Can someone please explain to me how the futures market is legal?

Question

It seems to me that the speculation in the futures market (among other things) seems to be one of the biggest factors influencing high energy and food costs. I don't understand how the federal government can allow this to happen without imposing some kind of regulations. I don't want to get into a party debate here, I just want to know how this all works from a purely economic point of view.

Answer 1

The futures market plays an important role by finding a price that people are willing to buy and sell different commodities at. In these markets there are many buyers and sellers and without a futures market the transaction costs would be much higher. For example to find the lowest price a buyer would have to go to every single producer to see there price. The futures market also plays an important role with the price signals that it sends on what things should be produced. If the price of corn is high people will plant less of the lower price crops and grow more corn.

On the regulation side, it is a regulated market by the government and also with rules established by the trading markets themselves.

Answer 2

the futures market was born out of a desire for farmers and other producers of commodity goods, like gas and oil, to be able to hedge the risk they have that prices will fall between the time that they commit to producing the goods and the time they are able to deliver those goods to the actual customer.    People who were willing to risk capital get paid a risk premium to guarantee the producer a certain price for their product.   The people that started out doing that were the ones who did extensive research on what all the other producers were likely to do, consulted weather indicators, and pooled risks over large areas.  It was kind of like insurance.  You pay a small amount to protect yourself against a bigger risk.

Well, in order to efficiently provide the futures contracts that help protect the producers, its reasonable to allow the contracts themselves to be bought and sold, to provide liquidity.  If you allow a free market, you can eliminate some of the costs associated with activities that otherwise would have low liquidity.   With the futures market, there is almost always a willing buyer and seller at some price.

Now, here is where we started to slip up:   Because people saw how beneficial it was to have a lot of ready buyers for futures contracts, to eliminate liquidity concerns for the people who buy and sell them, we decided to allow people to buy these contracts on margin.   That means you don't have to actually have all the money it might take to pay on the contract in the event the price changed in the opposite direction from what you expected.  You just have to have a portion of that cost.   this makes some sense, in that the commodity won't normally go down to zero value, or up to many times its average cost.   Except for when market conditions begin to move to an extreme.  that is where we are today.   Conditions have converged to make oil a very attractive place to put your money.  The stock market has been tough, oil supplies have been threatened, the dollar was declining in value rapidly for a while.  Why not take your dollars and buy something that looks like it will go up in value pretty certainly, and get out of the sinking dollar and make some money.

Well, a whole bunch of people thought that, and a whole bunch of them started doing it.  And the started to bid the price of oil way past what it can really be worth, in terms of a tangible, usefull asset.

The price of oil is very likely to fall, and fall far, eventually.  The trick is figuring out when, and by how much.

To ease the pressure of speculation on oil, we can increase the margin requirements.  This will reduce the possibility of investors making huge profits just by rolling the dice on the price moving in the direction they expect.   Forcing speculators to pay a larger percentage of the contract up front, will dampen the run on the price of oil, but still allow enough speculation to make a nice liquid market for the people who use it for good purposes.

We have agencies who are supposed to regulate speculation, and make adjustments in times like this.   they have not been doing their job.   They were appointed by GWB.   Remember where his family made their money?  Oh yeah, oil.

Answer 3

It was created to help the farmer and has be perverted .