The last chapter explained that classical economic theory indicates that derivatives trading has a stabilizing effect on spot prices and there is empirical support for this view. Nevertheless, derivatives markets have often been blamed for price destabilization. Contrary to the classical theory, there are also credible theories indicating that derivatives may destabilize spot prices. This chapter outlines the theoretical basis for a destabilizing influence and looks at empirical evidence. It first looks at ‘conventional’ (or older) theories on how derivatives may destabilize spot prices, spanning commodities as well as other types of underlying. It then looks at the more recent theory on destabilization of commodity prices through the use of commodities as an investment class, also known as ‘financialization of commodities’.

Economic theory versus political fact: Perception of derivatives as destabilizing

Outside the rarefied world of economists, derivatives have often been accused of being a major agent of price destabilization through excessive speculation, and even of being a cause of inflation. Admittedly, a general feeling that speculation is bad and (since speculation is presumed to be bad) derivatives are bad, lies at the root of many of these criticisms. It was something on which Abraham Lincoln and Vladimir Lenin were in surprisingly close agreement.

Traditionally, the response of most ‘mainstream’ economists to such popular perceptions has been to dismiss them as being based on insufficient understanding of the market mechanism. Regulators ‘have frequently expressed concern that futures and options markets can be price destabilizing and welfare reducing … [but] theoretical economists, on the other hand, have tended to follow the spirit of Frieman.’