Disruptions in Disruptions in Financial Financial MarketsMarkets

A critical analysis of A critical analysis of speculationspeculation

““It is generally agreed that It is generally agreed that casinos should, in the public casinos should, in the public interest, be inaccessible and interest, be inaccessible and

expensive. And perhaps the same is expensive. And perhaps the same is true of stock exchanges.”true of stock exchanges.”

- John Maynard Keynes- John Maynard Keynes

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1. Market behaviour1. Market behaviour

The client’s behaviourThe client’s behaviour

The market-maker’s The market-maker’s behaviourbehaviour

The arbitrageur’s The arbitrageur’s behaviourbehaviour

The speculator’s behaviourThe speculator’s behaviour

« For example, if I'm long one thousand S&P « For example, if I'm long one thousand S&P contracts and it's 11:30 Chicago time, I'm contracts and it's 11:30 Chicago time, I'm probably going to want to put in some sort of probably going to want to put in some sort of scale-down buy orders, like buying ten lots scale-down buy orders, like buying ten lots every tick down, to hold the market in my every tick down, to hold the market in my direction. It doesn't cost me that many direction. It doesn't cost me that many contracts at that time of day to support the contracts at that time of day to support the market, because there are not a lot of market, because there are not a lot of contracts trading. The longer you can keep the contracts trading. The longer you can keep the market up, the better off you're going to be. »market up, the better off you're going to be. »

Monroe Trout in Monroe Trout in The New Market Wizards: Conversations with The New Market Wizards: Conversations with America's Top Traders, by America's Top Traders, by Jack D. SchwagerJack D. Schwager

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2. Defining 2. Defining speculationspeculation

CFTC (Commodity Futures Trading CFTC (Commodity Futures Trading Commission): « a trader who does not Commission): « a trader who does not hedge, but who trades with the hedge, but who trades with the objective of achieving profits through objective of achieving profits through the successful anticipation of price the successful anticipation of price movements. »movements. »

Speculation is a directional bet Speculation is a directional bet engaged to profit from fluctuations in engaged to profit from fluctuations in the market value of a tradable goodthe market value of a tradable good

Lord Adair Turner (former head of the Lord Adair Turner (former head of the FSA) regards it as entirely socially FSA) regards it as entirely socially useless as a financial activityuseless as a financial activity

The successful campaign to allow The successful campaign to allow speculation (1850-1890):speculation (1850-1890):

The articles of law that prohibited The articles of law that prohibited speculation in France were speculation in France were repealed or repealed or amended by the Government of Jules Ferry amended by the Government of Jules Ferry in 1885, the same year he launched the in 1885, the same year he launched the French colonial empire.French colonial empire.

Article 421 of the Criminal Code stated Article 421 of the Criminal Code stated that: that: “Wagers made on the rise or drop “Wagers made on the rise or drop of securities are liable of penalties of securities are liable of penalties listed under a. 419”listed under a. 419”

Article 1965 of the Civil code stated Article 1965 of the Civil code stated that: that: « The law provides no remedy « The law provides no remedy against a gambling debt or for the against a gambling debt or for the payment of a wager ».payment of a wager ».

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3. The various speculative 3. The various speculative practicespractices

Short sellingShort selling

Credit Default Swaps Credit Default Swaps (CDS)(CDS)

Carry tradeCarry trade

High Frequency Trading High Frequency Trading (HFT)(HFT)

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4. Oil prices4. Oil prices

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« You have asked the question “Are « You have asked the question “Are Institutional Investors contributing to food Institutional Investors contributing to food and energy price inflation?” And my unequivocal and energy price inflation?” And my unequivocal answer is “YES.” In this testimony I will answer is “YES.” In this testimony I will explain that Institutional Investors are one explain that Institutional Investors are one of, if not the primary, factors affecting of, if not the primary, factors affecting commodities prices today. Clearly, there are commodities prices today. Clearly, there are many factors that contribute to price many factors that contribute to price determination in the commodities markets; I am determination in the commodities markets; I am here to expose a fast-growing yet virtually here to expose a fast-growing yet virtually unnoticed factor, and one that presents a unnoticed factor, and one that presents a problem that can be expediently corrected problem that can be expediently corrected through legislative policy action. »through legislative policy action. »

Michael W. Masters Managing Member / Portfolio Manager Masters Michael W. Masters Managing Member / Portfolio Manager Masters Capital Management, LLC - 20th May 2008Capital Management, LLC - 20th May 2008

« No one has been able to accurately and « No one has been able to accurately and consistently forecast oil prices, not oil consistently forecast oil prices, not oil companies, government, or people on Wall companies, government, or people on Wall Street. However, this lack of reliable oil Street. However, this lack of reliable oil price forecasting has created a vacuum that has price forecasting has created a vacuum that has been filled, in my view, by financial players been filled, in my view, by financial players with very short investment horizon, which with very short investment horizon, which significantly increased the price volatility. significantly increased the price volatility. Globalization of the financial market, ease of Globalization of the financial market, ease of trading, rapid movement of large sums of trading, rapid movement of large sums of capital, information overflow, and increased capital, information overflow, and increased global tension have created an ideal global tension have created an ideal environment for excessive speculation in the environment for excessive speculation in the world market. »world market. »

TESTIMONY OF FADEL GHEIT, MANAGING DIRECTOR AND SENIOR TESTIMONY OF FADEL GHEIT, MANAGING DIRECTOR AND SENIOR OIL ANALYST, OPPENHEIMER & CO.OIL ANALYST, OPPENHEIMER & CO.

COMMITTEE ON ENERGY AND NATURALCOMMITTEE ON ENERGY AND NATURALRESOURCES - 11th December 2007RESOURCES - 11th December 2007

« Oil price volatility has attracted a large « Oil price volatility has attracted a large and growing number of speculators seeking the and growing number of speculators seeking the highest profit in the shortest time. Vola- highest profit in the shortest time. Vola- tility, however, has an adverse impact on the tility, however, has an adverse impact on the oil industry because it increases uncertainty oil industry because it increases uncertainty and distorts market fundamentals, which could and distorts market fundamentals, which could result in poor investment decisions in securing result in poor investment decisions in securing adequate sup- ply to meet world growing demand adequate sup- ply to meet world growing demand for oil. »for oil. »

Fadel Gheit, ibidFadel Gheit, ibid

The measures proposed by Fadel Gheit to The measures proposed by Fadel Gheit to regulate oil trading by financial regulate oil trading by financial players:players:

setting limits on the number of oil setting limits on the number of oil contracts by each account; contracts by each account;

establishing a minimum holding period establishing a minimum holding period to hold these contracts; to hold these contracts;

preventing conflicts of interest by preventing conflicts of interest by financial institutions; financial institutions;

imposing stiff penalties on violators, imposing stiff penalties on violators, including minimum jail sentences.including minimum jail sentences.

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5. Futures markets5. Futures markets

Hedging to offset or reduce Hedging to offset or reduce the risk of price fluctuationsthe risk of price fluctuations

Exchange-traded versus Over-Exchange-traded versus Over-the-counter (OTC)the-counter (OTC)

Bypassing quotas of Bypassing quotas of speculators: the Swaps speculators: the Swaps loophole / Wolf in sheep’s loophole / Wolf in sheep’s clothingclothing

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6. Speculation and 6. Speculation and liquidityliquidity

Speculation is justified by Speculation is justified by the fact it provides the fact it provides "liquidity". What do we mean "liquidity". What do we mean by « liquidity" and does by « liquidity" and does speculation provide it?speculation provide it?

Protection against Protection against slippageslippage

The trend following strategyThe trend following strategy

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7. Speculation and 7. Speculation and priceprice

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1/ Participants in the 1/ Participants in the futures market for futures market for commoditiescommodities

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2/ Increased volumes and prices on 2/ Increased volumes and prices on futures markets for commodities.futures markets for commodities.

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3/ Crude oil prices on the futures 3/ Crude oil prices on the futures market and volume of swap positions on market and volume of swap positions on the commodity futures indexthe commodity futures index

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4/ Amount of investments in 4/ Amount of investments in commodity futures indexes commodity futures indexes superimposed on oil futures superimposed on oil futures prices.prices.

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8. Speculation and the 8. Speculation and the business worldbusiness world

« Investment in agricultural R&D « Investment in agricultural R&D was slashed: it grew at 2 per cent was slashed: it grew at 2 per cent per year through the 1980s, but per year through the 1980s, but since 1990 has shrunk by 0.6 per since 1990 has shrunk by 0.6 per cent per year. {…} Another change cent per year. {…} Another change was that research was increasingly was that research was increasingly privatised. Companies prioritised privatised. Companies prioritised research that would boost profits, research that would boost profits, whether or not it improved yields. whether or not it improved yields. For example, they developed hybrid For example, they developed hybrid maize, but not wheat, because the maize, but not wheat, because the flowering mechanism of maize makes flowering mechanism of maize makes it easier for companies to exert it easier for companies to exert patent control over its seeds.»patent control over its seeds.»

Debora MacKenzie, « What price more Debora MacKenzie, « What price more food » food »

New Scientist, June 2008New Scientist, June 2008