At the Chicago Mercantile Exchange in the US large volumes of derivatives on food, metals and other commodities are traded on a daily basis. The exchange provides a platform for buyers and sellers of commodities to trade goods long before they are physically available on the market. Over the years speculators have become increasingly dominant in the commodity markets. These investors are channelling funds into commodities to profit from price fluctuations, but are not interested in trading the goods themselves. Price speculation, especially on basic goods like food, has come under increasing public attack. On the nature of speculation and judging its value.

A derivative is a financial instrument that tracks the value of an underlying commodity from which it derives its existence. The most popular instruments are futures and option contracts where buyers and sellers settle a price to be paid at a future date. Farmers and miners, and the counterparties they are selling to, have been using these contracts to hedge against the risks that come with price fluctuations. They allow a farmer or buyer to fix the price of harvest e.g. six months in advance. Derivative trading is a zero-sum game: one of the parties will lose with respect to the actual price (at the day when the goods are delivered), the other will gain by the same amount.

Speculators add liquidity to the market. As there are more actors in the market, it becomes easier for sellers and buyers to find a counterparty to deal with.* The larger investors, that bring volume to the market, will be consulting analysts to learn about a market or have a profound understanding of the market themselves. As such they do not take random buying or selling positions. But, they do bring a new dynamic to the market. Where a buyer and seller in the ‘physical’ market both have a need to trade goods, speculators are only interested in price differentials and close their contracts before expiry. This could lead to asymmetric trading, affecting prices.

To understand this, assume an extreme case where there are only speculators betting on higher prices. Investors would want to buy derivative contracts to that effect, but cannot find investors willing to sell these to them. As a result contracts sold in the ‘real’ market would rise in value as they are the only ones available. Furthermore, herd behaviour might take place where buying encourages buying by others and draws new money into the markets. Prices will inflate and stop reflecting market fundamentals. Also, capital is fluid and moves in and out quickly. When the ratio of speculative trading to physical trading is too high, markets are prone to excessive volatility.

So, to a certain extent speculators are facilitating the real exchange of goods, while too much speculation either tends to distort the proper functioning of the market or increases the risk of doing so. Along this line it would be logical to introduce a quote, based on the aforementioned ratio of speculative to physical trading, so that costs and benefits become more balanced. The problem, though, is to establish this ratio for each type of market. Would basic goods, such as food, be subject to a stricter quote than let’s say oil or gold? Or do we consider oil to be as basic as food? What authority will be able to decide, regulate and administer these markets, on a global scale?

In itself price speculation appears to be a good thing, benefiting buyers and sellers. However, there are downside risks that are hard to manage. It depends on one’s moral stance whether to (partially through a quote) ban speculation on basic goods like food and raw materials used in clothing. In the current sentiment, where popular support for laissez faire capitalism is waning, and where inequality is a global topic, the status quo would not survive a public debate. And this is probably a good thing: we should carefully treat that what we depend on most. Food, housing, clothing and protection. There remain plenty of other prices we can bet on.

* Note: trading in the market is done through a middle man, called market maker. The market maker is the actual counterparty of a seller or buyer. A market maker does not trade for his own account, so his books (derivatives sold and bought) should balance at the end of the day. When there is more liquidity in the market, the spread that the market maker earns, will decrease, benefiting both sellers and buyers.