Kiyohiko G Nishimura: Financial factors in commodity markets
Speech by Mr Kiyohiko G Nishimura, Deputy Governor of the Bank of Japan, at the Paris
EUROPLACE International Financial Forum, Tokyo, 28 November 2011.
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1. Introduction
I feel privileged to have the opportunity today to speak at this International Financial Forum
organized by Paris EUROPLACE. This is my second time to stand before you, following my
presentation last year. It is always a great pleasure to join this forum, since Paris
EUROPLACE has been playing a pivotal role in providing opportunities for market
participants to deepen mutual understanding. I salute the members of Paris EUROPLACE for
their dedication.
It is also a great pleasure to have our friend Christian NOYER, Governor of the Banque de
France, among our distinguished participants. I would like to take this opportunity to extend
my sincere gratitude to Christian and the Banque de France for their invaluable support
under the French presidency, for the work of the G20 Study Group on Commodities, chaired
by my colleague Hiroshi NAKASO.1 My presentation today, in which I would like to share with
you some of the findings of the Study Group, has profited greatly from such cooperative work
between the Banque de France and the Bank of Japan. However, the views expressed
hereafter are my own, and do not necessarily represent the views of the Study Group.
Last year, I discussed in some detail the nature and impact of electronic trading in financial
markets, examining how the global expansion of electronic trading has affected market
microstructure. Today, I will focus on another significant development: that is, the growing
influence of financial factors on commodity markets. In fact, my presentation this year is in
many ways a sequel to the one last year, not only because both presentations aim to shed
light on financial innovations in the various markets, but also because electronic trading is an
important issue per se in commodity markets. I will come back to this point later.
2. High and volatile commodity prices
Commodity prices have been fluctuating considerably both in terms of speed and amplitude.
A surge in commodity prices until 2008 was followed by a sharp downfall in the midst of the
financial crisis. Prices rose again from early 2009 to levels comparable to the peaks reached
in 2008, though they had again declined until recently (figure 1).
These see-saw developments pose a serious challenge to policymakers when dealing with,
for example, inflationary pressures. Consequently, intensive research has been conducted to
discern the main drivers behind these price developments. At this juncture, three factors
have been identified as important.
The first, and the most fundamental driver, has been the tightening of demand and supply
conditions (figure 2). On the one hand, the rapid growth of the global economy, notably in
emerging economies, has been a major factor behind strong commodity demand. On the
other hand, a long period of underinvestment, coupled with geopolitical and climate-related
shocks, has severely constrained supply growth. Consequently, as inventories and spare
capacity have declined, commodity markets have become increasingly vulnerable to various
shocks in both demand and supply. The tariffs, export restrictions and other ad-hoc
measures adopted by some countries may also have aggravated market imbalances.
The second factor driving these fluctuations in commodity prices is global monetary
conditions. Accommodative monetary conditions, especially in the aftermath of the global
financial crisis, seem to have contributed to the rise in commodity prices in various ways
(figure 3). In particular, monetary policy affects aggregate demand in general, which in turn
influences the demand for commodities.
On top of these two factors, the third driver is what might be described as "financialization"
(figure 4). Partly influenced by globally accommodative monetary conditions, financial
investors have entered the commodity markets and changed market participants' behavior in
important ways, especially with respect to appetite for portfolio rebalancing and carry trades.
In fact, during the past several years, the rise in price levels and volatility in commodity
markets has coincided interestingly with the growing rate of participation of financial investors
in these markets.
3. Growing importance of financial investors
Investment in commodity-related financial products has increased considerably both in
quantity and scope in recent years. The estimated market value of commodity-related assets
under management reached almost 450 billion USD by mid-2011, from only 260 billion USD
in mid-2008.
Both instruments and players have diversified considerably. In addition to the traditional
commodity investors, such as commodity trading advisors (CTAs) and
commodityspecialized hedge funds, index investors and ETF sponsors have become prominent players.
Moreover, we now observe very active participation of various hedge funds, proprietary
trading desks of banks, broker-dealers and trading units of large non-financial enterprises.
Accordingly, investment and trading strategies have also become more diverse.
In particular, let me focus on the changing nature of index investment. It is true that a
significant proportion of investment is still tied to strategies which replicate major indices by
investing in the front end of the curve and passively rolling into the next contract each month.
However, some managers are adopting so-called "enhanced" index strategies, which may
entail positions on various parts of the curve or allow investments in subsets of
commodities.2
ETF sponsors have also diversified their investment strategies. ETF sponsors, especially in
the case of ETFs linked to the price of precious metals, typically take long positions in
commodity spot markets under so-called physical ETF schemes. However, we have seen the
emergence of synthetic ETFs, that is, ETFs backed by derivatives. Under synthetic ETF
schemes, ETF sponsors often engage in total return swaps or commodity futures to issue
ETFs linked to major indices. They also use other types of derivatives to issue complex
products such as short ETFs and leveraged ETFs, although their presence is still limited at
this stage.
Turning to other participants, hedge funds typically take both long and short positions for
arbitrage purposes or based on macro-economic views. CTAs trade in futures markets and
often employ technically-based trading strategies such as trend following strategies. More
recently, some CTAs have become increasingly involved in algorithmic and high-frequency
trading (HFT).
The growing participation of financial investors in commodity futures markets may also affect
spot markets. In particular, several leading commercial and investment banks have become
increasingly active in some physical markets, providing liquidity to their clients through
arbitrage between physical and financial markets.
There seems to be a variety of motives behind the growing investment in commodities. Some
investors view commodities as an effective tool in hedging against inflation. Institutional
investors with a long-term investment horizon have been attracted by the diversification
benefits for portfolio rebalancing and high convenience yields. Furthermore, some investors
consider commodity investments as a proxy for investment in rapidly growing emerging
market economies. Investable assets in these economies are still limited. Thus, in order to
gain exposure to these rapidly growing emerging market economies, some investors turn to
commodity investments correlated strongly with growth in these economies. Finally, for some
investors, arbitrage opportunities may have been the main motive for investing in
commodities.
4. Financial investors' impact on commodity markets
Greater participation by financial investors in commodity markets, which I have called
financialization, brings important economic benefits by providing liquidity to the market.
Enhanced market liquidity can reduce hedging costs for both producers and consumers.
However, there may be costs as well. The growing importance of financial investors suggests
that commodity prices may have become more sensitive to financial investors' decisions and
position-taking. This may lead to commodity prices deviating from values consistent with their
"fundamentals". Such deviation may occur, for example, when financial investors' liquidity
constraints outside commodity markets trigger substantial financial outflows, relative to the
size of the commodity markets themselves. A similar situation may arise when financial
investors' risk appetite swings wildly.3
A particularly delicate subject in this regard is the role of algorithmic and high-frequency
trading. Although still a matter of some debate, a general consensus seems to be emerging
in the equity markets that such trading techniques enhance the proper functioning of the
market in normal times by providing liquidity, but in contrast they tend to disappear suddenly
from the market and thus contribute to market disruption when sharp price movements occur
due to unexpected and unprecedented events. However, in commodity markets, the precise
role of algorithmic and high-frequency trading is yet to be determined.
To sum up, it is not easy to identify to what extent the growing presence of financial investors
has actually moved commodity prices away from "fundamentals". The current literature on
this point is inconclusive. Although there is consensus that the tightening in physical supply
and demand has been one of the main causes of large fluctuations in recent years, it is also
plausible that financial investments have affected price dynamics, at least over short time
horizons, as we have observed the same dynamics in other financial markets.
5. Toward resilient and well-functioning commodity markets
In view of what I have described so far with respect to recent developments in commodity
markets, let me now draw three policy implications relating to market functioning and macro
prudential policy.
To enhance transparency
First, the transparency of both physical-products and commodity-derivatives markets needs
to be enhanced.
As I mentioned earlier, the expansion of financial investor participation in commodity markets
can bring about benefits by reducing hedging costs for producers and consumers. At the
same time, trend following strategies, especially when they are combined with algorithmic
and high-frequency trading techniques, may move commodity prices away from values
consistent with "fundamentals" over short time horizons. This deviation may persist
depending on how quickly offsetting forces come into play. In this regard, it is important to
enhance the transparency of physical and futures commodity markets in order to improve the
market price discovery mechanism.
In this context, improving the quality and timeliness of information in physical-products and
commodity-derivatives markets is essential. Improving data availability on commodity market
transactions is also a precondition to understanding the microstructure of these markets.
To guard against financial vulnerability
Second, it is important to assess and bear in mind the potential financial vulnerability arising
from the increased exposure of financial investors.
The exposure of financial investors to commodity markets appears to remain relatively small
when compared to total assets under the management of institutional investors. However,
increased diversity and complexity of both financial instruments and players in the
commodity markets requires closer monitoring to assess their impact on the risk
management of financial institutions, and ultimately, on the overall development of financial
markets.
For example, the increased correlation between commodity derivatives markets and other
financial markets suggests a higher risk of spillover effects from one market to another. The
active involvement of several leading commercial and investment banks in physical
commodity markets may present challenges to the way they manage these risks and how
they incorporate them into their integrated risk management systems.
The increasing presence of algorithmic and high-frequency traders in the markets also
highlights the need to deepen our analysis of their impact on market stability and integrity.
Moreover, though their presence in commodity markets is as yet limited, increasingly
complicated products such as short ETFs and leveraged ETFs may also pose substantial
risks with respect to counterparty, liquidity, and collateral management when they become
popular.
To develop emerging economies' financial markets
Finally, I would like to highlight the urgent need to develop and expand financial markets in
rapidly growing economies.
As I mentioned earlier, commodity markets seem to be serving to some extent as a proxy for
investments in rapidly growing emerging market economies. This tendency may be stronger
when monetary conditions are globally accommodative and financial investors' appetite for
portfolio rebalancing and carry trades is growing. It would be helpful for financial stability to
broaden and deepen local bond and equity markets in those economies, thereby allowing
funds to be channeled more directly to investments, and hence reducing possible shocks to
commodity markets.
In addition, it is desirable that transparent and resilient commodity markets are developed in
Asia, where strong demand for commodities is being generated. Developing such markets
further would be beneficial for the area by enhancing the liquidity of commodities in the Asian
time zone, as well as by developing tradable markets for those commodities such as rice,
which are in great demand and produced in the region, but whose global market is yet to be
developed.
6. Concluding remarks
In my presentation today, I have highlighted recent developments in commodity markets and
the implications of these developments. As I have pointed out, the growing participation of
financial investors in commodity markets can bring important economic benefits by adding
liquidity to the market and thereby improving market functioning. However, the diversity and
complexity of financial instruments and players calls for closer monitoring of their impact on
the overall development of commodity markets as well as for an assessment of the potential
financial vulnerability arising from the increased exposure of financial investors. These
developments should be thoroughly and regularly analyzed.
In terms of the macro-prudential framework, the Bank of Japan will continue its efforts to
enhance the stability, efficiency and integrity of the financial system as a whole.
Thank you for your kind attention.