Good speculation vs bad speculation

Betsey Jensen, a family farm owner and instructor in farm management, has an opinion piece in the NYT today defending speculation:

My biggest worry is what the legislation will do to speculators in the market. These are the traders who buy and sell wheat or corn without taking physical control of the crops. Farmers love speculators when they are buyers, helping push prices higher, and we despise them when they are sellers, driving prices down. Regardless of their position in the market, I am well aware that the system would not function without them — there wouldn’t be enough liquidity, or money, in the market.

According to the trading commission, about one-third of the long positions in hard red spring wheat futures, which is what I trade on the Minneapolis Grain Exchange, are owned by speculators. If speculators were driven out of the market, it would be as if I’d lost a third of my customers.

Will speculators continue to provide market liquidity if the legislation ends up increasing margin requirements — the amount of cash an investor must deposit before buying futures — or restricting how much or how often they can trade? Changes like these could do a lot of damage to agricultural markets.

Contrast this traditional Chicago (referring as much to the pits as to the University) view of speculation with the current corporate view of the state of modern financial speculation.  The FT reports that a survey of “European companies that depend on raw materials markets” finds:

But the companies surveyed ranked financial hedging as the least effective way of managing volatile raw materials costs, believing instead that inventory management and flexible pricing systems were more valuable tools.

In other words even as small American farmers are defending speculation in financial markets in the New York Times, many of the biggest corporations trading commodities are giving up on the pricing provided by those markets.

I’m repeating myself, but here goes:

Speculation is good when the speculator trades with someone in the real economy and therefore bears real economic risk.  Speculation is bad when the market is dominated by speculators trading with each other and, as they become a tiny fraction of the contracts traded, contracts bearing real economic risk stop determining prices.  Futures markets are successful only if the amount and nature of speculation is careful monitored to ensure that “enterprise [does not become] the bubble on a whirlpool of speculation” and “the capital development of the country [does not become] a by-product of the activities of a casino.”

First rule of investing

The first rule of investing:  Once a trading strategy has become public knowledge, it will no longer be profitable.

This is in fact an immediate consequence of one of the weaker forms of the efficient markets hypothesis.  It is also enough of an empirical regularity that trading strategies constitute privileged information in the financial industry.

For this reason, I do not find this result surprising.

A final thought on wheat prices

I got into an extended discussion of the use of data in the social sciences over at Felix Salmon’s blog.  The underlying issue was the recent Senate report attributing price dislocations in the wheat market to long only index investors (aka excessive speculation).

dWj chimed in with a good summary:

The existence of the delivery oligopoly [in the wheat market] is necessary and nearly sufficient. That should be considered the primary cause of the failure here, even if it needed a trigger before the spreads got particularly wide in the last couple years. Making the futures cash-settled requires a way to determine the authoritative final settlement price; if it’s not too messy (in terms of performance risk) to dramatically expand the number of permitted deliverers, that would seem to me to be the sensible solution.

I think, however, that there are two important issues brought up by the Wheat Report:  first, what caused the huge divergence between cash and futures prices at expiration in 2008 and, second, is it possible for speculators to affect the spot price of a commodity.   dWj’s comment addresses the first issue — which may well require the existence of a delivery oligopoly.  On the other hand, I don’t see any reason that a delivery oligopoly is necessary for speculators to affect spot prices.

(I’m posting this comment here, because from an aesthetic point of view I think dWj’s comment is a fine conclusion to that thread.)