BY LAMON RUTTEN

Getting Familiar with Commodity Futures

From their inception, commodity futures markets have been accused of being gambling dens. Much of the reason why it took so long for governments to introduce regulations on futures trading was that for many policy makers, the difference between gambling and speculation (you can also call it futures trading or futures investment) was difficult to understand, and thus the debate on how to regulate gambling was confused with the debate on futures market regulation.

Already in 1890, in the US “House of Representatives a bill was introduced that would impose a prohibitive tax on people who sold agricultural products they did not own”^[1] – a bill that, had it been accepted, would have led to the immediate demise of the country’s futures exchanges. Those in favour of such repression of futures trade did not give up easily, however. Many bills were proposed in following years, with no less than twenty introduced in 1907 alone.^[2]

Futures exchanges themselves, from their early years, tried to combat gambling practices, and stressed the safe, rational and organized nature of their markets. Speculators on the exchanges helped make the agricultural market more efficient – they were like underwriters for taking on the risks of farmers, traders and buyers.

If traders could not lay off their risks to speculators, they would have to increase their margins, to the detriment of both producers and consumers – and Chicago Board of Trade could in fact show that after its start, traders’ margins had fallen sharply. As one trader remarked: speculators “are the people who carry the cash grain trade's risks and allow us to handle commodities on the few percentage points of profits as we do, instead of on the 30%-100% of gross profits which most businesses need.” ^[3]

Commodity Futures is NOT Gambling!

Gambling, in the view of the exchanges, was done outside, in so-called bucket shops, which had no public utility. Nowadays, bucket shops mostly take the form of unregulated online “exchanges”, but back in the 19th and most of the 20th century they tried to imitate legitimate brokerages – except that the trades that they accepted never entered into the futures exchange and thus, could not help any farmer or other industry actor to offset his risk. 

Ultimately, the exchanges succeeded in conveying their message to policy makers. In 1922, trading of grain futures outside of exchanges was banned – it was seen as gambling – while trading on exchanges became only mildly regulated. Policy makers looked to introduce “constructive” regulation, not “destructive or oppressive” rules. So, regulators had finally resolved for themselves the question on what was the difference between gambling and speculation – the former had no useful function, the latter did.  

More broadly, the following are the major key points that differentiate speculation on commodity futures markets from gambling:

Public utility

While gamblers create risk for the purpose of betting, speculators do not create new risks but rather, absorb existing risks from others in the market. Speculators thus fulfil a socially useful function, allowing others, who are less able or willing to take on risk, to lay off excess risk.

For example, after harvest, farmers want to be able to sell their goods at a fair price; but consumers are not able to buy all of the harvest and store it during the year. There is a significant price risk in storage (will one eventually be able to sell the produce at a profit), and without speculators to take on part of this price risk, farmers’ prices after harvest would be lower, and consumers’ prices later in the year higher. Speculation adds value, and eventually supports the growth of an economy.

Rationale

While gambling in markets is undertaken with the main aim of making an immediate gain/profit on price movements, speculation is undertaken with the aim of benefiting from perceived market inefficiencies – i.e., the speculator believes that the market prices are wrong, and that they will correct when others correctly analyze the market. 

This could concern absolute prices (e.g., the speculator believes that the futures price for crude oil does not take into account the expected cold winter – i.e., the price is too low), or price differentials (e.g., the speculator sees that palm oil prices have not increased as much as soybean prices, and believes that their normal price relation will come back soon).^[4] Also, participating in the act of gambling is doing so for entertainment or fun of it while an investor who speculates does so to improve his wealth.

Mode of functionality

Gambling involves a game of chance or luck with a lot of odds against the gambler or player to win (make profit). But while gambling is built on hope, speculation is built on education. It involves taking a calculated risk and conducting research before engaging in any financial investment. A speculator buys or sells assets when he believes the potential profit is worth the amount of risks.

Risk and returns

A speculator is ready to take a risk in expectation of moderate or higher returns in a usually short period, having at the back of his mind that he can lose (in fact, a good speculator knows that most of the time, he will actually be wrong in forecasting where the market will go. In contrast, a gambler is ready to risk his capital on a bet relying mainly on luck. Gambling therefore is for high risk takers, ready to lose their original investment. ^[5] The returns for speculating are proportionate to the risk while returns are not proportionate to risk for gamblers.

Foundation for making decisions

Foresight is the foundation for making speculation decisions. Speculation proper is based on scientific knowledge of business conditions, studying of an existing trend and proper forecasting. Speculators are by nature cautious. Gambling is totally a work of chance, undertaken blindly and ignorantly without much prior thinking. There is no objective knowledge of business conditions under gambling.^[6]

Legality

In recognition of the public benefits of speculation, in most jurisdictions, there is little or no legal restriction on speculation in foreign exchange and commodity futures markets. A trader/investor is free to speculate and invest in any exchange-traded commodity. Gambling on the other hand is restricted in most countries. It is true that this can lead people who otherwise would gamble on horse racing or in casinos to bring their gambling appetite to futures markets; thus, futures markets in countries where gambling is restricted do have a gambling element. But except in rare cases, this does not adversely affect the performance of futures markets. 

Conclusion

In conclusion, speculation is not gambling. It is a legitimate, socially useful activity that regulators should not attempt to ban, but rather, to promote – by helping make investors more aware of the portfolio benefits of speculating in futures markets, and by helping to make them more financially literate.

There is, of course, a fear among regulators that speculation can become excessive, which in practice applies to periods where speculators, as a group, become seized by irrational fears or hopes. To handle such eventualities, exchanges have price limits – they stop trading for a certain period when prices move excessively, giving the opportunity to speculators to cool down. But most of the time, speculation plays a healthy role, improving market liquidity and efficiency, and reducing trading costs.

References

1. Stuart Banner, Speculation: A History of the Fine Line Between Gambling and Investing, Oxford University Press, 2017.

2. Id

3. Virgil A. Wiese, Introduction to Hedging, in Ann Peck, Views from the Trade, Chicago Board of Trade, 1978.

4. Shared by Vaishnavi N. on http://www.businessmanagementideas.com/differences/difference-speculation-and-gambling-stock-exchange/12276

5. Shared by Sunil Sahdev (February 2018) on https://www.linkedin.com/pulse/investment-vs-speculation-gambling-sunil-sahdev

6. id (3)

(forex, trading, bursa berjangka, komoditi)