The Role of Financial Speculation in Commodity Markets: Harmful or Helpful?

Abstract

Recent years have shown an increased level of food insecurity: a surge in the level of poverty and hunger in low-income countries caused by higher global food prices. One of the potential causes of the commodity price spikes is the process of financialization, including an increased level of financial speculation in food commodity markets. Because the literature is inconclusive on the exact effects of speculation, this research aims to provide a fresh analysis of the potential impacts of financial speculation on food commodity prices as well as to explore policies that could influence the level of financial speculation. The main question to be answered through this research is: ‘What are the likely effects of the increase in financial speculation on the behavior of commodity prices in the current soybeans market, and which policies can be used to regulate these effects?’ First, a literature review was conducted to study sources on the potential theoretical effects of speculation, as well as sources on the current regulatory measures to counter speculation. Next, the system dynamics approach was used to investigate the role of speculative activity in price-setting behavior. Lastly, expert interviews were conducted to validate the behavior of commodity prices as shown in the model, as well as to gain knowledge on policy interventions.
Guided by the literature review, three important interacting markets were identified for inclusion in the conceptual system dynamics model for the soybeans market: the market for storage, the cash market, and the futures market. The results show how interactions between these markets determine the behavior of spot prices. Furthermore, in the literature review, speculators were found to be trend-following, fast-reacting entities who contribute to strengthening of price expectations and spot prices. The quantitative system dynamics model shows how speculators are able to amplify the oscillation of spot price behavior, which can be compared to the forming and crashing of price bubbles in a commodity market. This amplification occurs because speculators react faster to changes in spot prices than other market participants. While the model is still relatively simplistic, it creates an understanding of the system structure of financial markets that determines spot price behavior.
The research describes how experts agree on the fact that some kind of policy intervention is required to limit the negative effects of speculation. Policy makers should pay attention to the level of transparency in setting position limits and focus on clarifying and explaining the classification of speculators and hedgers. Furthermore, it is recommended that only traders with an active and real interest in the commodity should be allowed to participate in the futures market.