Commodity derivatives: the new currencies

Unable to otherwise explain today's high commodity prices, Frank Veneroso and others fear we are in a commodity bubble. Exhibit A is the recent vast increase in the use of commodity derivatives[*]:



Here's how Veneroso observes the unprecedented state of our commodity markets:

Though the six-fold increase in such positions over a few brief years is dramatic , it is the magnitude of these positions that is most alarming...It is hard to know what to make of this data. But it is noteworthy that several years ago, at the then prevailing lower commodity prices, the entire above ground stock of all commodity inventories was only in the hundreds of billions of dollars. Even if only a fraction of the increase in global commodity derivative aggregates in recent years corresponds to a net long position of investors or speculators, implying speculative and investment positions of a “few trillions of dollars,” it would appear that this increased demand for commodity derivative positions has overwhelmed what have been relatively small markets...

No wonder, then, that this cycle’s bull market in commodity prices has gone higher in inflation-adjusted terms [i.e. in terms of the CPI and PPI -- a poor near-term measure of inflation, see below] and for longer than in all prior uninterrupted half-decade cycles in the past.

I agree with Veneroso that the recent commodities boom has a strong causal link to the recent rise in the amount and variety of commodity derivatives. But I couldn't disagree with him more about the role of inflation. Prices, and especially wages, react very slowly to changes in money supply, so that the CPI and PPI are trailing indicators. The leading indicators are increases in money supply in excess to increased demand for money and the associated (if disproportionate) increases in commodity prices.

M3, an estimate of the supply of dollars (including a reconstructed estimate for recent years). M3 is increasing at the highest rate since the 1970s, as are to a lesser extent the supplies of euros and other major currencies, resulting in a commodity boom not seen since the 1970s. Source: nowandfutures.com

The recent vast increase in commodity derivatives, and the resulting commodity boom, is a largely rational response to the vast increase in the supply, relative to demand, for the dollar and to a lesser extent the euro and most other major currencies during most of the last decade. This despite the fact that commodities prices have in the last year risen (at about 40%/year) much faster than the growth of money supply (about 15%/yr). To see why, observe that one of the most useful but least talked about uses of derivatives is their ability to simulate the economic behavior (primarily risk and return) of one kind of asset based on contracts for another kind of asset or performed in another legal environment. The classic example is Eurodollars. But let's take a general scenario:

Alice wants to promise Bob to transfer asset X. But the risks associated with Bob holding asset X on his balance sheet, or Alice holding liability X on her balance sheet, until actual transfer of the asset, are too high, or the transaction costs of actually transfering X from Alice to Bob are too high, or both.

(1) Solution for risks of holding asset X on books: derivatives. Alice has both assets and liabilities on her books. These have individual and net risks just like an investment portfolio. If Alice has the same amount of assets and liabilities all denominated in the same currency, her portfolio is balanced. But if, for example, she imports from Europe (thus creating liabilities in euros) and sells in the U.S. (creating assets in dollars), her portfolio becomes strongly subject to risk of dollar devaluation against the euro. If a new asset or liability creates such unbalanced risk, it can be hedged with derivatives.

(2) Solution for transaction cost of transferring asset X from Alice to Bob: use derivatives to create a synthetic asset. Construct from derivatives and asset Y a synthetic asset that economically behaves like asset X. These separate derivatives and asset Y that form the synthetic all can be transfered with low transaction costs, thus forming an asset economically equivalent to asset X but that, unlike X, can be transferred from Alice to Bob at low cost.

The reason these uses of derivatives are seldom talked about is that the main cause of problem (1) is the instability of government currencies that it is legally necessary (for a variety of reasons) for contracts to be denominated in. The cause of problem (2) is usually a legal barrier to a particular transaction -- a tax, exchange control, risk caused by regulation, or risk of confiscation in Bob's jurisdiction are four examples. People who route around the law tend to do so quietly, explaining their acts by euphemism, even if as here the new route is perfectly legal and is made necessary by deep flaws in the law or the way the law is executed.

There are often, in other words, huge discrepencies between the contract terms required or incentivized by law and the most economically efficient contract terms. Partly this is due to political stupidity, and partly to the inevitable profound imperfection of any body of rules.

(3) A third function of derivatives is simply as a store of value: a way to diversify or hedge inflation risk in an investment portfolio that otherwise contains either (a) debt denominated in a potentially inflating currency, (b) equity in companies with assets consisting mainly of debts denominated in a potentially inflating currency, or (c) both.

In performing functions (1) and (2), derivatives usually substitute for or augment currencies as a medium of exchange. For (3) they substitute for or augment the monetary function of a store of value. Most derivatives, in other words, perform largely monetary functions. They augment or substitute for a flawed method of payment or a flawed store of value.

Gold prices in dollars (and, not pictured here, the dollar prices of many other commonly traded commodities) roughly follow changes in the global monetary base of dollars. Source: nowandfutures.com

In a climate where one or more commonly used currencies are inflating (and by "inflation" I simply mean rise in money supply without concurrent rise in demand for that currency, not the CPI or any particular and usually trailing measure of inflation), derivatives, if they can be analyzed and traded at low cost, are very much in demand. Furthermore, if all of the currencies practically available for contractual payment terms are inflating, these derivatives will come to be increasingly based, not on currency-denominated debt, but on commodities, especially commodities for which supply and demand are relatively inelastic in the short and medium terms.

Why is it rational, rather than reflecting a bubble, for the recent rise in commodity prices to outpace the recent rise in money supply? The rise in commodity prices reflects the increase not just in supply of dollars per unit of commodity, but greatly increased demand for a commodity as money, i.e. for the monetary functions it serves either directly or indirectly via derivatives, on top of the relatively steady demand for consumption. As I have argued elsewhere, this increase is broad-based: all commodities that can be traded with low transaction costs on modern markets, and that exhibit short- and medium-term inelasticity of supply and consumption demand, are useful for and are being used as reserves for the new derivative currencies. Where computerized analysis lowers mental transaction costs, as with modern derivatives, it pays to diversify one's books, portfolios, and hedges among multiple currencies.

Of course, the traditional use of commodities futures and derivatives by commodity producers and consumers to hedge the assets and liabilities of the commodity sales and purchases inherent in their business continues. But these don't account for the vast majority of commodity derivatives use in recent years.

Before modern computers, networks, and software engineering, the cost of such derivatives was usually prohibitive. In the last period of monetary inflation and the resulting commodity boom, the 1970s, derivatives were available to few and only the very simplest hedges or synthetic assets could be understood, and even then very imperfectly. Today derivatives, and their use in very complex hedges and synthetic assets, are much better understood by most of their users, thanks to computerized game tree analysis, and are available to many. They can be designed, simulated, and traded electronically with very low transaction costs. Computerized derivatives are smart contracts that lower mental transaction costs. So much so, that they've created a vast new world of contractual relationships completely impossible with the brain alone.

Speaking perhaps a bit metaphorically, we are witnessing the rise of new and privately issued fractional reserve currencies. They need not and effectively cannot legally be called "money" by their "issuers", nor can they effectively be used directly in most contracts for payments. But they can be used indirectly to hedge payment terms or investments denominated in flawed, that is in inflating or otherwise unstable, government currencies in which normal contracts and instruments are generally denominated. The results are synthetic "currencies" that, in their economic behavior, may be almost indistinguishable from a tradtional commodity-backed and privately issued fractional reserve currency.

No wonder the Federal Reserve and other central banks are moving hard to usurp jurisdiction over derivatives (per, for example, the recently announced Paulsen plan here in the U.S. to consolidate a variety of financial regulation under the Federal Reserve). To effectively regulate derivatives, for better or worse, the Fed will have to understand them first. But they do not have this knowledge. Indeed no human brain holds this knowledge. The knowledge needed to understand the dizzying variety of derivatives exists mainly in the form of computer simulations.

Derivatives, the money of the digital era, perform monetary functions in competition with the Federal Reserve's dollars, an increasingly primitive holdover of the paper era. By regulating derivatives the Federal Reserve regulates its competition. This creates a profound conflict of interest. It's like putting Rust Belt executives in charge of Silicon Valley. Such regulation may cause, not the popping of a commodity bubble, but the destruction of a nascent economic order made necessary by the prediliction of the Federal Reserve and other central banks to inflate their fiat currencies. Whether ignorance or conflict of interest will play the greater role in the destruction of the new currencies, or whether one will cancel the other out leaving the derivatives markets in relative freedom, remains to be seen.

[Obligatory Wikipedia links: Eurodollars, elasticity]

[H/T: I learned of Venero's paper from Byrne Hobart]

[Here's a prior explanation of mine giving a broader overview of why commodity prices reflect demand for their monetary functions as well as for their consumption, but not explaining the role of derivatives].

[*] These numbers are a bit stale -- it would be great to see to what extent this growth has continued. If any reader has data on commodity derivative use through 2007, please let me know.

[UPDATE: here is more straightforward article that gets the basic facts right: production up, inventories up, consumption down, prices up -- inexplicable if consumption is the only major source of demand -- but gets the explanation wrong, replacing the rational and efficient use of commodity derivatives as money that I have described here with the typical speculations about "speculation" resulting in a "bubble"].

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