Hail speculators; Leaders denounce them, but they make hedging possible

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Appeared in the Financial Post
The war on speculators is in high gear in both Europe and the United States, driven by ignorance and populist sentiment. French President Nicolas Sarkozy exemplifies the negative attitude toward speculators that is increasingly common. He has made numerous disparaging remarks, including accusing speculators in agricultural commodities of extortion and pillaging. Mr. Sarkozy has championed food security and curbing commodity price volatility as priorities of France's G20 presidency.

But while the strongest language on speculation may be coming from European leaders, the real damage to markets is happening in the United States, where the Commodities Futures Trading Commission (CFTC), the U.S. regulator of futures and options markets, finalized a rule imposing position limits in 28 commodities in agricultural, energy and metals.

Speculators play a vital role in financial markets by enhancing market completeness, liquidity and price discovery; they buy and sell securities, and take on the risk of future price fluctuations to gain a profit. Markets are complete when there is a buyer for every seller of risk. In liquid markets, participants can transact with a minimum effect on price. Price discovery is the determination of the price for a security through the interaction of supply and demand factors.

In the case of futures markets (financial contracts to buy/sell a good at a predetermined future date and price), the presence of speculators allows those who deal with physical commodities to hedge risks. For instance, a grain producer can acquire protection against the risk of fluctuating prices of its crops. The value to hedgers from speculators being active in the futures market include ensuring there are counterparties willing to take on their risk, and at good prices close to their fundamental values.

The new CFTC rule is intended to address excessive speculation by limiting the contracts that any single firm may hold other than for hedging purposes. The rule was passed 3-2 by the five CFTC commissioners, who voted along party lines, with the two Republican commissioners voting against the rule. The two commissioners who voted against the rule cited a lack of empirical evidence that the position limits are needed; they suggested the rule will make hedging more difficult and costly, and they had doubts that position limits will control volatility. According to Bloomberg, even one Democratic commissioner who voted in favour of the rule, on the basis that the Dodd-Frank Act directed the CFTC to impose these limits, described position limits as a sideshow, saying there is no proof of excessive speculation.

The rule also passed even though an Inter-agency Task Force on Commodity Markets, which the CFTC chairs, found that prices in commodity markets continue to reflect supply and demand fundamentals. In the case of oil markets, the task force examined the factors affecting the surge in crude oil prices between 2003 and 2008, and found that the activity of speculators did not result in systematic changes in price over the period. The task force found most speculative traders typically alter their positions following price changes, suggesting that they are responding to new information, as one would expect in an efficiently operating market. The findings are consistent with other empirical literature on commodity markets, which show underlying market fundamentals are responsible for commodity price effects.

Proof that regulatory curbs on speculative activity can be counterproductive can be found in the experience of recent short-selling bans on equities. A common practice by speculators, short selling is the sale of a financial security that the seller does not own with the intent of repurchasing the security later on to close the position. Shortsellers are betting that the price of a security will drop and will profit if this happens by buying the security back at a lower price.

Studies by both academics and the Federal Reserve Bank of New York on short-selling bans imposed in reaction to increased volatility in equity prices during the 2007-09 financial crisis found these bans largely failed to keep stock prices from dropping and instead had adverse impacts on liquidity and price discovery. Instinet, an electronic trading firm, came to similar conclusions in an analysis of the ban on short selling bank shares now in place in some European countries.

While the discussion at the G20 summit will likely be dominated by Europe's problems, Mr. Sarkozy might repeat his accusations that speculators are responsible for food riots in Africa, while ignoring the role that trade barriers and other government policies such as biofuels regulation play in agriculture commodity volatility and rising prices. Other G20 members with similarly misguided views toward speculation will likely join Mr. Sarkozy in pressing all G20 members to adopt policies harmful to financial markets. The better informed members of the G20 should respond to these proposals with four words: Three cheers for speculators.

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