Monday, September 05, 2011

Financial Distotion - A Ticking Time Bomb

Markets have lost their purpose

Anthony Hilton

14 Jun 2011

Twenty years ago, it used to be the case that only in the foreign exchange

market was the underlying business activity dwarfed by speculation -

meaning that the foreign currency needed for the buying and selling of

imports and exports was well under 10% of the global daily volume.

Today, similar conditions have an impact on all manner of markets which are

simply not structured to cope with such waves of speculation.

We are now in a position where flows of hot money drive prices, not the

fundamentals of supply and demand. And because other markets lack the scale

and resilience of forex, the results are less benign.

The belief that markets know best rests on a couple of important factors.

First, there have to be a lot of participants in the market so that no one

can influence more than 5% of either supply or demand, which in turn means

no group is in a position to use its buying clout or monopoly power to

influence price or supply.

Second, it is important that people are principals, either acting in their

own name or for a company which is either supplier or end user. When these

conditions exist, it is reasonable to assume that price signals from the

market are fairly accurate reflections of genuine supply and demand.

This begins to break down when buyers and sellers are in a position to use

other people's money - thereby acting as agents rather than principals.

It is often - though not always - the case that this coincides with their

being interested in speculating on price movements rather than the buying

or selling of the physical goods for some business purpose.

There are two reasons things have gone wrong in financial markets.

In recent times - since technology advanced enough to allow capital to be

moved in seconds into or out of any market in the world - the ebbs and

flows of speculative money have increased massively.

Capital is now mobilised on a global scale and directed anywhere in the

world at the touch of a button. It dwarfs the resources of the original

market participants.

At the same time, with a growing emphasis on trading profits and short-term

time horizons, money managers have embraced momentum - buying not on

fundamentals but simply because everyone else seems to be buying, or

selling because they all seem to be selling. They assume they will be able

to ride the price movement and then use instant-dealing technology to leap

off and take their profits just as the price is turning.

This has increased massively the amount of money swamping a market when it

is in fashion. It has also multiplied the power and influence of those who

are seen to have an edge in a market - the established traders or

investment banks - because where they lead others follow (or risk being

wiped out). The interaction of their expertise and third-party money gives

a few speculators disproportionate influence. These lead speculators now

have the power of the herd behind them. They have enough monopoly power to

distort prices.

Financial markets such as the oil market, the metals markets, the grain

markets or the sovereign debt market were created for actual users, not

speculators, but they are now so dominated by hot money that the sounds

from the original users are no longer audible. As a result, these markets

and their prices indicate what the speculative money believes at any one

time, and this is not necessarily what is happening in the real economy. It

also adds an overwhelmingly short-term perspective and huge layers of


We all pay a high price for this because the real economy is then forced to

adjust. In rich countries, oil consumption and economic activity get cut as

oil becomes too expensive. In poor countries, they have riots and

governments fall as food becomes too expensive.

In all countries, governments have to produce policies that put the whims

of the markets before the needs of their citizens - witness the way

policies across Europe are tailored to appease bondholders and debt


A letter to the Financial Times yesterday pointed out what are only the

most recent examples of how the financial market tail wags the dog.

In oil, pricing is based on two sources of supply: the North Sea's Brent

crude and West Texas intermediate. For years, the price difference between

them has remained between two and three dollars to reflect the oil quality

and its distance from market.

At present, however, the price gap is more than $17. Similarly, it has long

been a feature of metals markets that when stocks rise, the price falls.

But not since 2008. Today, stocks at the London Metal Exchange are high and

rising, but so are metal prices. In both these cases - as well as with

grain and foodstuffs - the new factor in recent years is that these markets

have become fashionable for financial speculators.

To sum up, we have financial institutions that have power without

responsibility. They are dedicated to using that power to make profits for

themselves. They now know they can drive markets in one direction or

another for most, if not all, of the time. The distorted signals these

markets then deliver hold governments and the world's citizens to ransom.

From being the servant of the world economy, the financial markets are

becoming its master.

This is not how the system was meant to work. This is not what a belief in

markets was meant to deliver. It is impossible to know how it will end but

it is surely unsustainable.