Policy Documents

The Impact of Index and Swap Funds on Commodity Futures Markets

Scott H. Irwin and Dwight R. Sanders –
January 1, 2010

The report was prepared for the OECD by Professors Scott Irwin and Dwight Sanders. It represents a preliminary study which aims to clarify the role of index and swap funds in agricultural and energy commodity futures markets. The full report including the econometric analysis is available in the Annex to this report. 

While the increased participation of index fund investments in commodity markets represents a significant structural change, this has not generated increased price volatility, implied or realised, in agricultural futures markets. Based on new data and empirical analysis, the study finds that index funds did not cause a bubble in commodity futures prices. There is no statistically significant relationship indicating that changes in index and swap fund positions have increased market volatility. The evidence presented here is strongest for the agricultural futures markets because the data on index trader positions are measured with reasonable accuracy. The evidence is not as strong in the two energy markets studied here because of considerable uncertainty about the degree to which the available data actually reflect index trader positions in these markets. 

An unexpected finding was a negative relationship between index and swap fund positions and market volatility. That is, there is some evidence that increases in index trader positions are followed by lower market volatility. This result must be interpreted with considerable caution. The possibility still exists that trader positions are correlated with some third variable that is actually causing market volatility to decline. Nonetheless, this finding is contrary to popular notions about the market impact of index funds, but is not so surprising in light of the traditional problem in commodity futures markets of the lack of sufficient liquidity to meet hedging needs and to transfer risk. 

The empirical evidence presented in this preliminary study does not appear at present to warrant extensive changes in the regulation of index funds participation in agricultural commodity markets; any such changes require careful consideration so as to avoid unintended negative impacts. For example, limiting the participation of index fund investors could unintentionally deprive commodity futures markets of an important source of liquidity and risk-absorption capacity at times when both are in high demand. 

Lack of convergence between spot and futures prices in certain markets, however, does raise a number of issues about the functioning of these markets and possible role of index funds. Further research is needed to understand better these recent structural changes in futures marks and how they may impact on the dynamics of price formation. But at this time, the weight of evidence clearly suggests that increased index fund activity in 2006-08 did not cause a bubble in commodity futures prices.