The rise of futures trading, part who knows what
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:
What happened between 1970 and 2002?
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.
Interesting, no?
In some ways the sudden rise in futures trading might resemble a diffusion model (from the periphery to the core). What’s interesting about the diffusion of futures is that it didn’t have the same positive, or at least benign, consequences that other kinds of diffusion (e.g., hybrid corn) processes have. Diffusion created some profound negative externalities.
might resemble a diffusion model
I agree maybe, but what do you think the ‘core’ is here, and why 90 years with little change then 30 years of massive speculation?
One hypothesis is that it’s about marketing by the exchanges, to go after wealthy clients as potential speculators.
A second hypothesis is that financials began in 1974 with currencies, 1975 for GNMA futures, then 1981 for interest rates. It could be that the agricultural futures got a second look from finance people once they were mobilized around financials. As in, ‘hey, we could do the same shit with grain as with DMarks’ – so the diffusion boomerangs back on the agriculturals with a new model derived from the financials.
And maybe it’s just like the hybrid corn processes, in that the massive negative externalities happen later, and are not obvious from the beginning. That certainly is one fear about hybrid corn et al. (even with the familiar dismissal as doomsayers, that).
“As in, ‘hey, we could do the same shit with grain as with DMarks’ – so the diffusion boomerangs back on the agriculturals with a new model derived from the financials.”
Definitely. When I learned futures trading formulas/modeling, the underlying doesn’t really matter much. It’s all expectations, volatility, and carrying cost, not fundamental differences in the actual underlining (even the way the term ‘underlying’ gets deployed betrays this).
Mike – what was interesting in open outcry trading was that knowing the commodity didn’t really make much difference. Traders sometimes traded commodities in which they had no expertise. But what was important was knowing the social norms of the pit in which you wanted to trade.
So you could trade interest rates, grains, securities futures all without much knowledge of the underlying. But not realizing that when you walked into the Nasdaq or SP500 pit people sometimes assigned trades to you without your knowledge, you could get screwed. Or not knowing who the players in the pit are, you could make money taking a position but not day trading.
This is maybe another version of local versus abstract risk. No local knowledge needed. All form, no content.