Excessive Speculation Defined

The Commodity Exchange Act was passed in 1936. The legislation mandates that regulators prohibit “excessive speculation,” but never defines the term. In the current public debate about the role of speculation, there’s been some understandable unease as we all should feel discomfort at the thought of prohibiting any transactions in a free market system. It’s important to move towards a definition of “excessive speculation” if our policymakers are going to comply with existing law properly and if we are going to have functioning commodity markets.

It should be understood that “speculation” in the commodity world is a specific, technical term which has no ethical connotations. Speculation is simply those transactions entered into by entities with no legitimate commercial interest in the underlying commodity (or related commodity – e.g., an airline might legitimately hedge jet fuel costs with heating oil futures). The university endowment manager making a permanent allocation to a commodity index is just as much a “speculator” as the day trader trying to make a quick buck in pork bellies. In other words, if you’re not a bona fide hedger, by definition you’re a speculator.

The introduction of OTC commodity swap contracts puts a slight twist on this definition. Wall Street’s swap desks are essentially “pass through” entities — if a swap desk is offsetting risks underwritten to a legitimate hedger, then their futures positions should be viewed as hedge positions; conversely if they are offsetting risks to say, an indexed endowment or to a commodity ETF, these should be considered non-commercial, speculative positions. The swap industry has tried to argue that every position they take is a hedge for some contract they’ve written — to my thinking this is an intellectually dishonest argument; the key factor is the commodity exposure of the end client, not the intermediary.

So just when is speculation “excessive”? In theory, the price of futures and derivatives should be a reflection of physical market pricing. That is, the price of consumable, commercial goods should be set by the consumers and users of such commodities. This makes good economic sense for allocating resources. The activities of non-commercial futures and OTC derivatives market participants should not determine the pricing. The reality has always been more complex — traditional speculators have served to bridge the momentary lack of a match of commercial interests (i.e., buyers and sellers not coming together at the exact time), and in doing so, set a market price. Speculators have also served to push the boundaries, finding out where commercials will enter the market, thus performing a price discovery role. However, in each of these traditional roles, commercial interests are “in the drivers seat” and the prime, long-term actor in setting price.

A good definition of “excessive speculation” is the market condition where non-commercial interests set the price. This occurs when speculative interests dwarf commercial volume and crowd out commercial transactions at a given price. The textbook belief is that this can never happen on the assumption that commodity prices are extraneous to derivatives market activity, and that there is an infinite supply of capital on both side of the market. Under such a theoretical system, when long speculators push up the price above the “true” level, for example, an adequate number of shorts will come in to stabilize prices. This is clearly an idealized and inaccurate set of assumptions as there is no known “true” price, speculative capital is not infinite, nor is it now neutral (many new entrants, e.g., institutions indexing, have a long bias). In the real world, speculation can be excessive.

Many commodity markets today display symptoms of excessive speculation. The breakdown of the basis (relation between physical and futures prices) and lack of convergence (cash and futures prices aligned at time of delivery) in certain agricultural commodities, the unusually high correlation with financial assets, and the huge buildup in oil inventories all bear witness to prices being distorted by non-commercial interests. The Wall Street firms that have profited from promoting and facilitating this participation are steadfastly denying the obvious evidence — they know that the simple recognition of this excessive speculation would compel regulators to act.

The crafters of the Commodity Exchange Act were right to worry about excessive speculation. When commodity prices are distorted by speculators, we all bear the economic burden – prices set too low cause disruptive shortages, those set too high result in wasteful inventory buildup. Distorted prices can send the wrong signal to the Federal Reserve and to investors. Erratic basis and convergence can financially ruin commercial participants and render the markets commercially unusable. The United States built up a huge competitive advantage in credible commodity exchanges – all this could be lost, too.

There are few higher economic callings for our regulators than ensuring the integrity of our financial markets. The policymakers of 1936 understood the dangers in “excessive speculation.” The CFTC begins public hearings on rules designed to protect against just this danger today. Let’s hope they get it right.

Comments

[TinyTim:]

Good article on the basics and amazingly, the word liquidity never mentioned once.

I'm more concerned that the CFTC will try to do some "creative" rule making rather than the old standby of limiting position size. Also, they seem to be prone to shooting themselves in the foot by granting exemptions / exclusions to big players.

On the plus side, and inline with the latest 'saw it coming" buzz, the CFTC tried to regulate CDS's at the beginning, but was shot down.

Jul 14 03:01 PM

[Rayden:]

Jeff - another insightful post on the commodity index investing issue. I think our opinions are pretty much diametrically opposite on this one, though. I would say there is simply no such thing as "excessive" speculation: there is "stupid" speculation, which is pretty much guaranteed to lose money, such as buying oil at $150 last year. When people engage in "stupid" speculation of this type, they lose money, but as a result they invariably help either producers or consumers or both realize *better* prices; although not necessarily immediately. This is a good thing, and I believe markets and the economy would both be worse off if that wasn't there.

To elaborate: in oil, the period of prices >$100 resulted major new projects and hence in an expansion of supply, which, plus the overhang of stored oil, all but guarantees below-equilibrium consumer prices (roughly sub $60) for a long time. At the same time, producers can even now due to the ETF rolls sell long-dated futures at very attractive prices, over $80, and lock in significant profits (and again drive expanded supply and lower prompt prices in the future). I don't see the problem with any of this; it is all beneficial to the real economy, and the speculators on the losing side footed (and are footing) the bill for it. If the problem was the price volatility itself or the brief period of high prices that consumers experienced: that served a beneficial purpose as well, which is to suggest that much higher oil prices and/or genuine shortages are at least possible and people should engage in appropriate contingency planning and/or hedging as needed. Lastly, we now have the fringe benefit of stored oil which is an economic good of the "uncertainty reduction" type, rather than pure uneconomic overhead as you suggest.

In wheat, the situation is quite similar, except for the fact that wheat index speculators actually have to sell (directly or indirectly, through the people who front-run their rolls) into the physical market, and consequently a situation like producer prices of $6 vs consumer prices of $5 in wheat seem to be here to stay, at least as long as this type of speculation persists. Again, entirely a good thing to everyone involved except the speculators. I don't know enough yet to comment on the "basis breakdown" issue, but intuitively it seems to create an excellent arb opportunity for someone (hedger or otherwise).

Lastly: you say speculators serve "to bridge the momentary lack of a match of commercial interests". I would propose that the role of speculators is exponentially more important when they bridge over longer periods of time: if there were no speculators on the seconds to days time scale, all that would happen is a little bit of extra market friction such as wider bid/ask spreads; but if there were no speculators on the months to years time scale, there will be occasional massive shortages and gluts, with attendant wild price spikes. This is true because not everybody who needs to hedge actually participates in the markets (directly or via proxy), and also because bridging over long periods of time is simply not the commercials' forte (either because of capitalization, because of mental bias or other factors). Commodity index funds and ETFs are the best long-term bridgers; it's not a bug, it's a feature ;)

Jul 14 03:35 PM

[Rayden:]

One more comment: you wrote "swap desks are essentially “pass through” entities" - I certainly *agree*. That makes obvious sense. However, if swap desks are pass through, then why not ETFs?

Additionally, what argument can be made that position limits at all should apply to a passthrough entity itself? If a passthrough entity is transparent in terms of the hedging/speculative character of positions, it should be transparent in terms of position size as well. Ie, there should be no limits applicable to either swap dealers or ETFs in and of themselves, but there should be the normal limits applicable to the individual owners of swaps or ETF units, calculated proportionately. This makes sense particularly because of the most part, the discussed passthrough entities are also *passive*: ETFs particularly do not decide when to buy or sell futures, they just respond to unit creation and destruction.

Several exchange rulebooks I checked (CBOT, NYMEX) say in the section on position limits "no person shall own or control positions in excess of ...". It seems by person they mean natural person; in other places they actually say "person or entity", but not in the section on position limits.

Jul 14 04:17 PM