Thursday, February 28, 2008

Are Commodity Specs Still "Useful"

Is speculation in commodities socially "useful"? Do classical economic arguments in favor of unfettered speculation retain their validity?

I have been ruminating upon these related questions questions for a while, composing several aborted missives over the past half-year, but I keep returning to it and would like to throw it out to the crowd for discussion. I know the classical arguments in favor - as utilitarian risk-transfer devices, as important market-signaling mechanisms, and hence re-direction of risk-capital for investment etc. But my fears linger, essentially wondering whether classical arguments may have significant and meaningful flaws in a modernity where behemoths now-dominate global resource exploitation; where the financial economy is bloated in relation to the real economy; where funds available for speculative activities pose structural hazards as they dwarf the size of the underlying market liquidity, or exchange-traded derivatives markets that often set the prices thereof; where such speculative flows are increasing employing the same techniques (momentum, trend-following etc.) thereby increasing position correlation amongst investors (and thus volatility) resulting in something resembling de facto collusion; where technology opens the Pandora's box for anyone and everyone to join the electronic herd in the [temporary?] stampede for this or that. What, for example, would be market-clearing price of wheat in a world where physical traders (i.e. real buyers and sellers) dominated?

I contemplate this as a long-standing on-the-record voice of the viewpoint that inflation is no simple chimera, that agricultural terms-of-trade have been secularly depressed and will recover; that poor global fiscal and monetary policies (particularly US, China & Japan, but increasingly EM and GCCs) cannot help to have consequences upon prices, so its not simply that prices are rising that raise the question. But to me, the question remains: should "we" be encouraging "it", by not only facilitating it, but institutionalizing it ? My gnawing suspicion is that the modern context poses challenges for classical market theory for even the US bond market and so US rates it would appear has been neutered by official flows of central bank reserve accumulation making traditional arguments in favor of the economic benefits of unfettered speculation suspect. This leaves second-order arguments such as "freedom" and "the right to speculate", or the argument that "the slippery slope" of intervention or regulation ultimately leads to an outright ban upon financial speculation which might engender worse outcomes than the volatile consequences of unfettered spec by nation-states, leveraged Hedge Fund wunderkinder and the agnostic but seemingly omnipresent systematic computer-driven CTAs.

At present these are but still-crudely-formed thoughts defining the camps at both poles, but I hope this will form the basis for a discussion of whether pure leveraged financial spec in commodities is parasitic, and if so, is it unduly detrimental to The Public's interest.


James said...

Nothing is going to change until something goes very very wrong. We're not there yet. And most likely it will be from a black swan.

vlade said...

I think the answer is "yes, but". IMNSHO, the "but" part is "slow trading". This is a term I invented (feel free to come up with better), and effectively means no intraday trading. The more volatile a market is, the more attractive it is to automated traders, which, in turn, make it more volatile, until something gives (=reality intervenes).
Basically, a lot of the trading is now playing a game with a sequence of random numbers, the more numbers, the better as for you to win the closer to 50% (from upside) you can be to win large.
From that perspective, slow, limited trading pits were actually more efficient as there was a delay in information processing which meant people weren't acting on spur-of-the-second (as opposed to spur-of-the-day). Doesn't mean you can't have crises, but it gives (and, in a way forces) you more time to think before acting.

Steve Waldman said...

Cassandra — I'll be a bit contrarian here, and suggest that in a certain sense, the problem is not overspeculation, but underspeculation. I agree with you about most of what's broken. But I don't think that speculation correctly names the culprit. I'm picking definitional nits, but if we get the names wrong, we're in danger of making poor choices when public outrage makes "reform" inevitable.

Speculators, as I see it, are those who purposefully take on economic risk based on conjectures about future relative values of assets (including cash). A true speculator makes her bets, expects the upside, and is capable of covering the downside if she is mistaken. By this definition, speculators are not our problem. We need more of them. This sort of speculator does all the good things traditional theory says — they force prices to efficient values and enable cost-effective hedging by those with natural risks they cannot bear.

Nearly all of the problems associated with "speculators" in financial markets come from two sources: risk-shifting and intramarket feedback loops. We don't get financial crises because speculators take losses. We get crises when leveraged "speculators" shift their losses to lenders. It's the hot mix of agency costs (including public guarantees, explicit and otherwise) and debt that turns "speculation" toxic. Intramarket feedback loops, e.g. speculative bubbles and panics, would naturally be less extreme without the leverage component, as any speculator might contribute to a price move, but levered specs gain increasing capacity to speculate as prices move with them, and vice versa, exaggerating (in nonlinear ways) the influence of their moves. Delevering markets wouldn't eliminate these dynamics, but would damp them dramatically, and in so doing would reduce the viability of herding and momentum strategies. Introduction of artificial short-term uncertainty in liquidity (transaction costs, timing, or both) could also fix a lot of the propensity of markets to feedback loops. Delevering markets would also reduce defaults, and the harmful, unpredictable cost and risk shifting that ensues.

I think true speculation by parties who internalize the consequence of poor decisions is a nearly unalloyed social good. It is "savers", those who want the upside from investing without making informational contributions to the allocation decision or bearing downside risk, who are the source of most of our problems. Life is risky, and the future is uncertain. Anytime anyone makes a claim on future goods and services (call it a bank deposit) is either bearing the risk that those goods and services won't materialize, or shifting the risk, forcing others to speculate sufficiently well to support the "savers'" future needs as well as their own. There are not enough genuine bearers of risk relative to claims of future resources. So when optimistic futures fail to materialize, like now, it's a game of hotpotato / shift the losses.

Byrne said...

I don't see how this huge level of speculation can be a real problem, in the sense of leading to incorrect prices: if speculators push prices in the wrong direction, people with access to speculative markets and productive capacity can arbitrage the profits: if oil is too high because of 'momentum', surely someone out there is shorting oil and drilling for it at the same time.

Byrne said...

Er. Arbitrage the prices, not the profits.

Mencius Moldbug said...

I think the question is actually pretty simple.

For any commodity, we can ask: is the current price, as set by speculative activity (how easy it is to forget that there's a short for every long), set at a level which increases stockpiles?

That is, is the quantity of real, physical wheat that really exists in the real world (a) going up, (b) going down, or (c) staying the same?

If the answer is (b) or (c), we know that speculation is normal. If the answer is (a), we continue.

(For some reason - I'm afraid I have been reading too much material from the wrong periods - the phrase "Jews and speculators" comes to mind. Or "speculators and Jews." Why is bread at three roubles a loaf? "Speculators and Jews.")

If the answer is (a), it means that wheat is actually being used as a substitute for money. In other words, under (a), we are seeing a flight to real values.

Is this "socially productive?" Probably not, because wheat is not actually a viable currency. So if wheat stockpiles go up, they must again come down, resulting in wild thrashage of the wheat price, the "burying the corpse" problem, etc, etc, etc.

The solution, of course, is to send some Cossacks for a chat with your speculators and Jews, and tell them what they should be buying instead of agricultural commodities. Or, if you actually want to end the flight into real values, um, stop printing money. I think it's called "austerity..."

Anonymous said...


Charles Butler said...

Looking, as we speak Cassandra, at a chart of the last 29 years of wheat futures prices, I'm struck by a couple of features. The most outstanding is the period's minimum of 232.5 in August of 2000. In second place is the first point on the chart - $461. Third, except for a very short period in 1996, wheat waited until June of 2007 to surpass 1980 high's. Without getting into things like changes in the percentage of caloric intake that is derived from stuff like grains and the percentage of income that that might represent, I have a hard time determining what is a fair price for wheat.

The rate at which, beginning in the mid-90's, wheat fields have been converted to olive groves around here might give a hint as to what side of that line landowners thought it was trading at. The above is notwithstanding the fairly hefty EU subsidy for grains and the fact that olives planted after 1998 were not eligible for assistance.

(None of this underestimating the potential of such matters to get the citizenry right pissed off).

Woops! Someone made eye contact.



I find your last paragraph a touch out of character. Or maybe its brevity does it no justice?

"Cassandra" said...

A couple fuurther thoughts:

(1) speculation in Gold, rare 1909 Honus Wagner cards or first editions of Marcuse or Mein Kampf, or matters not in the least in the king's realm, and is but a spectacle, sideshow, or indiviidual perversion, little different than the OJ Simpson trial or the late kneivel vault a few-too-many buses. This is not the stuff of life, and no one should be concerned with what oddities psychologically fascinate what individuals, often turning obsessions into financial folly.

(2) byrnes assumes perfection of markets arbitrage. To date, I've only seen one transaction as you suggest, and that was the Norwegians Norsk Hydro (or Statoil) buying a GoM producer and selling oil forward in a reasonably hedged accretive arb. BUT This is NOT risk free. IF oil goes to 300 quickly - more quickly than they can prroduce - their variation margin cuoldd bankrupt them as $10 oil bankrupted Metallgesellschaft. Quasi-state ownership gives them deep pockets, but few in private market could withstand such possibilites.

I am questioning precisely this perfection, hence, asking all to think for a moment: "What is the meaning and outcome for The Public's Interest in the event markets (as a result of call it purely leveraged financial specualtion), are, and remain deviant. This is ini the vein of the "limits to arbitrage" theses regarding why growth stocks overshoot - often for long periods. Now, misvaluation of a few growth stocks matters little to efficient allocation of resources so the batttle between diivergent feedback traders and value investors is - like the bearded lady, of little practical consequence. But leveraged feedback trading gone awry in markets that are the stuff of life MAY MIGHT POSSIBLY be another story.

Recall Kraft's manipulation of the Wisconsin chesse market whereby they sold and slammed the price of the thin future obaining less than the spot market - knowing they'd recoup losses many times over since their large off-exchange fowards and physical purchases are formulaically based on these prevailing "exhange market prices". Precsiely HOW imperfect markets are (and their impact) is meaningful, and wildly understudied.

(3) Vlade - it used to be market makers made markets rather simply for spread. too wide a market and you saw no flow. make too narrow a market and you lose money by being picked off too often by informed traders. Microstructure numerical gymnastics today IMHO, can be seen as sophisticated order-sniffers intent on front-running the flow - better business with postiive tails - than providing liquidity. Now, maybe you can do both (and indeed some smart and discerning people are), but IF flow-sniffing IS good business, and more people do it, and they do it across time frames, and there are limits to arbitrage for all the classical and practical reasons cited, and markets are imperfect in respect to participant size, it seems that this is a potential recipe for feedback-trading run amok, for each upward tick is self re-inforcing sucking in more leveraged specualtive capital. Physical and goods prices are thus set on the basis of ":wrong" prices (prices not prevailing in the absence of leveraged spec) and expectations begin to be erroneously shaped.

(4) Steve - your thoughts are most useful - for I agree with your sentiments. Real speculators (your risk takers) are, in fact, "investors" in my lexicon, and praised be they. Leverged feedback, momentum traders - whether systematic, programmatic or predatory - are mere amplifers and trend reinforces, adding more negative price volatility than positive price least that is my gut feel.

(5) I could be wrong, but I think Moldbug was being sarcastic about my characterization of leveraged specs for jews were always mentioned in the same old breath), rather than anti-semitic. In any case., as you know Moldy, Jews rarely do feedback trading or momentum investing. Jews are, by nature contrarian. Jews (and I'll slip into the "We" for it be my heritage) are convergent investors rather than divergent traders. Show me a Jewish CTA, and for every one I'll show you 10 value investors - far in excess of the market ratio.

But back to your point, Moldbug, "A' can mean lots of things, only one (I(and the less likely one IMHO) of which may be money substitute. For my gut feel says (in the example of wheat) that the Wheat contract is merely a venue for a game, and the game has struck the fancy of players, and that such players with excess capital, acumen, and prevailing size and structure of underlying market and composition of particiapnts, potentially have an edge in physical, technical and structural terms over the disagregated smalla-alot participant.

As for your final comment, again I think you parody my (in your eyes) bolshie sentiments, for as I suggest the command approach is a heavy hand indeed and indeed may pprovoke a solution worse than the problem. And at heart, I believe austerity IS a viable solution, certainly more in tune with my own financial Calvinist sentiments than either the rodeo or cossacks riding roughshod through markets.

(6) CB - I don't know the right price (for wheat is). As a recently minted large-scale industrial farmer, I am sellfishly pleased to wheat fly like Icarus, adn cotton break its 20 year range. That said, I am old an d wizened enough to know when a market is gripped by transient feverish flow - large MOC buys & sells, large fiished-for stops predatively triggered - and whatever that means, but when such activity is duplicated across multiple markets, I think its valid to ask the question (as I have): "Is This a "Good Thing" for womankkind...?

(sorry for all the typos - please forgive poor form for content!!)

OldVet said...

If only "Price Delta Wheat = Population Delta People." Or supply and demand for the physical commodity. All other price changes could then be ascribed to changing diets, a suitable speculation.

But with wild market speculation - frat boys running Dad's Mustang at top speed on a dark road - we have price inflation or price deflation of the commodity. Unless farmers learn to eat money, or banks learn to grow wheat, we have a problem.

As pointed out by smarter folk here, the problem isn't investing in the future of production or consumption, but the velocity and vast quantities of money that destabilize prices. Slowing down trading velocity is a very smart suggestion by Vlade.

Anyway, spec's are often using other people's money, or are sociopathic personalities with no sense of fear, so it's hard to buy the argument that spec's will "internalize the consequence of poor decisions" anytime soon.

Mencius Moldbug said...

Jews, at least in my experience, actually have a terrible fondness for simple, stably valued assets. In fact, I think my attraction to mold is a consequence of being half Jewish and half Scottish, giving me a sort of hybrid vigor in the tight-fisted department.

It's also worth noting that when Ezra Pound, a better poet than me but a much worse economist, railed against Jewish bankers, he was specifically concerned with their hereditary affinity for precious metals and their sinister, crafty opposition to Major Douglas's public-spirited plan for massive inflation. Pound actually thought "Joo-sevelt" was maneuvering to put the world back on the mold standard, when in reality the New Deal was pure Ezra Pound economics. They had very different sales pitches, but when it comes to actual policy you can't slip a sheet of paper between Keynes and Douglas.

As for Honus Wagner baseball cards, I'll have to disagree. There is no economic difference between a Honus Wagner baseball card, a 500-euro note, and a gram of gold. The price of any of these items in terms of the others is set strictly by supply and demand, not by any sort of objective utility, labor value, etc, etc. If you wonder why they are so expensive, at least as compared to something useful like a bushel of wheat, my latest post offers some theories.

As for the "game," here's what will happen: either (a) today's wheat price is set at a level at which supply matches demand, or (b) it isn't.

If the answer is (a), the activities of the speculators are productive and profitable, because they have signaled wheat farmers (who have not exactly been doing great business during the "Great Moderation" - ever watch that PBS documentary series, 'The Farmer's Wife'? I believe it's on DVD) to plant more wheat. This prevents the future price from going even higher, which would really suck. Thus it is a stabilizing feedback loop which makes tortillas cheaper in the long run. Hard to see how even a bolshie could see this as anything but socially productive, except of course for the fact that it enriches the kulaks.

If the answer is (b), the speculation is socially unproductive by any reasonable definition, because it is creating exogenous price fluctuations in the wheat market.

Let's assume that it is (b), and that the present fluctuations are in the upward direction - that is, speculators are setting the price at a level at which supply will exceed demand, resulting in stockpile growth.

In this case, the speculators will be punished for their crimes. There is no need to send out the Cossacks. The market will fine them itself. Justice may not be instantaneous, it may not happen tomorrow, it will not be perfect. But the Cossacks aren't perfect, either.

Anything that can't go on won't. The grain stockpile cannot go on growing, because grain is not suitable as a medium of intertemporal exchange. For one thing, the storage cost is too high.

Eventually, the speculators will realize this and switch to something that is suitable, whether Honus Wagner baseball cards, euros, mold, etc. As they sell their grain, the price will drop and the rats will start to flee. The first ones out will do fine, but they can't all do fine. This is the well-known "burying the corpse" problem.

What I'd like to think is that the speculators are not wrong, because I'd like to think that people who have a billion dollars to throw around hire traders who have already been winnowed by this Darwinian selection process.

The people trading up wheat are not a bunch of 17-year-old kids using their father's AOL account. At least I hope not. So I hope they are pricing wheat correctly.

It does worry me that people are using this black-box trading crap. I think the entire financial system needs a comprehensive program of demodelification. But whatever we can say about the present system, we can't say it's not competitive. Certainly, every time I hear about some quant fund disaster, something deep in my evil heart cheers. And I suspect I am not alone in this.

Charles Butler said...

The thing is, Cass, that having some idea of the 'right' price is crucial to your point, unless the problem is the volatility in itself. But determining what it is is mighty complicated because so much political effort has gone into supressing price setting mechanisms, and consequent adjustments, in food markets. Another brief look through the charts shows corn at its historic 1996 high, soy oil and canola having just crossed 1994 maxima and oats still shy of 1988 prices. An even simpler method is to look at the contracts with contango backed out. Hoarding grains has only rarely been a smart way to spend your money since Volcker.

On the other hand, if you're prone to think that the soon-to-be lining up of types like you and me at the public trough is going to be dealt with via the printing presses - then one of the these spikes will be the warning shot.

Not to say that I was wrong (or that the price didn't have its premium), but from a guy who sold 20-odd ha. of wheat a while ago, your timing impresses - almost as much as do the risks involved.

Byrne said...


The hedge as such may not be common, but T. Boone Pickens was not the first to realize that the cheapest place to drill for oil was the floor of the New York Stock Exchange. Even so, there were some deals in the late 1970s and early 1980s that perfectly matched the description: oil and silver companies sold bonds that paid interest or principal in oil or silver. I don't remember the specific companies (Texas International, maybe?), but it sure sounds to me like the bond would be priced based on futures, and the company's interest payments would correlate pretty closely to cash flows.

It's not risk-free when structured as a futures transaction, but when structured as a special-purpose vehicle whose owners hedge with futures, it works just fine.

I think it would make sense to rephrase the entire question: what financial instrument needs to exist for me to arbitrage the difference between real-life costs and financial market prices? And how much money could I make using this new instrument to arbitrage the difference? Given that you manage money and I do not (or at least don't manage as much, as formally), I'm guessing there's an obstacle I've missed, here.

Anonymous said...

What a truly interesting and chewy question. And timely. The thing at the core is, of course, that with commodities speculation the poor are paying the price - with their lives. It is one thing to get scorched on your investment position and another not affording to eat because of the prices. I see the question as: is it right for the rich with spare money to drive up the price of things that those who are not rich need every day? Undoubtedly speculative bubbles will deflate at some point, but what if a lot of people starve in the process?

So this is what i'd say: speculation on tulip bulbs may be excessive and wasteful but not destructive. Speculation on wheat prices is destructive.

Especially in the present time when a lot of land has been taken off food production and crop failures are common, real actual shortage is not that far off. Add to that the speculative herd. Equates to something really, really nasty. You cant'eat money. Not even gold.

Probably it is impossible to prevent speculation from doing it's thing. During famines the rich have kept stockpiles of grains because the price seems to just go up and up so it makes no sense to sell.

A good time to think about the relationship of money and real value. And the things one is willing to do to catch the gravy train. Let them starve, my position is winning! Oh, thy died, and my position is losing...

Francis MH White said...

Commodity specs are fulfilling the very useful function of constraining monetary authorities' accomodative proclivities.

Anonymous said...

Contributors to this discussion who haven't read Frank Veneroso's thoughts on this matter may find them interesting:
Presentation to the World Bank April 2007
Perils of the New Financial Architecture

Woland said...

The Veneroso presentation, which I just finished, was
highly worthwhile. Thank you for posting the link.

Mencius Moldbug said...

Veneroso's speech is great, and I have the highest respect for the man, but I think in a couple of places he misses the forest for the trees.

Veneroso's primary expertise is, as far as I can tell, in base metals. His hypothesis that investors are building huge hidden stockpiles of base metals is perfectly plausible. Of course, it is also impossible to confirm.

But not all goods can be stockpiled in this way. Natural gas can't, for example. And what happened in the case of Amaranth? The system worked. The manipulators were checkmated. Zinc keeps indefinitely, and is pretty cheap to store. The same cannot be said for wheat. Some goods, like oil, are in between - carry is expensive.

Note that Veneroso's theory that speculators are distorting markets (which happens to be exactly what his audience wants to hear - they certainly don't want to hear that the cause is monetary) relies on stockpile builds. He understands supply and demand.

All of his appeals to historical patterns are economic nonsense. Pricing patterns do not recur in any predictable way. It is impossible to disentangle the many supply, demand and monetary shocks that have affected the price of, say, copper, over the last century.

The worst bit is that Veneroso analyzes precious metals as if they were base metals. PM hoarding is rational, because PMs are suitable as currencies. Stockpiles can grow indefinitely. Of course PMs can be demonetized as well as monetized, but if CBs prefer the former outcome, they'll have to adjust their present behavior!

woland said...

I think it is safe to say that, while all metals are recoverable as scrap, the "precious" metals are much more cost effectively recovered than the base metals.
This is because they are not "consumed" in the same way as the base metals: they are turned into bars, jewelry, coins, tableware etc., not piping or wiring in structures, or coatings or alloy elements in long lasting industrial parts. Having read the presentation,I disagree with MM that Veneroso paints the precious and base metals with the same brush. For the most part, he ignores the precious
metals. His focus is on the industrial metals.
It is certainly true that, when the dollar price of an
element rises, one could reasonably ask, "Is it the
element that is rising, or the dollar which is
falling"? If a wide variety of commodities simultaneously behave in the same way, the latter interpretation gains credibility. That is not to say,
however, that just because 2 or more commodities
are rising or falling, they are doing so for the same
reasons. It is in no way ruled out that the specter
of a falling dollar could cause a currency proxy like gold to rise, while at the same time a powerful
fund or cartel could drive the price of copper or
nickel higher through supply withdrawal, a feat which would be infinitely more difficult with gold.

"Cassandra" said...

CB -
I don't enjoy being a carpetbagger, but as a dispassionate investor I do think commercial Ag assets are best bought out of others distress OR (as in your case??) out of a love of the land and associated life. The enterprises we discussed were undoubtedly distressed - a by-product of extended drought (for the time-being, now-ended) causing foreclosure, and the credit crunch that made it essential to clear them out ASAP. PBRs of 0.5x and implied PEs 3 to 4x (in the absence of drought at actual acquisition prices provide BOTH enormous downside protection and enormous leverage to Col Kurz's financial-equivalent of "The Horror..."

Byrne - I remember the Silver bonds, when I worked at a London Fix Bullion dealer, though I can't recall the issuer. Your question is valid. And even with metal & oil markets in backwardation the natural spread to intrinsic is an opportunity to buy a company - sell forward, and pocket the residual. Maybe this could done in a specific-purpose trust form, but think of the speedbumps: hyperinflation on the cost-side; credit risk of forward counterparties; variation margins should prices rise dramatically; regulatory & tax risk; all providing obstacles to arbitrage. The gold loan mkt, much decried by gold bugs, is as close to an effective attempt to lock-in the arb as possible, rather than being a nefarious attempt to manipulate prices. But here too, the landscape is littered with the corpses of co's bankrupted by variation margin costs on their short positions.

Anonymous - you articulated the visceral reaction to "speculation as a game" whose enjoyment and victory potentially creates misery amongst non-participants. Not deterministically, but sufficiently plausible to seriously contemplate the question's moralality, as well.

Anonymous/Woland/MM -

I am not qualified to judge his technical suuply-demand work. It looks reasonable, and I see no reason to diss it. Veneroso articulates in
"The NFA" precisely the theoretical questions and practical concerns I have with regards to market structure, participant size, player motivation, and how these [potentially] conspire to obfuscate actual market prices.

Everything I have leanred in my twenty-years in the trenches is that - more often than not - market prices are not set in the the classical fashion I learned studying agricultural economics. I recall research I did for one of professors studying peach prices vs. harvest times. THAT was classical market economics at work: multitides of small producers, still-reasonable diversity of purchasers, near-perfect pricing model showing that IF you picked and sold when everyone else did, you're realized prices wer lowest, while the early pickers, and late pickers realized the highest prices, though the late pickers when obtaining better than avg prices, ran the risk of running into the early So Carolina crop.

I like Veneroso for asking tough questions. The answers are easily obtainable by FSA (time and sales etc. - even if the trail ends in Zug at Glencore or similar) or other watchdogs if they chose to, but most do not seem inclined to want to know. That said, the one really obvious nagging question he doesn't ask or answer is: Why doesn't China as the largest consumer, and an astute trader, use its presence in the physical market to obliterate spot longs? With a single large raid, they could turn the tables upon The Big Boys and The Squeezers and force liquidation of speculative and near-corner positions that would greatly reduce their raw-material bills and perhaps yet again prolong the life of the peg for a while longer...

Anonymous said...

Me? Merciless destiny in its purest form.


"Cassandra" said...

that sounds like the beginning of soon-to-be-penned novella:

"I'd been accused of being sentimentmally attached to the land, the daily rhythm of work-drink-siesta-work-drink-siesta, the dwellings, the servants and itinerants alike, but only by those who knew me not, for intimates understood my presence there was an accursed, merciless destiny in its purest form....

More, please, more!!

Mencius Moldbug said...

Certainly there is no doubt that the price of commodities is being set by speculators. The question is: is the price they are setting the right price, or the wrong price?

This question would be the same if the price was set by the government, by the Freemasons, etc, etc. What makes me believe in the system is not that I am sure the speculators are right, but that I am sure the market will punish them if they turn out to be wrong.

As for arbitrage in the gold market, one of the problems with running a futures market in PMs is that the price of gold set by such a market is not actually a prediction of the future spot price. If an actual prediction market would set the price above the cost of borrowing money, the trade you describe (buy present and sell forward) would cap it.

Indeed, if you look at gold lease rates, arbitrage has driven them down near zero - although something interesting clearly happened in August. What I want to know is why silver lease rates went negative early this year.

(These Kitco charts (which I believe simply measure futures prices against spot prices, minus Libor) are fascinating, because they show all kinds of qualitative phase transitions - none of which seems to correspond to anything reported in the papers. I wish I had a better understanding of them.)

Mencius Moldbug said...

I should clarify that, obviously, the buy-now sell-forward arb strategy is not an effective tool for suppressing the gold price. In fact, what it does is to teleport any force that would tend to raise the future gold price back into the present, as the future price curve of gold simply becomes the monetary yield curve. This rigid structure then reacts as a unit.

If you want to suppress the gold price, you have to sell forward without buying now, ie, go naked short. Perhaps there was some of this in the '90s. Combined with CB dishoarding, it was certainly a toxic brew, with plenty of potential for collusion - real or imagined.

But the whole issue is ancient history now. In 2008, I can't imagine anyone but the boldest of specs wanting to be naked short PMs. Certainly not a bet for a banker.

"Cassandra" said...

Moldy, in the old days it was primarily trade sellers (mines hedging a portion or all of future production) or intermediaries who'd a natural contingent exposure vs. the same miners. The right, but not the obligation, giving the miners the feeling that they had unlimited upside. It's been more than twenty-one years since I was in the bullion business, but I'd be hugely surprised if most gold loans were not offset against what in the end is a bona fide trade short with gold-in-the-ground.

Mencius Moldbug said...

Miner hedging was certainly a big deal, but CBs also lent a lot of gold to the bullion banks - I think Veneroso himself estimated about 5000 tons. (I just checked - 6000.)

What was done with that gold? My impression is that it was sold on the spot market and the proceeds were used for securities. Resulting in a large naked short position, but one owed to CBs, whose interest in bankrupting banks is hardly legendary.

Almost all CBs still list monetary gold and "gold receivables" on one line in their financial reports - including, since May, Uncle Sam.

I suspect (unlike Mr. Turk) that this reflects not new transactions, but a desire to cover asses on old ones. The IMF is moving toward requiring CBs to disclose these structures and account for them separately, showing us how much monetary gold the CBs actually have. Present estimates are just that, and vary widely.

I would be pretty surprised if the "gold carry trade," a la '90s, is still ongoing. It takes two to tango. And I suspect that most of these short positions have been covered in some way. I mean, duh.

Many of the hedges entered into in the '90s were imprudent in various ways. The hedgers have been punished. Ashanti went bust. Barrick has paid through the nose. Hedgebooks everywhere are drying up. I think most mining investors figure that if they wanted to hedge, they'd do it themselves.

Ideally, gold shares would be quoted in gold, factoring out the whole variable. I wish someone in Dubai would set up a gold-quoted stock exchange and see who listed. But I ain't holding my breath.

"Cassandra" said...

While I wouldn't put it past the odd trader to take a punt - and I am thinking J. Aron and and Phibro - most bullion banks (and certainly the venerable one I worked for) would borrow bullion to "sell spot & buy forward", which is little more than a money-market arbitrage for they would only do it when it made sense. Since we had a large trade-options book that, typically, was short puts (and or long calls) vs. miners (and that just wasn't Munk, but Russians as well) and short calls to retail punters, the delta was net short, requiring a net short position. The decision as to whether to do this in spot vs. forwards was a mechanical function of where the switch market was trading, and what was the highest implied yield relative to the curve. Most small spec trade, and small-lot hedging was via comex, while the large spec trade and hedge (middle eastern traders and CBs) was in the physical market. We never took risk outside of volatility risk for more than brief intervals. It was all arb. I think this was true at the other bullion banks too, with the exception of Aron & Phibro, so still reckon that "there was another side" to whatever short posns were out there, rather than attributing it to a conspiracy. I am not saying this categorically, but I think that keeping a secret is hard work, and even deep throat was outed in the end, so a secret of THAT magnitude amidst public servants into and out of government, with counterparties, margin clerks etc. would have - in all likelihood - made it into the sober published realm long ago.

Dubai is too busy laundering everything that the Swiss are too embarassed to launder, or that, for whatever reason, the Russians don't trust the Cypriots and Maltese wash. With no question asked 10% spreads, why waste time scalping basis points in pursuit of an honest living?

Mencius Moldbug said...

Well, Portugal, which does break out monetary gold and gold receivables, reported lending 430 tons, or 70% of its reserve. So somebody's doin' it, or was.

I don't think "conspiracy" is the right word. CBs have an interest in low gold prices, and have for the last 300 years. Why else would they lend out their monetary gold, the payment system of last resort? In any situation where a CB would need to draw on monetary gold, gold receivables would be worthless.

Accusing CBs of "manipulating" the gold price is like accusing Rick's Cafe of tolerating gambling. It is designed to reach the ears of the "sober published realm," who (Ambrose Evans-Pritchard aside, and I'm not sure "sober" is the word for him) have no interest in hearing it. This was not true for Mr. Felt.

That said, what you say about bullion banks maintaining balanced books and avoiding naked positions strikes me as convincing.

But selling spot and buying forward remains a maturity transformation - it is credit expansion in the gold market. With the same effects as in fiat currency. You're effectively diluting the supply of present gold with future gold. Ceteris paribus, this lowers the price - even if all the future gold you're buying is produced by sellers who can actually deliver it. And in a decade when the gold price fell continuously, the temptation to oversell forward must have been pretty great.

Yeah, I know, I idealize these little libertarian paradises in the middle of nowhere. Actually, they are all full of Russian gangsters, etc. And they're not as libertarian as they sound. I know. But can't a man have some illusions?

Charles Butler said...


I find it, if you don't mind me saying, curious that you seem to have to travel outside the confines of UR (excellent bit of sci-fi that it is) to engage in reasonably satisfying discourse.

It's also notable that your acolytes, whose beautiful childlike belief that all known and knowable facts confirm their theses has rendered your comments section unserviceable (notwithstanding your gracious and appreciated introduction), have not caught on to this quirk. Unfortunately, using other people's publications to seriously engage you on the topics broached at UR is not acceptable.

Marbella was, under Jesús Gil, a curious case of a de facto city-state that was allowed to flourish under the watchful blindness of two superior levels of government.

Cass (ghost writer in the storm?),

You seem somehow to know already that I might be the only Bobby Orr fan whose grandfather was raised by the childhood tutor of Alfonso de Borbón y Austria-Lorena.

Byrne said...


What kind of problems are you looking for, here? It seems to me that if these banks also list their 'gold payable', everything should balance out -- instead of just looking at assets, we'd have to look at liabilities, too, but this is not exactly difficult. If they don't there's no end to the mischief, though: if the Bank of Grand Fenwick lends its reserves to the Bank of Qwglhm, which lends the reserves back to Fenwick, which lends reserves plus the new receivable to Qwglhm, they can pick any number they want to show up as their gold reserves.

Also: selling spot and buying forward isn't maturity transformation unless the counterparty doesn't actually own the gold. It can be more profitable because of maturity transformation, in the sense that the rates that determine forward prices may be too low. But the crisis that bankrupts people in a maturity-transformed environment doesn't work here: if spot rises and the forward contract's value doesn't, people who own physical gold for long-term investment have an incentive to sell their gold and buy contracts. If they don't think the contracts are creditworthy, it is once again a credit problem, not a mismatch problem.

Mencius Moldbug said...


I am interested in readers, not acolytes. Of course I don't like having conversations on my own blog - it's weird and embarrassing, like patronizing one's own whorehouse.


The problem is not that the CBs are hiding liabilities, but that they hold two very different classes of assets, which they are merging without any good reason to do so.

Monetary gold has no default risk. Gold receivables or "deposits" have not only default risk, but in the case of a crisis default certainty, because most of these deposits are backed by future gold, not present gold. Whereas the contracts stipulate the latter.

Selling spot and buying forward is certainly maturity transformation if the source of the spot you sell is a short-term loan. As in this case it is.

If the CBs called these loans, which they won't, gold would go into backwardation in a classic bank run pattern, as a large class of actors who wanted to exchange their future gold for present gold sprung into existence.