6 December 2015
On 11 November the magazine Islamic Finance News published my third monthly column.
I decided to tackle commodity speculation, a subject that is often misunderstood. The column is reproduced below, along with some additional material which was not included in the original article for space constraints.
Speculators always get a bad name but who are they? People who buy something because they expect prices to rise, or sell because they expect prices to decline. Speculators are much maligned, but their critics ignore speculators’ essential role in making markets.
Look at cotton futures. Each Muslim must decide for himself if he considers a cotton futures contract to be Shariah compliant. However the cotton futures market undeniably exists because it meets the real needs of cotton producers (farmers) and cotton users (spinners, weavers and cloth merchants).
Before deciding how much acreage to plant, how much fertiliser to apply etc., farmers need to know the selling price of the cotton to be grown. Similarly users need to know cotton costs to calculate prices for future finished products. They may be printing catalogues or otherwise quoting firm prices for an extended period of time. Unexpected cotton price variations risk turning those finished products, with fixed prices, into loss makers.
The New York Board of Trade satisfies the needs of both producers and users by quoting cotton futures prices as far forward as July 2018. These standardised futures contracts meticulously specify quantities and grades of cotton, with precisely specified dates and locations for delivery.
Some suggest these needs for price certainty can be met by cotton producers contracting directly with cotton users to grow and deliver cotton in the future for a price which is fixed today. While theoretically possible, I regard it as unfeasible in practice. The end user would need to find farmers, often located in another country, agree contracts with many farmers of uncertain credit rating, agree terms over cotton whose future quality is unknown today etc.
The futures market meets producer and user needs quite differently and much more efficiently.
Most of the market consists of speculators, with no need for cotton, hoping to make money from price fluctuations. A farmer expecting to produce a quantity of cotton in the summer of 2018 can today sell July 2018 futures contracts totalling roughly his expected production. Critically, the cotton he grows does not need to match the precise quality in the futures contract; its price will still vary roughly in line with the futures contract. Nor does the farmer need to find a user to agree the contract; he simply sells futures contracts to speculators. The opposite is done by cotton users, who buy futures contracts from speculators.
Almost all futures contracts are closed out by transacting the opposite contract; if you have sold a future, you close your position by buying the identical future. Delivery is not needed, since the producers and users are in most cases dealing in cotton with different characteristics, in different places, to that specified in the futures contract.
The diagram below illustrates the relationships mentioned in the article:
The futures market deals in standardised contracts.
In terms of quantity, quality and precise delivery dates, these standardised contracts are unlikely to match the real cotton that the real growers expect to harvest. However the price of the real cotton grown will go up and down in a similar manner to the cotton futures contracts.
Accordingly, by selling cotton futures contracts, a cotton grower can protect himself against the price of cotton being very low when he brings in his harvest and sells it. Conversely, by selling the cotton futures, he also gives up the opportunity to benefit if cotton prices happen to be very high when his cotton is harvested.
The same logic applies in opposite direction to cotton users. They protect themselves against the risk of cotton prices being very high at the time when they need the cotton, by purchasing cotton futures. Knowing the future cost of the cotton they will use enables them to print catalogues offering to sell cotton products at fixed prices, since they are insulating themselves against the risk of cotton prices rising.
The entire futures market could not operate without the participation of speculators. These are people who neither produce nor use cotton. They buy and sell futures because they hope to profit from price movements up or down. By definition they are taking risky mismatched positions. It is their willingness to take such positions that enables the cotton growers and the cotton users to sell or buy cotton futures. Without them, the market would have no liquidity and could not function.
Whether cotton futures speculation is permitted in Islam is a religious question. Each Muslim must answer that question for himself, with the benefit of whatever religious guidance he wishes to rely upon.
In his book "Islamic Commercial Law: An Analysis of Futures and Options" Mohammad Hashim Kamali concludes that they are religiously permissible.
Whether cotton futures speculation is socially useful is an empirical question. It can only be answered by looking at the real world, and comparing economies where such futures markets do not operate with economies where they do.
In my opinion the empirical evidence about the social usefulness of commodity futures markets and the role of speculators is quite clear. Such markets help the economy to run better and make society as a whole richer.