Commodity markets Summary

  • Last updated on November 10, 2022

The establishment of commodity markets allowed for efficient trading. As the United States grew, commodity trade and pricing drove the creation of standards for agricultural products, as well as transportation systems that could ensure their delivery. The development of futures contracts by the Chicago Board of Trade greatly facilitated agricultural development throughout the Midwest.

The purpose of modern commodity markets is to decrease the risk for the producers and consumers of commodities. Selling crops once they have been harvested often meant that the farmer had little choice but to accept the price offered the day the crops were brought to the market. Similarly, those needing the crops could not make good plans, as they were uncertain of the quality and quantity of crops being grown. Agriculture;commodity marketsThere were also uncertainties regarding the price that would need to be offered to obtain the crop. The same was true for other commodities. By creating exchanges where futures contracts, or their predecessors, were bought and sold, some of the risk was decreased. Farmers knew that they would get a predetermined price for their crops. Businesses needing those crops knew what their costs would be and the amounts of those crops that would be delivered at a set time. The one risk factor that could not be overcome was whether aparticular crop would fail. However, with the development of an effective market mechanism, it became possible to replace a crop from one source with the same commodity from another source.Commodity markets

History

The Chicago Board of Trade in session around 1900.

(Library of Congress)

There is evidence that agricultural commodity markets, with possible futures contracts, existed in the ancient Middle East. However, during much of the more recent history of Europe, agricultural and mineral commodities were sold as they were produced. This was generally at the site of production or where the commodities were needed. It was only with the urbanization of the population and the ability of farmers to produce large crop surpluses that regional centers of trade became the focus of commodity economic activity.

In the United States, during the nineteenth century, midwestern agricultural production increased to such an extent that regional trading centers in cities such as Chicago and Kansas City were needed. On the East Coast, large amounts of agricultural and mineral commodities were needed in the New York City area, so that commodity exchanges developed there as well. Although the majority of transactions in the nineteenth century involved commodities already produced, forward contracts started becoming more common. These guaranteed the delivery of a set amount of the commodity to a specific person on a specific date.

Over time, this type of contract tended to disappear at the large exchanges. It was replaced by a futures contract, which differs from a forward contract in that the commodity goes to a generic delivery point. Grain, pork, and cotton were the earliest commodities to have large numbers of futures contracts written. Other agricultural items were added for futures trading, as benefits became apparent. As the United States became more industrialized, trading in natural resources such as oil, copper, and gold became important in the twentieth century. In the first decade of the twenty-first century, trading in energy commodities, such as oil, has grown appreciably. As with many financial areas, markets in the United States handle a larger percentage of commodity trades than any other country in the world.

During the late nineteenth and early twentieth centuries, certain exchanges came to dominate trade in specific commodities, so that smaller exchanges began to disappear. For example, the reliability of the Chicago Board of Trade for the purchase of high-quality grain allowed it to become the principal market for this commodity. By the end of the 1920’s, three-fourths of all futures contracts were for grain. While the amount of grain traded on the exchanges has not decreased, the number of other futures contracts has increased to such an extent that the relative value of the grain contracts has decreased substantially. Estimates of the percentages for goods trading on global commodity exchanges in the twenty-first century (as measured in dollars) gives the breakdown as: energy, 75 percent; industrial metals, 7 percent; precious metals, 2 percent; agriculture, 13 percent; and livestock, 3 percent.

Various commodities were tried at some exchanges, but not always with success. Thus, the Chicago Mercantile Exchange, which was originally the Butter and Egg Exchange, added several other farm commodities. Some commodities experienced small demand, while others were in demand but primarily on other exchanges, and still others met stiff resistance. The latter category included onions, which were traded until onion producers forced the end to futures contracts on their crops. At one point after World War II, the Chicago Mercantile Exchange had shrunk so much it was principally an egg exchange, with dim prospects for the future. During the mid-1960’s, new members sought out new trading opportunities, which allowed the exchange to survive.

Trading Financial Instruments

In 1972, a subdivision of the Chicago Mercantile Exchange offered futures trading on foreign exchange rates, ending the reliance on trades solely based on physical resources. The development of this type of futures contract spread quickly to other exchanges. Areas such as interest rates and mortgages were added during the upcoming decade. Many see the culmination of this move being the trading of stock Futures tradingfutures that began in 1982. Early critics of this form of commodity charged that future trading on stocks increased the price swings for the underlying stocks. However, once established the trading of financial instruments, or derivatives, became a staple of most commodity exchanges. The importance of trading financial “commodities” has increased dramatically.

During most of history, items being bought and sold were present for the buyer to examine, to make certain they were of the type and quality that the seller claimed. Early commodity markets worked this way. With the development of futures contracts as the trade mechanism of choice, however, no items can be physically present to be examined, since they do not yet exist. What are bought and sold are electronic entries, formerly paper certificates, giving ownership of a preset amount of goods of a certain quality at a specific date in the future at a specific location.

Modern commodity markets work only because buyers have confidence that the exchanges (and government regulators) will enforce the contract in terms of the quality of the goods that will be delivered. Without this type of enforcement mechanism, modern commodity markets could not operate. At times in the past, the government attempted to limit participation in commodity trading to those who already had, or would have, goods to sell or those who could take delivery of the goods. However, from the 1960’s on, this type of regulation of the commodity markets gradually decreased, so that anyone with adequate financial resources was able to trade on the markets.

Individuals, often called speculators, can buy or sell commodity contracts even if they do not have any of the commodity or have any use for it. As long as they do not have an open contract to ship a commodity they do not have, or conversely, receive the commodity on the delivery date, any amount of buying or selling futures contracts is legal. This means that only a small percentage of the contracts sold on commodity exchanges actually result in the delivery of the commodity. Most contracts are canceled out by individuals purchasing the opposite type of contract prior to the delivery date of the commodity.

Regulation

Initially, commodity markets were regulated by the state in which they were located. Although the basic task of ensuring honest transactions was part of each state’s laws, different rules applied for each market. During the 1920’s, the federal government passed a law applying the same regulations to all agricultural markets. During the Great Depression, additional federal regulations were created. However, with the growing importance of natural resource markets and then the development of trading “commodities” based on financial instruments, such as currency exchange rates, the government realized that more regulation was needed.

In 1975, the Commodity Trading Futures CommissionCommodity Trading Futures Commission began operating to regulate all aspects of commodity exchanges. As with its predecessor, the CTFC is charged with making certain all exchanges operate so that the rules of the markets and all financial transactions are fair and honest. During the early twenty-first century, new “commodities” were being traded, such as financial instruments or the right to produce polluting emissions. The novelty of this type of market made regulating such trades difficult.

Further Reading
  • Baer, Julius B. Commodity Exchanges and Futures Trading: Principles and Operating Methods. Seattle: Baer Press, 2007. This text covers the history of commodity exchanges, how they work and some societal effects.
  • Bouchentouf, Amine. Commodities for Dummies. Indianapolis: Wiley, 2007. One of the numerous Dummies books, this one focuses on how commodity markets work and how they should be approached.
  • Fontanills, George A. Getting Started in Commodities. Indianapolis: Wiley, 2007. Seeking to give advice to investors, Fontanills begins with an overview of what commodities are and how the markets work.
  • Geman, Helyette, ed. Risk Management in Commodity Markets: From Shipping to Agriculturals and Energy. Indianapolis: Wiley, 2009. Dealing with a variety of commodity markets, this book examines the factors that affect trades.
  • Kline, Donna. Fundamentals of the Futures Market. New York: McGraw-Hill, 2001. Although written to guide investors in the futures market, this text also contains material on market history, definitions of terms, and regulatory agencies.

Agribusiness

Agriculture

U.S. Department of Agriculture

Banking

Bond industry

Farm subsidies

Mineral resources

Stock markets

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