The forces of speculation

By Benedict De Meulemeester

By Benedict De Meulemeester on 22/06/2009

This week’s Economist states that not having enough derivatives in the world’s financial and commodity markets might be worse than having too much of them. It is true that the current economic crisis started with excess quantities of financial derivatives in the mortgage markets. It is true that this caused market participants to believe that any amount of risk could be hedged away. This inspired the greed that bred the disaster. This makes it easy for the public to come to the conclusion that the crisis was caused by ‘speculators’. Moreover, ‘speculators’ are, like ‘big corporations’, an easy scapegoat, as they are not very popular with the larger public anyway. But we shouldn’t forget that the credit crisis was caused by fundamentals. If Americans hadn’t been so desperately over-borrowed and if they had continued to pay off their mortgages, the crisis wouldn’t have happened, regardless of the amount of CDO’s or CDS’s that were circulating. The derivatives magnified the effects of the credit crisis and leveraged a local mortgage problem into a worldwide crisis. But they didn’t cause the crisis.

People that blame speculators for all that went wrong, seem to forget that they have been a huge victim of the credit crisis also. Their speculations in the commodity markets were aimed at prices going higher. With the credit crisis came a huge bearish market correction and most speculators lost a lot of money in it. This has stifled their appetite for risk. The result is that the risk premiums included in prices for derivatives have risen. Counterparty risk has also become an issue, now that it has become clear that even a large bank like Lehman Brothers can fail. Airline companies and industrial companies are confronted with refusals based on counter party risk to enter into fuel or currency derivatives. And those companies are not buying those derivatives because they want to speculate, they need them to hedge the business risk that they have to deal with.

We observed the effects of speculators withdrawing from the markets in electricity and natural gas markets also. To swap an oil-indexed gas price into a fixed price, constructions with oil forwards are necessary. We have observed that risk premiums in those fixed prices have risen. Moreover, we see that energy suppliers are more and more reluctant to take volume off-take risks when entering into such fixed price deals. Especially suppliers that use banks to make the swaps for them seem to be affected.

Speculation and hedging, they are two sides of the same story. Speculators provide the liquidity that is necessary to make markets with derivatives function. And if you want to hedge, you need such liquid derivatives markets. It is true that speculators turbo-power these markets. When prices rise, they rise more quickly as all the speculators jump on board. But as we have seen very clearly in the past ten months, the opposite is also true. When the market goes down , it goes down deeper as all the speculators sell off their positions. Speculators also curb the power of dominant market players. It becomes more difficult for e.g. dominant power producers to influence the wholesale power prices. So, we should be very careful with chasing those speculators away from the markets. Without them, hedging business risk will become a lot more difficult and expensive.

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