Commodities trading is banking's new battleground

Forget bonuses. Don’t worry about bailouts. That’s all history. The battleground that matters most for the banking and finance industry right now is the profits it is making from commodities trading.

Over the last few days, prices have been bouncing all over the place, a reminder for everyone of just how unstable the market in food and raw materials has become.

Now there is a backlash building. The banks should take note of that. If they don’t, they could easily be driven out of this business - and they will only have themselves to blame.

Investors held a record $412bn of raw-material assets at the end of March, almost 50 percent more than a year earlier, according to estimates by Barclays Capital. Trading in futures and options contracts is rising rapidly. For banks and fund managers, it is a lucrative business. And the more volatile it is, the more profitable it gets.

Not everyone is happy about that. Last month, Barclays was targeted at its annual general meeting for its trading profits in food commodities. The World Development Movement, a London-based group, claims that Barclays may be making as much as £340m ($554m) a year from “food speculative activities.”

That may be exaggerated, but there will be plenty of sympathy for that view. French president Nicolas Sarkozy has blamed speculators for pushing up food prices. The European Union’s financial services commissioner, Michel Barnier, is even calling for limits on trading in commodities.

It would be easy to dismiss those protests as nothing more than the complaints of a few anti-business fringe groups and grandstanding politicians. Easy, but wrong. In reality, there is a serious issue here. Speculation in commodities isn’t like trading in financial instruments. People don’t eat Nestle SA shares. They don’t need Treasury bills to keep their factories running. The prices of those instruments can jump around like crazy without it affecting people’s lives.

But when the price of wheat or copper soars, it makes a big difference. Some people can’t afford to eat anymore because food is too expensive. Companies that used to be profitable start losing money and firing workers because the cost of their raw materials has risen so much. If they think the banks are to blame for that, they will be angry.

So what should the banks do? There four things they should try to maintain public legitimacy for this business.

First, explain that it isn’t speculation that drives prices higher in the long run. It is supply and demand. For every buyer of a futures contract there is a seller. So while prices may be more volatile, they don’t change the general direction of the market for long.

Two, shift the blame. It isn’t necessarily traders who are pushing up commodity prices. It is just as plausible that monetary policy by central banks is the culprit. Quantitative easing creates more money, and it has to show up somewhere. Private bankers shouldn’t take all the criticism when it may well be the government’s bankers who are guilty.

Three, explain that commodities are now an investment class of their own - and a pretty good one as well. Over the next decade, returns from equities may be restrained by heavy regulation, a legacy of the financial crisis. Bonds don’t look a much better bet: most major countries are struggling with sovereign debts and inflation, both of which are bad for bonds.

So it is better for ordinary people if their pension funds can invest in commodities as well - and they can only do that if banks make the instruments available. No one is going to know that unless you start telling them.

Finally, don’t overtrade. There is no point sticking to the line that all trading improves the efficiency of the market. We have seen too many examples over the last few years of complex derivative contracts making markets less stable. Take a look at what you are operating in and how - and pull back from the places where the market is getting too fevered. It will be better in the long run.

Commodities trading is a huge industry for the banks. But they need to get their arguments straight. If raw-material prices keep rising and the idea takes hold that the banks are to blame, sooner or later they will find they get regulated out of the industry. If that happens, it will be their own fault.

(Matthew Lynn is a Bloomberg News columnist and the author of “Bust,” a book on the Greek debt crisis. The opinions expressed are his own.)