The role of speculators is very important in any leveraged markets as they provide the required liquidity into the system thereby allowing smooth entry and exit of traders in the exchange. A market can prosper only when there are enough number of speculators who stand behind a trade.
The intent of the speculator is just to make money out of the fluctuations in market. He can be anybody who enters a trade with the intent to make profit out of a transaction depending upon the move of the market which he perceives will happen. The short selling concept further helps speculative activity as these trades are cash settled. The LME is the best example where deliveries constitute less than 1 per cent of the entire volumes on exchange clubbing the remaining 99 per cent of trades as speculation. Speculative activity helps in boosting volumes. The trading volumes constitute the source of revenue to the exchange and the government. The maturity of the market is directly proportional to the number of speculators in the market as a large number of speculators are a sign of decontrolled markets.
In currency markets where there are no deliveries of actual currencies the whole trading gamut can be termed as speculation where individuals, corporate and banks speculate on currency pair fluctuations thereby providing liquidity in pair.
The classic example in the currency market is the USD-INR pair which has a twelve month contract listed but except the first three months there is hardly any liquidity available due which the cost of entry and exit is huge because of the spread or difference between the bid and ask quotes. The interest of speculators in markets is also an important factor as the USDINR pair constitutes 95 per cent of trading volume of domestic exchanges where the other three pair clocking in less than 5 per cent. The global trend has also been the same as major volumes are witnessed in USD then followed by Euro and other major currency pairs.
Over a period of time the difference between the Bid and Ask of both USDINR and other currency pairs has been contracting not only in near month but also in far months too since its existence, thanks to the rising number of speculators without which it is next to impossible to provide the liquidity continually.
The government exercises direct control over the speculative activity in order to control the prices by directing increases in trading margin and capping the trading limits of members. Speculation is healthy for markets but becomes a double edged sword in the event of sharp rise in speculation resulting in irrational prices or quotes which wipes out the traders from markets.
A speculator can be anybody who may or may not have interest in the actual currency he is dealing with. Sharp rise in speculation will result in choppy trades wiping out of traders which is not good for long-term health of the market. But by exercising active controls the speculative activity can be controlled reducing the ill effects of speculation.
(The author is CEO, Alpari Financial Services, India.)