1

With thanks to Professor Antal E. Fekete This dissertation aims to show how a futures market coordinates itself under free action. The intention is to look at a futures market as an extension of the documented observations of Carl Menger in his Grundsatze der Volkswirtschaftslehre of 1871. Sandeep Jaitly, 29th February 2012

Definition: A futures market for a particular entity is a market for the date-defined later exchange of this particular entity with the price being agreed between the buyer and seller now. A futures market has standardized settlement dates with exchange between buyer and seller conducted through a clearing house via the clearing houses members.

TABLE of CONTENTS 1. A. B. C. D. The Development of a Futures Market The Production of Agricultural Goods. p.2. Storage and Speculation. The Carry/Basis. p.2-4. Warehousing and the Limitation of Risk. The De-carry/Co-basis. p.4-5. Storable and Lendable Entities. p.5-6.

2. The Spread A. The Observation of the Spread. Menger & Fekete. p.7-8. B. Extension of the Spread to a Futures Market: Basis and Co-basis. p.8. 3. Implications from Changes in The Spread A. Spectrum of Implications from Changes in the Bases. p.9-10. B. Coordination of the Futures Market of a Monetary Metal. p.10-13. Bibliography. p.14.

THE DEVELOPMENT of A FUTURES MARKET

1A. The Production of Agricultural Goods The production of agricultural goods follows cyclical patterns. Particular agricultural produce can only be farmed at particular times of the year. However, some produce is needed at all times throughout the year. This created a problem for early society. Definition: An entity is said to be able to be storable if it can be physically stored. An example of a storable entity is wheat. An example of a storable, more abstract entity is a bond. An example of an abstract, non-storable entity would be the volatility of that bond over the next week. As far as agriculture is concerned, granaries were the first form of storage. Granaries have existed for as long as documented civilisation. Of course, this makes sense as the former is a prerequisite of the latter. The earliest granaries were most likely under the ownership of the local potentate. For the promotion of public well-being, their economic viability would not have been of the greatest importance and especially if the potentate had the ability to tax. Private granaries that stored produce apart from that produced by the owner themselves developed much later. Granaries of this nature would have to maintain economic viability to pay their way. The owner of a granary would purchase produce during season and sell it out of season for a sufficient margin to adequately cover their running costs. The granary owner would compete with the market stall holder during season to purchase produce whilst its available. Out of season, when the owner wishes to sell the produce for a sufficient profit, they would face no competition (apart from others in exactly the same line of activity, should they exist.) When the granary owner purchases produce, one leg of a spread is opened. The spread is closed at a later time when the produce is sold. The profit gained in this transaction is not known at the outset. This uncertain facet would restrict the numbers wishing to pursue this particular activity. Salient points to remember: the profit from the spread is not known on the outset. It is not closed until the produce has been sold.

1B. Storage and Speculation The Dojima Rice Exchange in 17th century Japan was the first documented example of an organised futures market. Rice will be used as the central example going forward in this chapter. Rice, like all agricultural goods, is produced annually. In India, the main harvest occurs through the end of the monsoon from September to early November. The harvest in Southern America occurs from February to April and is disjoint form the Indian harvest season. A successful crop guaranteed sustenance for the people. In the absence of granaries, a very successful crop would see abundance without the ability to store the produce for less abundant times. Therefore the ability to store the rice would be paramount.

In the absence of a granary, the only purchasers of a farmers surplus produce would be the customers at the local market or to them through other agents. Imagine a small village that focuses on rice production. The granary owner joins the consumers bid for rice in season and is the sole person to offer it out of season. In this way the granary owner buys low holds and sells high naming their price within reason. This state of affairs would naturally introduce competition in the granary business. The total number of new entrants being limited by their tolerance for a minimum return on their granary construction costs and running overheads. For simplicity it will be assumed that only one granary exists. Indeed, this single granary could be identified with the marginal granary amongst all the granaries operating. The bid/offer spread for rice, should it exist, would be narrow in season and wider out of it. The introduction of a granary elevates the bid for rice during harvest season. The granary owner competes with the rice consumers in season to obtain a sufficient amount of produce to store. Without the existence of a granary, there would be no one to offer rice out of season, however there will most likely be a bid (that could not be accommodated by anyone.) It should be emphasised that the entrance of a granary to store rice allows an offer price for rice throughout the year. The granary owners operations as is are not without risk. There is a risk that the granary owner would not be able to sell their rice for a sufficiently high price to amortise their overheads. For example, an out of season supply outside of competition from other granaries from a different part of the world would potentially ruin the viability of the granary. This is not a hollow point: it was mentioned earlier that rice is produced asynchronously on a global basis from September to November in India and February to April in Southern America. A village in Southern America might have its granary business impaired with the development of swift global transport such as the jet propelled aeroplane. Imagine now that a group of merchant-speculators in the village decide to establish an exchange for the expected price of rice immediately after the harvest. Those that expected a poorer harvest and higher prices interacted with those that expected a better harvest and lower prices. The interaction produced a bid/offer spread for the exchange of fixed amount rice after harvest with the price agreed now. This came to be known as a futures contract.

If a shortage of rice occurs unexpectedly for some reason, the granary owner will have their inventory bid away (assuming that the granary owners offer is accepted.) The difference between the granary owners offer and the futures contract bid would become more negative. It is at this stage that the carry [of rice] can be defined. The carry is defined as the difference between the futures contract bid and the offer for immediate delivery (e.g. the granary owners offer.) Definition: The carry of a particular good is the difference between the futures contract [of that good] bid and the prompt [immediate delivery] markets offer. The basis is defined as the carry expressed as a percentage of the prompt delivery (mid) price annualised. In an expected shortage, immediately available rice is bid up, consequentially the carry of rice falls. Peculiar points to remember about this example Initially, the granary owner purchased rice in season and sold it out of season. They were left hostage to gluts of rice and associated price falls. To manage a business in such a way would be far too risky on the whole. There is no source for rice out of season apart from the granary owners supplies. The granary owner does not bid for rice out of season the bid coming from the rice consuming public. The introduction of the merchant-speculators with their futures market allows the granary owner and indeed the rice producer to mitigate the price risk from the work that they conduct. These concepts will be developed in the next chapter.

1C. Warehousing and The Limitation of Risk In this chapter, the granary is replaced with the general warehouse and the granary owner with the warehouseman. The examination of cyclical agricultural production will be exchanged for non-cyclical commodity production. The production of copper does not follow cyclical patterns. Copper is produced continually throughout the year. The market for copper would establish itself as a two way bid/offer quote market. An auction process to determine the exchange price of copper would quickly evolve into a two way bid/offer quote for copper. The speed of evolution from an auction process to a two way quote (should it occur at all) would be determined by the marketability of the entity in question (). Copper is undoubtedly one of the more marketable entities in the spectrum of entities that is given value to.
() Imagine an amount of copper is put up for auction. The bidders will bid up the exchange price such that the reluctance of the potential marginal bidder to bid presents the current bid for copper. In an auction for copper, when the bid reaches a level where no further incremental bid takes place, this is the exchange price at which the copper is offered. As was mentioned, the global market for copper operates on a two way bid/offer quote basis. The bid and offer are necessarily different at all times but the benefit versus an auction for copper is that a definite acquisition price for copper can be obtained by anyone wishing to acquire copper. The evolution from an auction to a two way quote market occurs as follows: the sellers at auction of copper (set I) are complemented by another set of sellers (set II) who offer copper at a higher exchange price than the price at which copper tends to get cleared at the auction by set I. The (potential) buyer of copper now has two choices: bidding at the auction with price unknown, or taking the higher offer from set II with price known. The set of copper producers and consumers is joined by copper market makers who make a two way quote for copper.

The copper futures market allows the copper warehouseman to operate their business in a less precarious fashion than the granary owner without a futures market. Rather than purchasing copper and hoping for a later higher sale price, the copper warehouseman can buy copper at the prompt markets offer and sell a copper future at that contracts bid. Evidently, this assumes that the spread between the future contract bid and the prompt markets offer previously defined as the carry is positive. The carry for copper will be arbitraged [contracted] to the point where the marginal warehouseman refuses to carry copper in view of their opportunity cost. The opportunity cost is determined by the bid rate of general interest in the absence of other factors like the existence of a borrowing/lending market for copper. Definition: The de-carry of a particular good is the difference between the prompt markets bid and the offer on the futures market. The co-basis is defined as the de-carry expressed as a percentage of the prompt delivery (mid) price annualised. It was previously mentioned that in a shortage of the underlying good the carry tended to fall. This can be augmented further. Should the shortage be extreme, the de-carry will rise and may well turn positive. The warehouseman will be compelled to sell their (hedged) inventory and replace it with a discounted future. The de-carry premium can be thought of as the cost of unwinding a carry ahead of the maturity of the underlying future. As one might expect, this is normally negative indicating a direct cost to the warehouseman. However, in a severe shortage, the cost turns to a payment or premium received to forgo the ownership of physical inventory.

1D. Storable and Lendable Entities In the purest sense, there is not necessarily a relationship between the futures market of an entity and the prompt market of that entity. However, should an entity for which a futures market exists be storable (as it usually is) then there are boundaries involving the general market rate of interest which determine the shape of the futures curve. Furthermore, should the entity be both storable and lendable then the market rate of interest as well as the market rate for loans of the entity itself will be involved. Certain entities are storable. For example, all tangible commodities are storable for a certain period at least. Copper and oil can be stored indefinitely whereas all agricultural commodities can be stored up to the ability to preserve them. Certain financial entities such as common equity or bonds can also be stored. A contract representing the realised market volatility of the equity over the next week to be settled the week after cannot be stored. Some entities have an associated lending market. For example, there is an active market for copper leasing as well as equity borrowing.

It should be appreciated that the subset of storable entities that have an associated lending market is much smaller than the set of storable entities. Agricultural commodities are storable without an associated lending market. A closer examination of a futures market for an entity that is both storable and lendable throws up some interesting observations. For example, there is no particular bound to the size of its associated futures market. A simple example will illustrate the mechanism: imagine a copper warehouseman buying physical copper and selling a six month future. In order to earn an extra return the copper is lent for five months to a copper producer for hedging purposes. This borrowed copper is sold to another copper warehouseman, say, who sells a three month future against it. It can be seen that the same copper has originated two different futures contracts. Indeed, the same copper can originate numerous different futures contracts of varying maturities the only limiting factor being the willingness to carry copper for a lower and lower return. At some point, the marginal warehouseman will refuse to carry copper in lieu of a more profitable endeavour. So the size of the copper futures market will have a natural limit. Of course, the continued circulation and movement of copper is a given prerequisite.

THE SPREAD

2A. The Observation of The Spread Menger was the first to realise that there is no such thing as the monolithic price of an entity. The price was composed of a lower and upper bound called the bid price and the offer price respectively. Prices get cleared within that range. The more marketable goods also induce the presence of market makers: those that buy at the bid price and sell at the offer price. The offer price of a good is the outcome of the competition of consumers of the good, and the bid price the result of the competition from producers of the good. The offer price is lifted by the consumer until the marginal consumer of the good refuses to purchase any further. The refusal of the marginal consumer to purchase further presents the offer price. The bid price is pushed down by the producer until the marginal producer refuses to sell any further. The refusal of the marginal producer to sell further presents the bid price. Fekete applied Mengers observation to resolve the harsh conflict between the time preference and productivity schools of interest. Interest is entirely a market phenomenon and is directly related to the bid/offer spread on bonds. Prior to Feketes discovery, there were two schools of thought as to the origin of interest that conflicted: time preference and productivity. Simply put, the time preference theory assumes that a time premium exists a kind of fee for having substituted a present good (money) for a future good (the bond in question) regardless of whether there is a productive use of the present good. The productivity theory assumes that the marginal productivity of capital determines the rate of interest in apparent independence of temporal considerations. Fekete realised that these two theories were two sides of the same coin. Arbitrage between the bond market and the gold market establishes the interest rate bid price or floor. The interest rate floor (bid rate) is pushed lower until the reluctance of the marginal bond holder to hold bonds becomes apparent. The reluctance of the marginal bondholder to exchange gold (a present good) for bonds (a future good) presents the interest rate floor. The interest rate ceiling (offered rate) is pushed higher via arbitrage from the bond market to the stock market (in broad terms) through the action of entrepreneurs until the reluctance of the marginal entrepreneur becomes apparent.

The reluctance of the marginal entrepreneur to exchange bonds for stocks presents the interest rate ceiling. Improvements in economic coordination related to productivity are defined by improved spatial arrangements of already existing entities; for example the joining of two wheels via a rod to create an axle, or the creation of the rod itself from a whittled branch. What is the most productive use of the space around you? Indeed what is the space around you? The jet engine was there 5,000 years ago in the most abstract sense or at least the materials to make it were less the knowledge of how to make it. The interest rate offered is related to spatial considerations. The boundary between the immediate requirement of the monetary substance (the present good) against less immediate requirement (substitution of the present good for a future good or bond) is the determining factor for the floor of the interest rate. The interest rate bid is related to temporal considerations. In this way, Fekete has combined the two most important facets of the human psyche space and time into the most refined theory of interest of available.

2B. Extension of The Spread to A Futures Market: Basis and Co-basis In the line of Mengers observation about the non-existence of a monolithic price, one comes to the observation that there is no such thing as a monolithic carry in the future market for a particular entity. As a reminder, the carry of a particular good is defined as the difference between the futures contract [of that good] bid and the prompt [immediate delivery] markets offer. The basis is defined as the carry expressed as a percentage of the prompt delivery (mid) price annualised. The de-carry of a particular good is defined as the difference between the prompt markets bid and the offer on the futures market. The co-basis is defined as the de-carry expressed as a percentage of the prompt delivery (mid) price annualised. The act of warehousing an entity (in a hedged manner) has its boundaries determined by the carry/basis and the de-carry/co-basis pair. The marginal warehouseman determines the extent of the carry available. The premium paid (if that is the case) to the warehouseman to unwind their marginal inventory holdings determines the de-carry premium (more likely cost) available. In and of themselves, the bases, as the pair of the basis and co-basis shall be known, do not tell much. Rather changes in the bases give a spectrum of implications about the state of latent demand for the entity underlying a futures market for that entity. These concepts shall be developed in the next chapter.

IMPLICATIONS from CHANGES in the SPREAD

3A. Spectrum of Implications from Changes in the Bases Changes in the bases tell much more about the state of the market than absolute levels of the bases. Why? Consider the example of the set of copper warehousemen. Each of the warehousemen who has marginal capacity to store copper will have a threshold at which they will be willing to carry copper: for example, should the basis exceed 1% annualised then one warehouseman would enact a carry, should the basis exceed 2% then another (potentially different) warehouseman would enact a carry and so on with purely personal preferences. However, if the basis for copper advances in a continual manner then there is no doubt that all the warehousemens thresholds will eventually be hit. Therefore one can say that in an environment of a rising copper basis, the state of full (copper) warehouses will be tended to for sure. Reference to the co-basis can be done in a similar manner. Each copper warehouseman will have a threshold at which they will be willing to unwind their carry of copper for a consideration. For example, a co-basis of 1% might induce one warehouseman to unwind their carry of copper. Another warehouseman might be compelled to unwind their carry when the co-basis hits 2% and so on. If the co-basis for copper advances in a continual manner then all thresholds will eventually be hit. Therefore one can confidently assert that in an environment of a rising copper co-basis, the state of empty (copper) warehouses will be tended to. The observations above can be condensed into two general statements about goods with an attendant futures market: Statement I A positive and rising basis for a good implies that the next warehouseman of this good with spare capacity can make a higher profit by carrying the good. Therefore the state will tend to full warehouses for the good. Statement II A positive and rising co-basis for a good implies that the next non-empty warehouseman of this good can make a higher profit by unwinding the carry of the good. Therefore the state will tend to empty warehouses for the good. Statements I and II, as well as their duals, form the building blocks of carry analysis. From statements I and II, there are four further cases to consider. A. B. C. D. I&II happening together. Not I and Not II happening together. Not I and II happening together. I and Not II happening together.

Case A is redundant it is not possible to have a positive basis and co-basis simultaneously for a good. Referring case B, statement not I happening implies that the basis is not positive or the basis is flat or falling. Or the basis is positive but falling. Statement not II happening implies that the co-basis is negative or the co-basis is flat or falling. There are further subsets to statement B which are (relatively) more or less bullish (as far as demand for the prompt good is concerned.)

10

For example, a negative basis that is rising is less bullish than a negative basis that is falling. Referencing case C, statement not I (non-positive basis or flat or falling basis) and statement II happening is defined as backwardation proper. This would be the first clue to a shortage of the good in question. Finally with case D, statement I happening (positive and rising basis) and statement II not happening (negative co-basis or flat or falling) implies a resumption to an amply supplied market for the (prompt) good. This is defined as contango proper. A thorough summary of the states is given in the table below.

It can be seen that the changes in the bases are more important than the absolute level of the bases. Indeed, one can only make inferences about the state of the market for the prompt good when the bases are changing and not otherwise.

3B. Coordination of the Futures Market of a Monetary Metal. The coordination of the futures market of a monetary metal is a special case. Gold is the ultimate extinguisher of any debt as a consequence of its constant marginal utility. Fekete coined the expressions of gold being the most marketable in the large or the most saleable and silver as being the most marketable in the small or the most hoardable. Gold and silver are the examples par excellence of a storable and lendable commodity. These two metals were the units of account for all matters financial. Gold forms no obvious anchor in the current monetary system. No country is on any form of gold standard. The last battered remnants of a gold standard were buried in 1971 with the closing of the Bretton Woods system of currency exchange. There are common misconceptions about the nature of the gold futures market in a fiat regime, but before these are addressed, it may be useful to recap the nature and being of a financial system under a true gold standard.

11

Gold, as the monetary substance, formed the basis of all matters financial. Credit is a manifestation of the movement and circulation of the gold and is therefore independent of the amount of gold in existence. Credit arises from two sources: savings and consumption. The former is as a result of the entrepreneur seeking capital for a profitable and productive endeavour, whereas the latter occurs from the mere fact of our existence and our will to maintain it. Savings are the origin of the interest rate and consumption that of the discount rate. The loan of money for the construction of a granary saw gold flow from the lender to the borrower, from the borrower to others and so on. It also saw the creation of a bond, the repayment of which saw gold flowing in the opposite direction and the extinguishment of the bond. Of course, these gold flows would not have been enacted in the first place unless there was a productive reason to do so initially. Credit granted for the sale of fast moving consumer goods like bread would be extinguished by the sale of the goods themselves. The acceptance of a thirty day bill by the baker from the miller for the millers wheat creates a bill which is extinguished upon the sale of the bakers bread. The credit in this example is of a different form to the example of the granary owner. Bonds were the manifestation of credit that was not self-liquidating; where the credit was required for lengthy periods with no certainty of entrepreneurial success. Bills were the manifestation of self-liquidating credit credit that was to all intents guaranteed to be extinguished by the mere fact of the saleability of the items upon which the credit was initially granted. There is no limit to the potential number of productive and useful endeavours that an intelligent society can find assuming a philosophy of continual and elevated education. Consequentially, there is no limit to the size of credit that a given amount of gold can liquidate should it be allowed to move quickly enough. What is presently termed higher order money found its genesis in higher order credit: claims to gold with varying maturities were ordered with the furthest maturing (broad money in current terminology) deemed least like money (gold) and the nearest maturing more so with the bill of exchange the most money-like. In the current fiscal regime, gold is no longer able to act as the ultimate extinguisher of any debt because it is not allowed to circulate. Public and private debt piles up and is hopefully rolled over for the problem to be solved another day. Catastrophe will be struck when there is the general realisation that none of the debts can be cleared and consequentially the quality of the paper in their hands is next to naught.

12

The structure of a gold futures market in a fiat regime mimics the structure of higher order credit under a true gold standard. Financing economic endeavours with credit of a shorter duration than is required whether through intention or miscalculation is the cause of what is termed the business cycle and deflationary nadirs. Financial assets/debts which should never have existed for want of their erroneous financing suddenly are not there. This phenomenon has a counterpart in the gold futures market. The gold warehouseman is compelled to buy physical gold at the offer and sell gold futures at the bid. In order to earn an extra premium the gold is lent on the leasing market for a duration shorter than the duration of the futures written. The gold lease will mature into physical gold ahead of the requirement to deliver the gold to the futures exchange. As such, the gold warehouse might look empty until a few days before the futures expiry. This would be perfectly legitimate as gold is a lendable commodity. The deceitful gold warehouseman will lend the gold on the leasing market for a much longer duration than the futures contract written. Why? Because the premium received is higher for longer leases. If the purchaser of the gold futures contract never requires delivery of the underlying gold and is willing to roll to the next gold futures contract indefinitely, then the deception will never be exposed. If the time preference of the gold futures holder is well in excess of the length of the warehousemans gold lease, then this dishonest state of affairs will never be exposed. How would this deception be exposed? The time preference of the gold futures holder cannot be guaranteed to remain well ahead of the length of the warehousemans gold leases. The percentage of owners of gold futures that demand delivery of the underlying gold rarely exceeds 1% of contracts outstanding. As such, there is always an active bid for the next active futures contract. As a result, the dishonest warehouseman can always roll to the gold futures contract by selling the expiring contract and purchasing the next active one. However, should the percentage of those requiring physical gold start escalating, a certain threshold will be breached whereby the physical gold cannot be exchanged and a gold receivable from a gold lease will have to take its place. The cessation of the gold futures market will have less to do with an excess of gold futures being issued compared to physical gold, but rather the temporal misallocation of the physical gold capitalising the gold futures market. Permanent backwardation in gold will be the defining characteristic of the unravelling of this precarious state. The problems caused by the lack of a gold futures market will not be confined to gold investors, but everyone on the planet. Up until a permanent state is reached, the gold and silver markets are likely to swing in and out of backwardation. The silver market of late has come out of a lengthy backwardation that saw 750 tonnes of silver arrive at the exchange warehouses for the length of the backwardation.

13

At some point, backwardation will not induce such a flow of the metal towards the exchange warehouses. Gold has been oscillating in an out of backwardation ever since the onset of the financial crisis in 2008. The first appearance of a lengthy gold backwardation across the two most active contracts is given in the chart above. Surely gold can be kept out of backwardation by escalating the rate on irredeemable Dollars well above gold lease rates to maintain an impetus to hold paper? This may be true, but if the financial problem supposedly calls for lower (irredeemable paper) rates, then there is a limit to the level that this can be brought down to, without moving gold into backwardation. Why? Because there is a limit to the level that gold lease (read interest) rates can be brought down to. The appearance of backwardation is synonymous with the realisation that true interest rates i.e. the interest rate of gold (commonly termed as the derogatory lease rate) cannot be manipulated indefinitely without serious harm to society. Paper rates can be brought down indefinitely, whereas gold rates cannot. Golds monetary characteristics are exposed: governments cannot manipulate the interest rate on true money, as it can with fiat.

END

14

Bibliography Principles of Economics, Carl Menger, English translation by the Ludwig Von Mises Institute, 2007. The Positive Theory of Capital, Eugen Von Bohm-Bewark, Reprint by G. E. Stechert & Co, 1923. The Bond Market and the Market Process Determining the Rate of Interest, Antal E. Fekete, 2003.