A recent article in the Economist explores the issue of commodity price benchmarks, those oft-quoted numbers that we take as gospel and, indeed, trillions of dollars of derivatives and contracts are priced against every year.
Numbers such as Dated Brent and Light Louisiana Sweet in the oil industry are matched by dozens of others in the metals markets. The Economist explains that rather than hard numbers, these are often the best estimation of price-reporting agencies (PRAs), businesses that make money by gathering market information and selling it to subscribers.
These are often not the standardized commodity contracts that trade transparently on busy exchanges such as Comex or the LME, exchanges that do not always cater to the many different specifications required by industry, the magazine explains. So PRAs, of which Platts is the largest, essentially estimate what the market price is based on information fed to them by buyers, sellers and brokers in the market.
For most people, most of the time, this seems to work well enough, but the point of the article is that the European Union fears such unregulated benchmarking is open to abuse and needs more oversight.
Not surprisingly, the PRAs are furious, the Economist says, claiming the putative regulations the EU is proposing will simply shift trading elsewhere, to New York or Dubai, possibly with Chinese and Russian benchmarks replacing European ones.
It is feared reporting in Europe will become impossible, as information will dry up. Buyers and sellers are under no obligation to discuss their trades. The new regulatory burden will simply encourage them to not release any information, as some already do. The PRAs may be right, but by the same token, the debate is highlighting the frailty of a system we have already seen can be gamed with abandon – think of the London banks’ manipulation of LIBOR, the London Interbank Offered Rate.
It doesn’t take a leap of faith to see traders feeding prices to the PRA at higher or lower than the true market level in order to influence a derivative or contract. Indeed, a number of traders or brokers on the wrong side of a short or long could collectively sway prices without even colluding as they respond to a collective desire for the price to rise or fall.
The Bottom Line
The reality is, as desirable as a transparent, well-regulated market price would be, it may not be possible without “killing the goose that lays the golden egg.”
The PRAs favor a more limited set of reforms advocated by the International Organization of Securities Commissions (IOSCO), a club for financial-market regulators that, while not as rigorous as what the EU is proposing, may still allow what most accept is a price discovery mechanism with flaws to still provide the benchmarks that the market just can’t do without.