NEW YORK (TheStreet) -- Commodity derivatives were first introduced to help farmers manage the price risk related to their crops. I believe that helping end-users - specifically, companies who either produce or consume a physical commodity - manage their business risks should still be the driving force behind these markets. I am not sure that is still the case.
As the implementation of financial regulations such as Dodd-Frank and EMIR (European Market Infrastructure Regulation) continue to cause a reorganization of financial and commodity markets, there has been much talk of systemically important institutions, the need for increased regulatory oversight, and mandatory clearing for certain products. That is before we even consider the countless articles written on high frequency and algorithmic trading and whether it benefits or hurts markets. However, no-one has focused on the most important question: does the current market infrastructure actually serve an underlying economic purpose?
In answering this question, let me take each of the key players in turn.
Historically, banks facilitated business between companies by providing loans for capital projects or trade financing. These days they are heavily involved in trading both physical commodities and commodity derivatives. They tie trade finance and loan terms to a commitment to execute hedging transactions on a bilateral basis with the bank. This leads to hugely uncompetitive prices through wide bid / ask spreads and drives up the cost of food and refined fuels, among other things, for consumers. It also leaves banks with a large amount of counterparty credit risk on their balance sheets.
Moreover, there are significant issues surrounding potential conflicts of interest regarding hedging advice. If a bank is advising a corporate client on a hedging strategy and taking the other side of that trade (as opposed to just facilitating its execution or making a market), is the advice provided in the best interests of the bank's client or its own trading desk? As banks have become owners of physical assets in the commodity industry (refineries, oil tankers etc.) and traded increasingly for their own book, they have in many cases become competitors with the businesses they claim to impartially serve.
The CFTC (Commodity Futures Trading Commission) and the SEC (Securities and Exchange Commission) have oversight for financial and commodity markets and are responsible for ensuring they are fair, functionally robust ,and free from manipulation and abuse. It may surprise you to know that the CFTC is also responsible for ensuring economic utility.
Historically, the CFTC was not responsible for behavior outside of the regulated markets. This all changed after 2007 when the taxpayer had to bail out financial institutions that were close to failing as a result of, among other things, their unregulated over-the-counter trades. Regulators now designate products that must be 'mandatorily cleared', that is, novated to a central clearing house. There is no economic purpose here and no benefit to the end user; the sole reason is to allow regulators to collect more information on the overall level of risk in the system. This is not necessarily a bad thing, in and of itself. However, the byproduct of these regulatory changes is to increase, or in many cases add, significant compliance costs to businesses that are not financial companies and were never a threat to the financial system.