The financial crisis has made it appear as though futures markets have been humming along famously and unproblematically until the past few years, when credit default swaps and esoteric derivatives made the otherwise functional system toxic. And this may be. But let’s not pretend that futures markets were always just hedging mechanisms with an added speculative benefit for entrepreneurial risk-takers. They’ve been primarily about speculation for some time.
A couple of interesting data points here. The first is a chart from EHnet (in a well-cited article:
As you can see, the total amount of produced grain trends upwards, but the amount of speculation trends exponentially. More data points would help, of course. But I can provide an educated guess that in the mid-1970s the modal speculator in futures was a rich, risk-taking individual; by the 1990s it was corporate and financial institutions; and in the 2000s it’s been financial firms big and small.
And why might rich folks have taken note of futures trading through the 1970s and into the 1980s? Taxes, baby.
There are numerous ways that uses of futures markets for tax avoidance purposes are practiced by people who have income from “unrelated sources,” such as real estate, stock transactions, etc. Brokerage houses and advisory services have promoted these tax avoidance ideas among high income persons. And such uses have been growing.
A common method is the “tax straddle” and its many variants. Essentially, these are spread positions in pairs of futures delivery contracts that fluctuate closely together – most commonly in pairs of delivery months for the same commodity – handled in such a way as to create paper losses in the current tax year, with offsetting gains deferred until the next tax year (and repeatable in the following tax year). Also, it enables short-term capital gains to be converted to long-term capital gains.
The precious metals futures markets have become rife with such transactions, as well as other types of tax avoidance maneuvers, but so have interest-rate futures markets and perhaps some agricultural commodity markets, like soybeans. All futures markets are subject to tax avoidance transactions and many have been used for that purpose by traders in such markets.
The Treasury estimates that in 1981, about $1.3 billion will have been lost by taxpayers’ use of futures markets to defer taxes and to convert tax obligations from ordinary income and short-term capital gains rates to long-term capital gains rates. The IRS has been challenging such taxpayer claims in the courts and believes it will win most cases but wants to plug the loopholes now through legislation (see “Statement of the Honorable John E. Chapoton, Assistant Secretary for Tax Policy Before the Committee on Ways and Means, House of Representatives,” U.S. Congress, House, 97 Cong. 1 sess., given 30 April 1981, unpublished transcript).
There seems to be general agreement that futures markets should not exist for tax avoidance purposes but there is apprehension in agricultural circles that the liquidity of agricultural commodity markets would suffer if the successful speculator in futures could no longer count on sheltering income from speculating in futures from high tax rates. They argue for exclusion from any modifications in the tax laws.
- pg. 301, fn 8 in Paul, Allen B. 1982. “The Past and Future of the Commodities Exchanges.” Agricultural History 56(1): 287-305.