Ashima Goyal

Using tradeoffs in G20

ASHIMA GOYAL | Updated on November 16, 2012

If a policy benefits one set of countries but has negative spillovers for another set, it should be accompanied by other policies to moderate the spillovers.

The recent summit of Finance Ministers and Central Bank Governors of G20 nations at Mexico had something positive to offer on issues important to both advanced as well as emerging economies.

The communiqué emanating from the summit, held early this month, referred to the macroeconomic impact of excessive commodity price volatility on growth, which is relevant also in the context of India’s own struggles with runaway inflation and current account deficits.

Leaders at the summit, while reaffirming their commitment to improving transparency and functioning of commodity markets, also sought practical steps for implementation that G20 countries could take up in the next 2013 summit.

Volatilities in financial flows also found a mention, though progress on revamping regulations here has been slow, as the International Monetary Fund has admitted.

Can the required regulatory changes be pushed through? Well, they can, provided the various trade-offs, involving the advanced and emerging economies, are clearly articulated. If a policy benefits one set of countries but has negative spillovers for another set, it should be accompanied by other policies to moderate the spillovers.

The US, the UK and the Euro Zone today need variants of quantitative easing (QE) policies, given the persistent unemployment in their economies.

But QE creates negative spillovers for others, by unleashing global liquidity leading to volatile capital flows and pressure on global commodity prices. So, in order to moderate the effects of QE, other reforms that help reduce these spillovers could be fast-tracked.

One example here would be standardised position limits.


Imposing position limits is a normal regulatory response to prevent large traders — acting alone or in concert — from building up large positions in commodity markets to manipulate prices. When properly imposed, no single party (or set of parties) can influence prices, so that competitive markets are maintained.

Currently, most emerging economies, including India, do impose such limits. But the UK, which is a major global financial hub, does not, while the US is still debating it.

Our research shows that oil futures markets work well on the whole, but are subject to short-term bubbles that appropriate regulation can well address.

A peer group such as the G20 can certainly push for such regulations and their more uniform application.

There is no doubt that price discovery through futures markets can be useful for producers, as long as informed traders keep prices of the underlying commodities nearer to the fundamental determinants of their value.

But investor diversification into commodity futures has posed a major challenge in this case. The so-called financialisation of commodity markets got a huge boost following the US Commodity Futures Modernisation Act of 2000. It weakened position limits, among other deregulations.


Intermediaries such as banks and ‘swap dealers’ offer products that track commodity indices. Examples of these include exchange-traded funds (ETFs), which are traded in stock exchanges, and swaps that are largely over-the-counter (OTC) products.

Swaps were granted exemption from speculative position limits on the grounds that OTC dealers transact in order to hedge their own short exposures, after netting across their clients. But then, the clients themselves largely take ‘long-only’ positions, speculating on continuously rising price movements.

Commodity ETFs, moreover, have no real underlying exposure in the commodities concerned; there is no actual delivery, unlike in commodity exchanges. Since a contract is for a limited period, long positions are continuously rolled over.

Such positions, in turn, convey information to other investors with less information. Any short positions can then become risky, if large index or hedge funds are predominantly long. The consequent rise in margins also reduces normal commercial hedging, as it becomes costlier.

During the 2004-08 period, open interest in oil derivatives more than tripled and trader numbers doubled. The market distortions from such large trades are obvious.


When the US commodity futures and options market regulator eventually, in 2011, tightened position limits and reduced exemptions for swap dealers, industry associations took it to court, alleging that these had caused an estimated $100 billion loss to them.

They even argued the cost of hedging would now go up, with liquidity in the markets falling and increased paperwork in order to establish valid hedging. The Government, in short, should not tell the industry how to trade and the CFTC must first establish overall gains to the ecosystem, for example from improved financial stability, before applying the regulations.

The CFTC, on its part, responded that the mandate it had received from the Congress and the Dodd-Frank Act was sufficient for it to go ahead with its schedule of implementation; it was not in any way obliged to show concrete gains.

The criticism from outside the industry, however, was that the CFTC’s proposed reforms were too weak. This will be an intensely contested area over the next few years, as the court cases progress and the commodity markets regulator reviews the impact of its proposals.

The possibility of investors taking recourse to arbitrage across different regulatory regimes is an issue raised by those who oppose regulatory tightening.

The US, in this case, will lose from tightening its regulations if the UK does not tighten similarly. Since spot and futures markets around the world are tightly integrated, one region with lax standards would then attract volumes, and continue to destabilise markets.

Moreover, the fear of loss of business makes any country unwilling to tighten regulation on its own, and any institution reluctant to forsake risky strategies by itself. That only emphasises the necessity for convergence to common regulatory standards.

One reason why the CFTC has been able to progress even as much as it has is because of the International Organisation of Securities Commissions or IOSCO providing general regulatory guidelines, on prodding by G20.

This pressure from G20 must continue for more countries to come on board. Moderating the systemic impact of large investment banks is a major G20 reform agenda. Uniform position limits would contribute to this since large investment banks are the major swap dealers.

(The author is Professor of Economics, Indira Gandhi Institute of Development Research, Mumbai. >

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Published on November 16, 2012
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