Baffes discusses the implications of the “new really” on the basis of two questions:
1) Has the “new reality” contributed to better facilitation of risk or more efficient hedging instruments?
2) Has the “new reality” improved the process discovery process?
He argues that the answer to the first question is yes. In the case of the second question, he argues the answer is not clear because: the views differ, the opinions are very strong, the empirical evidence is mixed, and the issue has been politized by the financial and popular press; the “new reality” is often discussed in the context of speculation without explicitly stating what it means.
Some of his personal and non-technical observations on this matter are:
- Historically, blaming speculation has originated from politicians and populists, a reflection of ideology or search for scapegoats to assign blame for unpopular price increases. Most economists and market participants, however, have been strong defenders of futures markets which are viewed as the most important price discovery mechanism.
- The current debate has divided economists and market participants.
- Most empirical studies follow a similar approach in the sense that they correlate a quantity variable with a price variable (futures contract).
Although the empirical evidence is weak, recent studies tend find more impact compared to earlier studies, perhaps because more data and better econometric techniques are available.