Saturday, May 8, 2010

The Hunt Brothers, Silver, and Exchange Trading

I began working on futures market issues for the U.S. Treasury in 1980.  At the time, the Treasury was pondering how it should feel about the new financial futures markets, especially the contracts on U.S. Treasury securities.  My real introduction to the world of futures, though, was the problems in the silver markets, in which the Hunt brothers figured prominently.  This episode is long-forgotten, but it was scary then.  The price of silver during this episode went from around $5 an ounce to about $50 an ounce.  People were digging through their houses for silverware and jewelry, and house burglaries were also focusing on these items.  The price of silver subsequently plunged; the Hunt brothers could not meet the margin calls on their silver futures positions; the capital of their futures commission merchant (broker), Bache Halsey Stuart Shields, fell to alarmingly low levels as it had to make good on the margin calls to the clearinghouses; and questions occurred to observers about whether the clearinghouses could fail.  The stock market fell 50 points, which at the time was considerable.

I mention this episode because it highlights some points about the current financial regulatory reform effort.  Forcing most derivatives onto exchanges does not solve all problems.  A look at the history of the problems in futures markets demonstrates this, and the concentration of risk in one or two clearinghouses poses risks of it own.  This is not an argument against forcing most derivatives on exchanges, but one should be aware that it won’t miraculously prevent future systemic problems, market manipulation, frontrunning, prearranged trades, etc. from occurring.  Also, it should be noted that it benefits one financial industry segment over another.  It does, though, enhance transparency, and makes it easier for regulators to figure out what is happening during a market crisis.

It would be good for the pros and cons of forcing most derivatives onto exchanges to be debated as consideration of financial reform goes forward.   What we now have in many quarters is the knee-jerk reaction that any “loophole” for non-standardized contracts or for certain participants is a cave-in to Wall Street.  Perhaps the exceptions to exchange trading should be minimized, perhaps not.  But commenters should realize that “Chicago,” as well as “Wall Street,” has economic interests.

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