April 3, 2013

How Wall Street Gets Development Agencies to Push Emerging Economies into Derivatives

Why are development institutions so supportive of the derivatives industry? Given what we now know about derivative instruments and markets—they are complex, volatile, poorly regulated, crisis-prone, and dominated by very large financial firms—the alliance between prominent global development agencies like the World Bank and UNCTAD and the derivatives industry gives real reason for concern. In fact, this appears to be yet another instance in which the interests of the development establishment seem grossly misaligned relative to the goals of the constituencies they purport serve.

As I detail in my recent book on the topic, the governments of commodity dependent economies, agricultural firms involved in commodity trading and processing, and even small farmers have been targeted by these two institutions as actors who stand to benefit from more derivatives trading and the expansion of derivative markets across the developing world. The basic argument is that the welfare of these actors depends critically on prices in global commodities markets. By using derivatives to manage the risk of price fluctuation, tax and export revenues, business revenues and personal incomes could be stabilized and even raised in some cases.

To this end, UNCTAD has been recommending the establishment of local commodity exchanges in a variety of developing countries, exchanges that can both facilitate spot exchanges as well as provide opportunities for forward contracting, and futures and options trading. Similarly, though with a slightly different orientation, the World Bank has been recommending that various developing country parties (public and private) trade on global derivatives exchanges (located mostly in the West) in order to mitigate price risk.

Despite the fact that UNCTAD pictures itself as an “honest broker”, merely “informing those active in the commodity sector of the new possibilities open to them, assisting in the evaluation of the benefits of new tools and the implications of their use”, the evidence suggests that UNCTAD and the World Bank have positioned themselves both as friends of and marketing tools for the derivatives industry itself. In at least three contexts—employment crossovers, programmatic cooperation, and joint research and promotion—the uncomfortable closeness of the development establishment and the derivatives industry is apparent, leading me to question the impartiality of the derivatives policy recommendations issued.

First, there are several cases of employment crossover between prominent global development institutions and the derivatives industry. This means that the people recommending derivatives for development have subsequently reaped personal financial and professional benefits from the implementation of such projects on the ground, creating a clear conflict of interest. In one case, UNCTAD’s Chief of Finance and Risk Management in the Commodities Division was hired on as a top manager of India’s MultiCommodity Exchange (MCX). In another case, a senior economist at the World Bank and former commodities expert with UNCTAD was subsequently hired on as the CEO of the Ethiopian Commodity Exchange.

Second, there are a growing number of instances of cooperation between the development establishment and specific financial firms, for the purposes of marketing derivatives to developing country actors. For example, in 2011 the World Bank announced a new program to be undertaken in conjunction with JP Morgan. The program intends to “improve access to hedging instruments to shield consumers and producers of agricultural commodities from price volatility” by extending lines of credit along with derivatives expertise to potential hedgers in the developing world (consumers and producers alike). JP Morgan is matching the credit extended to these prospective traders by the World Bank’s IFC: “In the debut facility with J.P. Morgan, IFC will commit up to $200 million in credit exposure to clients that use specific price hedging products, while J.P. Morgan will take on at least an equal amount of exposure to them. Since the exposure associated with risk management operations is typically smaller than the principal amount of hedges made available to clients, these combined credit exposures should enable up to $4 billion in price protection to be arranged by J.P. Morgan for emerging markets agricultural producers and buyers.”

Not only do the derivatives and development industries share personnel and programmatic work, but they also sometimes jointly prepare the research and documentation that provides ideological and empirical support for increased derivatives usage in developing country agriculture. For example, UNCTAD collaborated with the Swiss Futures and Options Association (an industry advocacy and lobbying group) to produce a 2006 report that unequivocally recommends increased derivatives usage in the development context. I quote the report at length as it exposes the uncomfortably close, “friendly” relationship between UNCTAD and the derivatives industry, despite UNCTAD’s assertions of its “impartiality” on the matter of expanding commodity exchanges in the South:

As an international organization with considerable accumulated knowledge of commodity sector development, UNCTAD is ideally placed to overcome the trust gap that often still exists between the public and private sectors in developing countries and which hinders investments in trade-related institutions. An organization like UNCTAD brings a measure of impartiality to the discussion on the use of modern risk management and financing tools, and thus helps potential users of these tools to feel more comfortable about such use…There are many further opportunities out there which are yet to be realized and much poverty that could be alleviated if only decision-makers know how to utilize modern financial tools for managing commodity production and trade, particularly the commodity exchange. With the continued support of our stakeholders in government and friends in the industry, we will stand for a brighter future in this domain.

As I detail in my book, derivatives have at best an erratic record of success in mitigating price risk in the agricultural commodity context; in many cases, derivatives trading can augment risk. The tools are difficult and costly to use, and the markets are dominated by large financial institutions (exchanges, clearinghouses, brokers and speculators) whose interests are not necessarily aligned with those of developing country agricultural actors. Why, then, do development institutions continue to recommend them so brazenly and carelessly? Alliances and friendships between development institutions and the industry itself appear to partly explain this continued advocacy.

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