“Mister Thorn once cornered corn and that ain’t hay” sang Ella Fitzgerald, in the year that two speculators cornered the market for onions in Chicago. It was 1956, and Sam Siegel, a Chicago trader, and Vincent Kosuga, a New York grower, had managed to buy up most of the onions in the city using futures contracts.
In a variant of the scam played by Eddie Murphy and Dan Aykroyd in the film “Trading Places”, Siegel and Kosuga first drove the price up by keeping their onions off the market. They induced a group of onion farmers to buy a large part of their inventory at a high price in a scheme to continue propping up the market value.
Siegel and Kosuga then reneged, taking advantage of the increased supplies of onions flowing to Chicago from the rest of the US, attracted by the high price. They used their physical inventory to “short” the market, driving the price down.
Contracting to deliver onions in March at US$1.02 which in the end could be bought for 10 cents – less than the cost of the bag they came in – they reaped a profit of 92 cents a bag. The speculators made a fortune and many onion farmers went bankrupt.
In response to the subsequent outcry, partly from the double-crossed accomplices, congressman and future president Gerald Ford promoted the Onion Futures Act, which means that onions are the only commodity in which futures trading is banned by law in the United States.
The European Union has now taken steps to prevent any future Mr Thorn cornering corn. MIFID2 (the revised Markets in Financial Instruments Directive) provides for regulators to impose limits on the size of the bets commodity futures dealers can place.
Speculators make money in two ways. If they hold a “long” position, having agreed to buy more than they have sold, then a price increase is good news. Now, they can sell the commodity for which they have agreed a fixed price at a profit.
They can also make money if prices fall when they hold a “short” position, having agreed to sell (at a future date) more commodity than they have bought. They can then buy the extra commodity they must deliver for less than the fixed sale price, and the difference is profit.
Whether long or short, the larger the position, the larger the profit (or loss, if the price goes the wrong way). Since market prices respond to buy and sell orders, large deals can drive the price in the speculator’s favour and deliver an easy kill, as in the onions case.
The EU’s action is a response to the 2008 crisis and the preceding commodity boom. According to the EU’s internal markets commissioner the aim is “to improve the way capital markets function to the benefit of the real economy”. Yet does the real economy need commodity speculators at all?
The irony is that the early futures exchanges were established to offset the effects of speculation in spot markets (the markets for immediate delivery, “on the spot”). Both growers and processors of commodities want to fix the prices they receive or pay at harvest and not be at the mercy of the market on the day. Thus futures contracts can provide a valuable hedge against price fluctuations.
Speculators, it is argued, provide a useful service by studying the “fundamentals” and smoothing the balance between supply and demand over time. Some academics argue that the historical evidence indicates that the banning of futures, like the Onion Futures Act, actually increases price instability.
Nevertheless the high cost of carrying physical stock and the limited availability of finance constrains the ability of a private speculator to take more than a very short-term position. Thus destabilising activity may be the only profitable option.
This process is nothing new. Back in the 1930s John Maynard Keynes wrote:
Experience teaches those who are able and willing to run the speculative risk that when the market starts to move downwards it is safer and more profitable to await a further decline … Even if it would pay to buy at the existing price on longer-period considerations, it will often pay better to wait for a still lower price.
This EU initiative will not prevent speculative pressure if the sentiment takes hold in the market that the price is moving one way. The fall of sterling in 1992 was caused not solely by the speculative position taken by George Soros’ hedge fund, but by the signal this sent to the market as a whole.
The real problem is the (literally bankrupt) doctrine of financial liberalisation which allows footloose capital to move from market to market, testing for weaknesses like a burglar checking windows. A better sequel to MIFID1 would be its repeal.