Streetwise Professor

August 3, 2008

History Lessons

Filed under: Derivatives,Economics,Energy,Exchanges — The Professor @ 2:30 am

The recent assault against commodity speculation could use a little historical perspective. In particular, history can provide some lessons regarding what happened during previous attempts to restrict–or ban–futures trading.

Example 1. Gold futures during the Civil War. Union fortunes were ebbing during the spring of 1864. In early-June, Grant had suffered a punishing defeat at Cold Harbor, suffering 7000 casualties in a period of an hour. In mid-June, he made a brilliant descent on Petersburg (a major transport hub south of Richmond), but his assaults on 15-17 June made only limited headway. In Georgia, Sherman was making only slow progress against Joseph Johnston, and was mired in the piney forests around Dallas and New Hope Church in late-May. West of the Mississippi, Banks’ Red River Campaign had ended in disaster in late-May, with the US Navy’s Riverine fleet barely escaping capture only through the ingenious efforts of Army engineer Joseph Baily.

Union military failure was reflected in a skyrocketing price of gold in greenbacks (i.e., a collapse of the paper dollar.) Data from The International Center for Finance shows that from the time of Grant’s crossing of the Rapidan on 4 May until 16 June, the value of the Greenback fell from $.557 gold to $.507 gold–a 9 percent drop.

Congress soon found a culprit–gold speculators. Congressmen lashed out at speculators on the New York Gold Exchange, and soon matched their words with deeds. On 17 June, 1864, Congress passed the Anti-Gold Futures Act of 1864. The Act prohibited the trading of gold futures, and for good measure, banned the trading of foreign currency contracts with more than 10 days to maturity. The Act also made it a crime to transact in gold bullion anywhere but the ordinary place of business of the buyer or seller, effectively putting the Gold Exchange out of business.

The exchange closed, but speculation didn’t. Instead, trading activity in spot gold moved to the offices of brokers. And the price of gold continued to plummet. From 17 June to 30 June, the price of greenbacks fell to $.4082–a 21 percent drop. Congress soon recognized the folly of its anti-speculation legislation, and in a commendable example of legislative humility, repealed the Anti-Gold Futures Act on 2 July, 1864.

What had driven down the price of greenbacks during the Act’s short life? In a word: Fundamentals. Bad news continued to flow from the war fronts, indicating a long war–and a continued need to run the printing press to finance it. Grant was definitively stopped in front of Petersburg, and suffered some punishing defeats at the Battle of the Weldon Railroad. Sherman suffered a bloody repulse at Kennesaw Mountain. A large Confederate force under Jubal Early was on its way north through the Shenandoah Valley, with nothing in its way to stop it.

The moral of the story: constraining speculation is easier said than done, and such constraints are too weak to overcome the effects of powerful fundamentals.

Example 2: The German Exchange Act of 1896. This bill implemented many restrictions intended to constrain speculation in agricultural commodities and stocks. The Act gave German state governments the authority to ban futures trading. In addition, in an interesting parallel to one feature of the Stop Excessive Energy Speculation Act, the German legislation empowered the state to appoint a board consisting of agriculturalists and grain processors to oversee the operation of grain exchanges. The Act also eliminated futures trading in the stocks of industrial and mining companies.

The attempt of the Prussian state government to appoint a board to oversee the exchange, with its implied threat of eliminating futures trading on the exchange altogether, led the members of the Berlin Exchange to decamp from their facilities to a theater across the street–evocatively named “The Fairy Palace”–where they continued to carry out their business, but without calling themselves an exchange. The outraged Agrarians railed against this attempted evasion, and pressured the Prussian authorities to announce to the Fairy Palace crowd that if they did not disperse, the police would be called to break up the gatherings of traders there.

According to contemporary accounts, such as an article by Henry Emery in the Political Science Quarterly, and by Ernst Loeb in the QJE the Acts did not have the desired results, and actually had detrimental effects. Although neither author presents any empirical evidence, according to their accounts, speculation did not decline, but shifted into securities not covered or into cash transactions. Market liquidity declined, and prices became more volatile. Transactions costs increased. In foodstuffs, the absence of a central location for price discovery led to more negotiations and haggling between buyers and sellers. In stocks, trade was driven from exchanges into the hands of big banks who internalized orders. Some trading activity was diverted to foreign markets. According to Emery, the passage of the Act and the reduction of trading activity on the exchange was accompanied by a dramatic increase in the commissions that banks earned (and this presumably does not include the effect of the profits that the banks made on the internalized order flow in the absence of competition from a liquid and transparent exchange.) According to Carl Parker, “Governmental Regulation of Speculation” (Annals of the American Academy of Political and Social Science, 1913), the elimination of futures, and the resulting increase in difficulties of short selling, led to more pronounced rallies followed by more pronounced crashes as prices returned to levels dictated by fundamentals.

In time, even the German government recognized that the law was ineffective at best, and pernicious at worst. A 1907 government report stated “[t]he dangers of speculation have increased, the power of the market to resist one-sided movements has weakened, and the possibilities of misusing inside information have enlarged.” The report further stated that the law “has proved injurious to the public, without accomplishing its original purpose.”As a result, in 1908 Germany repealed many of the features of the law. The continued outrage of agricultural interests led to the continuation of the ban on agricultural futures, which lasted until almost 100 years after its passage. Ag futures trading was allowed only in 1998. (Personal aside: after the repeal of the law, I worked on a feasibility study and contract design work for the first German ag futures exchange, the Warenterminborse, or WTB. The exchange continues to operate under the name Risk Management Exchange, or RMX.)

So, the bottom line is that previous efforts to ban futures trading, or sharply constrain it, have failed in their object. They have reduced market quality, increased transactions costs, and impaired competition–without actually reducing speculation or affecting prices in the way that the sponsors of the anti-speculation laws intended.

Will Congress take these lessons into account? Somehow I doubt that a consideration of the facts will overcome the temptation to engage in political pandering and demagoguery.

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