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.