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Source link: http://archive.mises.org/5954/the-social-function-of-futures-markets/

The Social Function of Futures Markets

November 29, 2006 by

Forward and futures markets are yet another refinement in the growing complexity of a modern financial economy, writes Robert Murphy. By distilling the purely speculative aspect out of intertemporal transactions and placing this risk on those who want to bear it, forward and futures contracts foster a greater specialization in the division of labor. Even though the vast majority will never own such contracts, all consumers benefit from the more efficient allocation of resources and production decisions over time. FULL ARTICLE

{ 9 comments }

Person November 29, 2006 at 8:13 am

Great article in terms of summarizing futures, but …

As Ludwig von Mises argued, the very nature of action implies a higher valuation (other things equal) of a present satisfaction over the same satisfaction to be enjoyed at a future date. In short, people have positive time preference.

Er, didn’t you spend a huge section of your PhD thesis refuting this exact statement and showing the ceteris paribus clause to be meaningless? Like, here? I mean, I don’t expect you to go Howard Roark and all, but it seems you didn’t even need to make this statement for the rest of it to make sense.

David C November 29, 2006 at 10:18 am

Futures are only systemically stable in a non fiat monitary system. Otherwise it guarantees that the extra money sloshing arround the system will not be used for speculative purposes that are productive. In addition, when the fed came up and bailed out LTCM, it sent the message loud and clear that they will bail out your bad bets if those bets create a systemic risk. So now it has led to reckless speculation and risk that rational people would not normally take. Not even the fed can bail out multi trillion dollar derivatives disaster without causing all hell to break loose. With an estimated 300+ Trillion in contracts out there, I do not want to be around when it hits the fan.

M E Hoffer November 29, 2006 at 10:59 am

Where did this come from: “Even though the vast majority will never own such contracts…” ??

And, is it even true?

What are ‘insurance’ contracts, if not conditional forward sales agreements?

M E Hoffer November 29, 2006 at 11:07 am

David C illuminates a compelling point: “…it sent the message loud and clear that they will bail out your bad bets if those bets create a systemic risk. So now it has led to reckless speculation and risk that rational people would not normally take.”

This: “they(the FedRes) will bail out your bad bets if those bets create a systemic risk.”–has been occuring on a serial basis, mopping up ‘small spills’, over the previous, post-LTCM, interlude. It is one of the main reasons that the public reporting of M3 has gone ‘the way of the Dodo’.

Mike Linksvayer November 29, 2006 at 2:26 pm

About time to run another mises.org article on the social function of prediction markets (hint, hint). Many new developments since 2004.

GPayne November 30, 2006 at 9:37 am

I think the point about context of the fiat monetary system is essential and may change the textbook description of futures and forwards in this article.

Critically, futures (as opposed to forwards) can be settled in cash wihtout delivery so great volume can be added to futures markets without any requirement for posession of the underlying asset. This allows interested parties to sell massively what they don’t own to suppress futures prices, which can have an effect on spot prices as well.

I think this is going on with many commodities. Yes, they have risen a lot in the last several years, but I think with the US dollar monetary and financial system nearly out of control, that commodity prices would be much higher if they were not being kept down by fiat-supported futures selling.

It is true that fiat can support futures buying as well, but it is the selling that creates the open interest and the liquidity, and it is the controllers of the fiat system who have the most interest in keeping commodity prices down.

I’d love to hear Robert Murphy’s (or anyone else’s) comments on this because I’m not sure I’ve got it right but it’s been a growing suspicion of mine.

M E Hoffer November 30, 2006 at 11:08 am

I, too, would be in interested in Mr. Murphy’s view of the take/question proffered by GPayne.

GPayne,

You may want to further investigate:
http://clusty.com/search?v%3afile=viv_615%4029%3ap1O9EI&v%3aframe=list&v%3astate=%28root-0-30%29%7cN353&id=N353&action=list&#

+ the “Use of Gearing in Financial Markets”, in general.

You raise an interesting, and valuable, point re: “Social Function of Futures Markets”.

John Crowe December 13, 2006 at 10:38 am

As a person that has made my living on the floor of the various exchanges trading futures and options I would like to say that there is way to much thought going into those comments above. I realize that the futures and options markets have a reputation of being out of control and being little more than some kind of casino. The reality is that the vast majority of trades are made by people, groups and companies that are trying to take the risk out of doing their day to day business. Let me give an example. An airline needs to sell tickets that represent an obligation in the future. The problem is that they can not know what there cost of fuel will be in the future (fuel is obviously a major cost). By buying a futures contract on crude oil they can largely know what the cost of fuel will be. It is true that the cash (spot)price of fuel may be wildly different than the price they locked in but they have already sold services in the form of tickets that were based on the cost. By buying the futures contract they have taken risk out of their business. The seller of that contract is the group that supply the oil. An oil company has to make purchases and exploration commitments based upon what they think the price of oil might be when they finally get it out of the ground. If they can sell a futures contract that matches their production schedule they can know what price they are going to get. The oil company can thus make risk go away. The magical part is that these two different interest ( the airline and the oil company) both are greatly benefited by the transaction. Risk is canceled out of the system. This same type of example can be replayed for all of the derivative products that are out there. There is always a producer of a product and a consumer of a product and they have exactly offsetting risk profiles that are canceled with a futures contract. There is a whole army of traders like myself that carp around the edges keeping everything in line but the underlying customer and reason for the market is the guy that wants to get rid of risk.
In response to how fiat money affects the market I would say that it is the same as how it affects the price of everything else. If there is money expansion the price of assets goes up. I do not see how it affects these financial instruments in any other way. Even in the case of the contracts that are settled for cash the price of the underlying commodity is kept in line by traders like myself. I have made a living for over twenty years keeping them in line and it is my experience that there are very powerful, rational and efficient market forces that do keep them connected. The futures that are settled to cash are settled to real prices for real things. The idea that someone can artificially lower the price by continual selling does not match with my experience. On the contrary I have seen people try to push the market around and have had their heads handed back to them as the army of arbitragers put things back in line. I would argue that commodity prices are higher now because of monetary expansion (inflation) not lower due to some futures scheme.

GPayne December 15, 2006 at 9:24 am

John Crowe, you reiterate the basic case for futures and the offsetting of risk. This is appreciated but I think it sidesteps my argument.

I will expand the argument to derivatives in general since I don’t know the specific growth rates for futures markets only. The derivatives market now has notional values outstanding that are more than 5 times global GDP. How can this all simply be hedging by real buisnesses? Derivatives outstanding and trading volumes have grown 20% or greater annually for 20 years, while GDP grows in single digits? How can this reflect the growth of real hedging needs?

Something else is going on here. New money is flooding the system and most of the trading is financial not real economic hedging. Cash settlement is critical because derivative markets (and futures markets in particular for commodities) couldn’t sustain the kind of volumes they enjoy if they actually had to deal with the real product.

You say that futures markets respond to ‘real prices for real things’. I contend that ‘real prices’ (whatever that means in a fiat world) are influenced and can be manipulated by futures markets. Can you really deny there is market manipulation when central banks are created to control credit and central bankers even openly contemplate buying in asset markets? And central bankers (and their Wall Street allies) certainly have an interest in keeping commodity prices contained.

You say that money expansion makes the price of assets go up. That is very revealing. What about goods prices? Yes, it has been assets over the last 30 years, but do you think the day will never come where people look to realize the value of these assets, through consumption of goods and services? At that point you will see that inflation embedded in monetary growth eventually finds its way to inflation as it is conventially measured and not just to the portfolio balances of investors.

The effects of monetary and credit inflation
(of which derivatives is a critical component) are very complex and insidious. It is nowhere near as simple as you contend.

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