Comment by dataflow
3 years ago
I get why farmers do it but what's the societal benefit of letting a rando like me buy and sell (i.e. make bets on) such contracts? Do farmers really prefer that random people do this?
3 years ago
I get why farmers do it but what's the societal benefit of letting a rando like me buy and sell (i.e. make bets on) such contracts? Do farmers really prefer that random people do this?
Theoretically, the societal benefit of lettings randos buy and sell contracts is that there is (a) better price discovery and (b) better liquidity. There are probably theoretical counterarguments to both of those points, but it's hard to see alternative systems that provide either or both those features.
At a basic level, obviously thee needs to be someone assuming the price risk from the farmers, and those people will obviously need to be compensated.
I buy that there's some benefit, but I don't buy that it's significant. And I don't see any reason why I should believe this provides a net benefit to society. Sure it saves the original parties some money, but then a bunch of unrelated parties come in and siphoning money from the existing parties. Why should I believe this is net-benefiting society?
Your viewpoint here is kinda weird?
The more something trades, the more likely we will have the right price. When things don't trade as much, we don't actually know what that thing is worth.
This concept is a benefit to society as many things are interconnected and correlated, so the more accurate we can quickly find the current price (and expected future price) the more we can evaluate value.
(Also, they aren't "siphoning money" really it's "value" because the contract isn't actually money)
2 replies →
If it "saves the original parties some money" than how is it "unrelated parties... siphoning money from the existing parties"?
But what's the negative to society? You seem really bothered about this and it's not clear why.
In general/basics/origins, farmers only want to sell futures, because they actually have (intend to have) the commodity for physical delivery, and do want to physically deliver it.
So who is on the buy-side? Exclusively supermarkets/distributors, while exclusively farmers sell? I suppose that could work, but I assume it would quickly regress into tight relationships like we have (probably regionally variable) for smaller market's, like most vegetables (vs grain) where as I understand it it's largely a direct relationship with the buyer - you probably still sell a future contract, but it's not via a central market and it is 'farm x will deliver to buyer y', i.e. a pre-order if you will, not really a commodity.
And as others say, price discovery, liquidity. What harm does completely open (no obligation) do? And maybe you eat a lot of potatoes and want to lock in the price today. (Or more seriously maybe you're a big baker, but not big enough to be buying direct from farm, your miller is. So grain price affects you, but ypu can't directly control/choose when to take it. Secondary grain futures allow you to hedge risk of it moving against you. In turn this means lower prices or lower risk of shock price increase to your consumers.)
Farmer agrees to sell an agricultural commodity to a grocer, for a price fixed now, with delivery after the harvest. Assume price falls a lot, and then the grocer goes bust. Ouch! Then the farmer must instead sell on the open market, at the lower price, and so becomes unable to make the payments on the mortgage on the tractor. Ouch ouch!
The farmer did want the price certainty that allows the risk of being more leveraged (tractor mortgage). But the farmer was not the optimal person to hold the credit risk of the grocer.
And the farmer might have sold without the intent to deliver. It might be that the delivery specification, or location, or whatever, isn’t perfect for the farmer. But if the farmer is confident that the prices will move together, then it still works.
It creates the market and should thus create the best possible price. Think of any speculation as a voting system with proof of stake.
Problems always appear when market participants try to affect reality to increase their odds, like shorting a position and then releasing some ugly news.
It's doubtful that farmers care about you in particular. However, in general, the societal benefit should be like a loan, like insurance, or both, depending on what it is.
Loans are useful and necessary because businesses need to buy things before they get paid. It can't all be done using Kickstarter! Farming works this way.
Insurance is useful because you get paid when something bad happens to you. On a day when you're glad that you had insurance, it means someone else lost a bet.
Buying insurance you don't actually need is kind of dumb because you'll lose on average, but people do sometimes win in casinos, too. Selling insurance when you can't afford to lose is risking disaster, but sometimes people get away with that too.
I don't follow. If the goal is insurance then why not just have... something more like insurance? Like when you buy insurance for your car or home? We don't let randos buy options on the average Joe's mortgage or car loan and claim it helps price discovery or liquidity, right? Or is it the case that even I can do that and I'm just out of the loop?
To answer your question directly, there are active markets where insurance policies are effectively "traded" like this (reinsurance and retrocession and the Lloyds market). A single policy with sufficient limits absolutely does get syndicated out and bought like this. For smaller policies they get bundled up. But they're professional markets where participants must be regulated because insurance regulation is how we mitigate counterparty credit risk on insurance policies.
But "like insurance" I think was meant as a broader term. Traditional insurance contracts look a bit like options. But forward purchases or sales are also often used as "insurance". The big gain is that purely cash settled contracts (or contracts where cash settlement is possible as a result of sufficient market liquidity existing to allow closing a position before physical settlement) can be used for risk mitigation in other ways which offer much better liquidity and better cost-efficiency in the right markets.
A good real world example is oil price hedging. An airline might want to mitigate the risk that their future cost of jet A-1 goes up. On the other hand, an oil producer might want to mitigate the risk that their future sale price of a particular blend of their crude goes down. Instead of using insurance or entering into bilateral forward contracts, both can trade futures or options on a standardised crude (which neither of them is ever planning to physically deliver or take delivery of[0]). The contract they are trading will not be a perfect hedge for either of them, but it will mitigate their risk significantly. In fact if they are both large enough, bilaterally the liquidity available to them would likely be insufficient to mitigate the same amount of risk.
Having a "single", transparent price also brings some other benefits beyond simple liquidity. For example, it enables several ways to manage counterparty credit risk which would otherwise be unavailable (daily margining, use of central counterparties or clearing, etc).
[0] although the contract might enable an oil producer to make physical delivery of their own blend with a price adjustment
I don't know, but one reason might be history. Modern insurance companies are pretty recent. Before the 1920's, there were mutual-aid societies. Commodities trading is ancient.
But they also do different things:
You need insurance companies for one-off risks. Someone has to go see the house and say, "yep, it burned down." Also, we don't let people bet on other people's houses burning down for good reason.
Other risks are more impersonal, like "what if this company I bought a bond from goes bankrupt" or "what if the price of corn drops in half" or "what if the price of oil doubles." There are lots of people and companies who might want to hedge against those, not just the owner of the property.
> I don't follow. If the goal is insurance then why not just have... something more like insurance?
Because this is more efficient and useful.
Society allows the people to trade futures, but makes it difficult. US brokers seem to make it very easy for “randos” to own equities, but difficult to trade futures. Recently, when I wanted to trade a one-by-one call spread on a commodity future (not saying which) via Interactive Brokers, the required initial margin would have been eight times my maximum possible loss. Bonkers! Hence trade not done.
And what would you rather happen? That you were prohibited?
As others have said, your counterparty won’t know who you are: hedge fund; commercial hedger; rando — unknown.
Provide liquidity. Speculators are trying to make profit, but their existence is important to make sure the farmers are correctly priced.
Do farmers prefer that? Yes, the larger the futures market, the price of selling futures will be closer to optimal. If the market is illiquid, farmers often have to sell futures at a lower prices to market makers.
Many 'randos' like you have lots of money and would happily buy the contract in the hope that they win out, and would be not bummed out completely if they lose, unlike the farmer, for whom such events could be existential.
They prefer a liquid market