Speculative gambles without any social benefit

Wednesday March 10 2010

Sir, It is interesting that Robert Reoch (Letters, March 8) tries to give me a lesson on the importance of market intermediaries, using the example of the wheat market. You see, I started my - rather successful - career as a wheat trader in 1974. I used derivatives and complex structured products involving both commodities and currencies long before the team at JPMorgan - that "created" the credit default swaps market - graduated from college.

No, I have not read Moorad Choudhry's books and frankly I don't think I need to. The biggest mistake made by those involved with "the markets" is the failure to distinguish between commodities and securities markets. And it is the blind application to the securities market of trading tools that are appropriate only to the commodities market, which is the major issue.

In the commodities market the "market intermediary", being the trader or the speculator, provides liquidity to the market whether he is long or short. If he is long, he provides liquidity to the producer. If he is short, he provides liquidity to the consumer. Both producer and consumer of a commodity have a legitimate need to obtain liquidity. In the securities market (both equities and bonds) it is not the same. The investor (and I mean the investor, not the speculator) who invests in a security is expecting: . That the value of his security will not decrease. . That he will obtain a return. . That the day he would like to sell, he will find easily a buyer.

The speculator who goes long on the security actually provides liquidity to the investor. Let's see to whom the speculator who goes short provides liquidity: to someone who is not an investor in a given security and who eventually would like to be. But by giving liquidity to the non holder of a security, the speculator automatically takes away liquidity from the holder. And it is only the holder of a security who has a legitimate need to obtain liquidity. And the biggest difference between commodities and securities? You can live without ever owning an equity or a bond (actually billions do). No one can live without food. So I guess that the issue is much broader than the CDS! It has indeed to do with naked short selling of a security.

So yes, I seriously think that banning the use of equity put options without owning the underlying security is indeed as important as banning naked CDS (see Matthew Ridley's letter of March 3). Both are purely speculative gambles without any social or economic benefit. In a nutshell: yes to short selling in commodities, no to short selling in securities.