Financial Regulation

Written evidence submitted by the World Development Movement

Executive Summary: The financial reform consultation does not provide a clear mandate or mission for the regulation of commodity derivatives. The underregulation of these products has contributed to excessive volatility in commodity prices for end-users, hurting domestic commercial and consumer interests as well as undermining international development goals. WDM recommends charging the new Consumer Protection and Markets Authority with regulating commodity derivatives trades in order to reduce excessive speculation, price volatility and counterparty risk.

1. The World Development Movement (WDM) is a UK campaigning organisation which tackles the root causes of poverty. WDM is a democratic membership organisation with 15,000 supporters and 60 local groups. We lobby governments and companies to change policies that keep people poor.

2. WDM shares the Treasury’s aim of promoting "confidence in stability, integrity and efficiency of financial markets". However, in this regard we have been surprised and dismayed by the considerable gap within the Treasury report around the legislative and regulatory standards governing derivatives trading in general, and the trade in commodity futures derivatives in particular.

3. The consultation document briefly mentions that Over-The- Counter (OTC) financial markets, exchanges and other trading platforms will be regulated by the Consumer Protection and Markets Authority (CPMA) and that investment banks will be monitored by the Prudential Regulation Authority (PRA). However, the regulation of commodity derivatives is not specifically addressed within the remits of the proposed agencies. This means there is no improvement upon the current situation in which the FSA, which is nominally responsible, does "not have dedicated rules for commodities and commodity derivatives markets. Rather, its regulation of commodities markets is derived from several different regimes and its overall approach combines these." [1]

4. The regulation of commodities derivatives must be addressed specifically as these markets have clear and immediate impacts on spot markets, and therefore on both direct consumer and commercial buyer prices in the UK. Recent food inflation and rising input costs for food manufacturers, hauliers, and aviation companies – driven in part by financial speculation on commodity derivatives – is damaging for the entire UK economy, especially at a time of fragile growth.

5. As an organisation primarily concerned with international poverty issues, we are in particular concerned that commodity trading must be regulated to reduce volatility in food prices and ensure that the patterns of the global food prices in 2007-2008 are not repeated. According to the World Bank, the 2007-8 food price spike resulted in the number of people in extreme poverty increasing by 20 million. [2]

6. Research by the World Bank [3] , the UN Special Rapporteur on the Right to Food [4] , UN Conference on Trade, Aid and Development [5] , and the World Development Movement [6] demonstrate the central role of financial investors in the 2007-2008 world food crisis. As outlined by these reports, it is evident that the increase in food prices in 2007-2008 was due to the financialisation of commodity markets. For example, the World Bank stated that:

"commodity related activity on the financial side can induce higher price variability in the sense of exacerbating the length and the amplitude of price cycles, as they most likely did during the ‘perfect storm’ of 2007/08." [7]

According to an analysis for WDM by Prof Jayati Ghosh, Chair of the Centre for Economic Studies and Planning, Jawaharlal University:

"it is clear that the recent volatility in world trade prices of important food items simply cannot be explained by real demand and supply factors... FAO data show very clearly that there was scarcely any change in global supply and utilisation over this period [Jan 2007- Sep 2010]." [8]

7. A wave of recent reforms and discussion in the US and EU have reshaped the future of the regulation of commodities. The Dodd–Frank Wall Street Reform and Consumer Protection Act in the US specifically focuses on regulating agricultural commodities and position limits. However, effective implementation of the Act is dependent upon countries like our own similarly reforming regulation so as not to create a system of arbitrage in which American money uses Europe as an underregulated offshore haven.

8. The European Commission will be addressing the regulation of commodity speculation during the 2011 review of the Markets in Financial Instruments Directive. Specifically, OTC regulation will be addressed shortly in the proposal for a Regulation on OTC Derivatives, Central Counterparties and Trade Repositories. It is essential that the UK government support strong measures through reforms to these regulatory instruments in order to create greater transparency and efficiency in these markets, and so that effective limits can be applied to prevent financial institutions from distorting the price of essential commodities such as food grains or oil.

9. Recommendations

In order to curb systemic risk and ensure an efficient market flow and efficient price formations, we recommend that the CPMA be given clear responsibility for regulating both OTC and exchange-traded commodity derivatives, with the regulatory objectives of:

· Reducing counterparty risk, for example through improved transparency and channelling of a vast majority of over-the-counter deals through clearing on an exchange.

· Reducing price volatility, through increased margin requirements for purely speculative derivatives transactions.

· Reducing excessive speculation, for example, through the introduction of strict position limits on the amount of contracts that can be held by financial services for speculative purposes (as introduced in the US Dodd-Frank Act).

4 November 2010

References