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April 07, 2010

Steeling for a fight: U.S. Senate takes on derivatives

For those who think that headlines and newspapers still matter, this front page news appeared in the March 30 issue of the Financial Times: "Steel prices set to soar." The end of 40 years of forward contracting iron ore annually will be replaced by three-month contracts in the cash markets from which multi-billion dollar financial derivatives contracts in steel will emerge. Steel prices are predicted to rise a third and be passed along to consumers. Price volatility in iron ore and steel will increase. The highly concentrated iron ore mining industry will prosper, as will traders in steel derivatives.

What does this headline event have to do with the ongoing U.S. congressional fight over how to regulate over-the-counter (OTC) derivatives contracts currently traded in unregulated "dark markets?" Furthermore, what does the OTC legislation have to do with agriculture and agribusiness?

Next week the U.S. Senate Agriculture Committee will begin to negotiate its version of the OTC derivatives provisions that will form part of the overall financial reform legislation. The Agriculture Committee oversees the Commodity Futures Trading Commission (CFTC) which regulates the trade in commodity derivatives, such as iron ore futures. The banking committee oversees the regulation of financial derivatives, such as stock and interest rate futures. The Senate will take elements from both committees to incorporate in the final financial reform bill that Senate leadership hopes to move to a vote by June.

On March 25, IATP wrote to the agriculture committee as a member of the Commodity Markets Oversight Coalition and to the entire Senate in a sign-on letter led by faith-based and nongovernmental organizations. Both letters asked Senators to authorize the CFTC to set and enforce limits on the number of futures contracts that any one entity can own in all trading venues during a specific trading period. The lack of these contract trading limits, called "aggregate position limits" in the draft legislation, enabled excessive speculation by financial institutions in commodity markets. In 2008, we reported on how more than $300 billion in speculative money drove extreme price volatility in both agricultural and non-agricultural commodities in 2007–2008.

Most of the excessive speculation took place in unregulated OTC trades, which led to a near meltdown of the global financial system in the last half of 2008, avoided only by a multi-trillion dollar taxpaper bailout. In dark markets, nobody knows which traders have enough reserves to pay up when their "bets" go bad. Wall Street lobbyists have written exemptions in the House of Representatives "Wall Street Reform and Consumer Protection Act of 2009," passed on December 11, 2009. These exemptions to restrictions on OTC trading would leave up 60 percent of the $300 trillion U.S. OTC market still unregulated, according to a March 24 speech by CFTC Chairman Gary Gensler.

Many of the corporations represented by the Wall Street lobbyists are agribusiness firms, such as Cargill, Bunge and John Deere, that belong to the Coalition for Derivatives End Users. Like their industrial brethren, they use dark market instruments to hide debt, manage currency and interest rate fluctuations, and, yes, to manage price risks in physical commodities such as steel, which Cargill trades and John Deere uses. Traders on regulated public exchanges give price information to the whole market. Dark market traders give no information to discover prices, as is required by the U.S. Commodity Exchange Act: they only use public information to create unfair competitive advantage. 

On March 4, IATP submitted a comment to the CFTC that rebuts the Wall Street arguments to the Senate banking committee as to why trade in dark markets should continue. The comment is in response to a proposed CFTC rule on aggregate position limits for energy futures trades. The proposed rule, to close what is colloquially known as the Enron Loophole, is open for comment until April 26.

The CMOC and faith-based organization sign-on letters to the Senate argue for very strict limits to any exemptions from trading on public markets. Only bona fide users of commodities would be allowed to hedge risks off-exchange, and then only for commodity derivatives trades and for no other financial purpose. Those specifically exempted trades would require higher capital reserve requirements to prevent failure to pay and would be subject to strict daily reporting requirements, unlike the current six month lag of government reports of disaggregated OTC trade data to the Bank of International Settlements. (Six months is an eternity in the world of derivatives trading and cannot aid regulators to monitor trade flows and types.)

If the Senate allows transnational corporations to continue to trade in dark markets, all consumers of commodities and financial products will be exposed to the systemic risk of the "too politically connected banks" through whom the Coalition of Derivatives End Users members trade. Higher prices for consumer products using steel will seem like the good old days compared to the havoc that another global dark market failure could unleash. According to Simone Johnson, former chief economist at the International Monetary Fund, in the absence of tough regulation of the financial and commodity markets, another global financial crisis could hit within a year.

Steve Suppan

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