In our Risk Management class, I relayed the story of Silver Thursday and the Hunt brothers, who attempted (and failed) to corner the market on silver. To quote Time magazine from the 1980s:
Hunt…developed a passion for silver. His bland understatement of the reason:
“Silver looked safer than overseas oil concessions, the way things were going. And precious metals were a good hedge against paper money.”
There were other factors: world demand for silver, spurred largely by its use in photographic materials, regularly exceeds new production from mines, and Hunt believed silver was greatly undervalued in relation to gold. Bunker and his brother Herbert bought in 1973 an astonishing 35 million oz. in futures contracts. Their buying drove prices up for a while, but when the brothers stopped their purchases, prices fell again. The Hunts lost an estimated $25 million to $50 million on paper. Undeterred, Bunker called for actual delivery of the metal, a rare occurrence in commodity markets, and just kept it. [link]
We all know the ending to the story – the Hunts declared bankruptcy in 1988 largely due to lawsuits that stemmed from the silver speculation.
Last year, the “speculation” theory reared its ugly head when oil prices spiked up in the summer. I blogged about it and while I still don’t think speculation “caused” last year’s spike, the issue is back again in the latest Economist. An article discusses the regulations against naked credit default swaps (naked CDSs are analogous to futures in that the CDS buyer does not own the underlying bond). But that’s not all, it then goes on to talk about futures speculation, and increased regulation on those exchanges:
CDSs are not the only members of the derivatives hall of shame. The CFTC, emboldened by bubbles in oil and gas prices to fight “excessive speculation”, this week wrapped up hearings that foreshadow position limits for futures traders in energy markets. Such limits would curb the number or value of contracts a trader could hold in a particular commodity and across relevant exchanges. A trader’s intent is hard to pin down, however. Index funds, for instance, do not hold commodities themselves but passively invest their clients’ money in energy derivatives to hedge against inflation. And their positions are in any case regularly dwarfed by those of supposedly genuine hedgers, says Kamal Naqvi of Credit Suisse. Market insiders reckon that firms such as Shell and Lufthansa routinely trade more than their commercial needs would justify. [link]
It’s impossible to get inside the head of a trader, and the article mentions the added function of liquidity that these trades provide. However, it doesn’t look like this is going to stop the regulators from regulating. The environment is ripe for excessive regulation. In the end, though, the question is whether people find ways to get around it. They most likely will, if there are profits to be made, and if there is a specific function to the trades (i.e., risk management). And if people can get around it, does it really make sense to crack down on them? Other than the political points that are to be gained from it, of course…