On not understanding futures markets

In fact, on getting entirely the wrong end of the stick altogether:

The message is unambiguous: those who are undertaking these trades are abusing the market. They have no intention of taking supply of sugar, or onward supplying it. They are simply price arbitraging for speculative gain. And that is both undermining the real market and increasing prices due to the application of excess liquidity to this activity.

Yes, there can be excess liquidity. And free markets can result in abuse and inappropriate outcomes.

That’s why regulation is such a good thing. It lets fair markets operate. And fair markets are what we need. Without them people will be priced out of food, and the consequences are all too obvious to require spelling out.

There\’s two major problems with this analysis.

The first is that the very purpose of futures and derivatives markets is to let the speculators in. We actually want people playing with their money, people who have no intention whatsoever of taking delivery of sugar (or any other commodity) or of onward supplying it.

For it is exactly these speculators who shoulder the risks of price volatility. Recall, if you would, what we\’re actually trying to achieve with a futures market. We want to take the risks of price volatility off the shoulders of the producers (in softs, usually the farmers) and also off the shoulders of the consumers (the bakers, weavers, chocolate makers etc, for wheat, cotton and cocoa respectively). We want farmers to know as they plant, even before they plant, their crops what they can get for them when harvested. We also want consumers to know what they\’re going to have to pay for next year\’s raw materials for t-shirts, Easter eggs.

This is the very purpose of the whole shebang.

So, what do we need in the middle there? Yup, that\’s right, we want people speulating, playing with their own money, risking it, to take the risks off those producers and consumers.

So to complain that there are speculators, that there are people \”price arbitraging for speculative gain\” is simply nonsensical fatuity. This is what the entire system is set up to facilitate, to allow, for this is the very purpose of it all: to transfer price risk from producers and consumers to speculators.

It\’s like complaining that restaurants serve food or sewage works deal with shit*: these are the things we\’ve built these systems to do.

Oh, and did you know that the sainted Keynes was an enthusiastic speculator in such markets?

The second is this very strange notion that \”excess liquidity\” in such markets leads to price rises.

It\’s not just that there\’s no evidence that this is so, it\’s that conceptually it\’s extraordinarily difficult to see how more money being speculated would lead to higher prices. For futures markets are, for the participants in them (ie, for the speculators, not the producers or consumers) zero sum games. For every person who takes a long position of a certain size (ie, bets on prices rising) there must, by definition, be another person or group of people who have taken an equal and opposite short position (ie, bets that prices will fall).

This is what derivatives markets do: pit one group of speculators against another. The market as a whole cannot be either long or short. It must, by definition, be neutral as to the future direction of prices.

Do note that this is not true of spot or physical markets, but is of futures and derivatives. But then Ritchie\’s (for of course it is he) railing against the futures and derivatives markets, not the spot or physical where people do indeed take delivery.

But do you know the best thing about this particular complaint? It is only those people taking physical delivery and then storing it who can possibly affect current spot prices. No, don\’t believe me, believe Professor Krugman, a recent, as you know, Nobel Laureate:

OK, how can speculation affect this picture? The answer is, it has to work through accumulation of inventories — physical inventories. If high futures prices induce increased storage, this reduces the quantity available to consumers, and it can raise the price. And you can, in fact, argue that something like this has been happening for cotton and copper, where there are apparently large and growing inventories.

But for food, it’s just not happening: stocks are low and falling.

My experience in these debates is that the response consists of a blizzard of statistics about the size of forward positions, etc.. But remember, every purchase of a futures contract is also a sale — there’s someone on the other side. And neither the purchase nor the sale changes the physical quantity of the commodity available to the market.

So if and when I see signs that speculation is really driving up prices, I’ll say so. But the signature just isn’t there right now.

Only those who do take delivery can influence current prices: those speculating without intending to do so cannot.

So, guess what, one of the country\’s leading tax accountants has got it wrong.


* Even the loudest cheerleader for futures markets such as myself will acknowledge that there is a similarity between such sewage works and such markets. The chunks tend to be larger in the markets.

9 thoughts on “On not understanding futures markets”

  1. Ritchie only got it wrong according to the old-style, outdated and largely irrelevant economics of yesterday.

    According to the brand new, improved and largely illogical New Economics of Today, all economic activity that doesn’t meet with Ritchie’s approval is unneeded and unneccessary.

    And just who are you gonna listen to? Some Ivy League Ph.d. who looks like a axe murderer, or Ritchie, who probably will end up being an axe murderer?

  2. Though some producers just do that and some speculators just do their thing, many producers speculate. I’ve just been writing some software to let agricultural producers manage consolidated risks of expected production, sales contracts and options and futures contracts.

    They want to do this because agricultural production is very sensitive to things like weather and “speculation” forms part of a management policy that keeps them in business, producing food. They can ‘bet’ on a bad harvest while directly profiting from a good one. Then, either way, they’re viable that year.

    People normally seem to talk about speculation at a remove from the actual producers, but that’s just uninformed. It helps people at the level of an individual farm to stay in business.

  3. (I mean Murphy’s stuff seems uninformed, not your commentary; he sees food production and speculation as being antagonistic when in fact they’re part of the same process)

  4. That’s not speculation, it’s hedging. [I mean in the normal senses of the word, but also in US regulatory terminology]

  5. Also I tend to agree with you, but I think you’re too certain. Lots of people who know the markets well disagree. The case for would go something like this

    There tends to be more long speculators than short. If a large amount of speculative money is flowing in, then there might not be enough shorts at a given price. So the price (futures) rises to get the shorts into the market. Now obviously in your model this means the futures price diverges from the spot price, as that can’t be affected by the futures. This creates an opportunity to buy physical and deliver into the shorts, but this takes time and increases the spot price.

  6. Matthew,

    None of that contradicts anything above.

    What you have discussed here is EXACTLY the mechanism by which speculators can bring forward a price rise: the long speculators believe that there isn’t going to be enough – or the price is going to be higher – in the future and they are betting on that now.

    The very act of doing so causes the spot price now to rise, thereby bringing forward the market price signals that it might be worthing planting more “x” and less “not x” for next season’s crop.

  7. It does contradict it. There isn’t any hoarding. Tim’s argument (which I have sympathy with) is that futures’ speculators can’t bring forward a price increase, only physical stock movements can.

  8. You are reckless when you talk of Keynes’
    active speculating ( and cruising) days.(Has anybody worked out that code in his diary yet?)
    Keynes was very keen on the anti-speculation buffer stocks: countries building up stocks of cheap oil ,grain etc during times of plenty and releasing them during times of dearth when the price goes up.What Europe actually needs now is grain mountains that the old guaranteed price mechanism provided.BTW guaranteed prices are essential:dairy farmers killed themselves after the the Milk Marketing Board fell to the laissez faire minstrels.The last people to decide prices are the big supermarkets:the classic” middlemen” the American farmers,Grangers and Populists warned about in the 1890’s.

  9. DBC Reed – building up stocks during times of plenty and releasing them during times of dearth when prices go up is exactly what speculators try to do. The ones that don’t get the attempt right go broke.

    What Europe actually needs now is grain mountains that the old guaranteed price mechanism provided.

    Okay, at a time of record spending on healthcare, an aging population, and massive debt levels, you think Europe needs more waste?

    BTW guaranteed prices are essential:dairy farmers killed themselves after the the Milk Marketing Board fell to the laissez faire minstrels.

    This shows the problem with government guaranteeing anything, eventually matters change and they have to change the guarantee, and the people who relied on it are shafted.

    The last people to decide prices are the big supermarkets:

    I don’t know what this means. Prices are set by the interplay of supply and demand. Saying that only one side of this sets the prices is like saying that only one blade of a set of scissors does the cutting.

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