Sunday, September 20, 2009

Social consequences of the futures market

Not all observers agree that the futures market results in a net gain for society by helping financial institutions reduce risk and use scare resources more efficiently. Some analysts believe that the futures markets are largely speculative and not really geared for the hedging of risks per se. they see these markets as aimed principally at providing wealthy investors with a speculative outlet for their funds, and resulting in unnecessary risks due to excessive speculation. Some have argued that the futures markets increase the price volatility of those securities whose contracts are actively traded. If this is true, it would tend to make the impact of government economic policy, aimed at promoting high employment and low inflation, more difficult to predict. There is evidence from the commodities field that trading in futures tends to smooth out seasonal fluctuations, but only limited evidence exists to date as to the overall impact on the securities markets of contracts trading.
Certainly the more existence of the futures market and its continuing growth creates additional problems for regulatory authorities, especially those concerned with the regulation of financial institutions. Another market must be supervised and additional regulations prepared to cover new forms of risk and new fiduciary relationships. Some observers have expressed the fear that the futures markets substitute "gambling" with securities for "investing" in securities. If this view correct, it suggests a withdrawal of some risk-taking activity from the traditional securities markets and a redirection of this activity towards the futures market. To the extent that risk taking by securities investors is curtailed, this limits the flow of funds into venture capital and decreases the aggregate volume of investment in the economy. Other things equal, the economy's rate of growth is reduced.
On balance, the financial futures market probably has resulted in a modest net benefit to the financial system and to the economy. Those who support the development of this market have certainly overdramatized its positive features, alleging, for example, that interest rates tend to be lower and less volatile with a well-functioning futures market. There is little evidence that this is, in fact, the case. Regardless, it seems clear that the futures market has separated the risk of changing security prices and interest rates from the lending of funds, at least for those institutions actively participating in this market. The risk of price and yield changes is transferred to investors quite willing to assume such risks. The futures market has helped to reduce search costs and expand the flow of information on market opportunities for those who seek risk reduction through hedging. In this sense, the market tends to promote greater efficiency in the use of scare financial resources. Moreover, this developing institution has tended to unify many local markets into a national forward market, overcoming geographic and institutional rigities which tend to separate one market from another.
It should not be forgotten that futures trading is not without its own special risks. While the risk of price and yield fluctuations is reduced through negotiating a futures contract, the investor faces the risk of changing interest rates and security prices between the futures and spot markets. It is rare that gains and losses from simultaneous trading in spot and futures markets will exactly offset each other, resulting in a perfect hedge. Moreover, there are substantial brokerage fees for executing futures contracts, and required minimum deposits for margin accounts. To the extent that the futures market encourages speculation, does not fully offset all prices and interest-rates risks, and is characterized by substantial transactions costs, its net benefits to society will remain both limited and a subject of continuing controversy and close regulatory security.

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