The development of organized cotton markets as existing in the 1920s and 1930s started in late XVIII century, when British cotton trade begun to grow quickly in volume, importance, and technical organization and when cultivation of cotton was first attempted in North America, to lead the USA soon to become the most important producer in the world. A crucial evolution in cotton markets, however, took place from mid XIX century when a regular steam service (first trip accomplished in 1840) was established between England and the USA and when a transatlantic cable was successfully laid (1866). The steam service reduced the time necessary to cross the Atlantic from about seven weeks to nine days, thus increasing the speed at which crop reports from the USA could reach Liverpool, and allowing samples of raw cotton to be delivered to Liverpool merchants long before the bales sent from America in ordinary cargo ships. This improvement in transportation caused the development of a market for cotton to arrive which gradually replaced auctions of cotton on the spot or on
consignment. A formal regulation of contracts of cotton to arrive was issued by the Liverpool Cotton Brokers’ Association in 1869, but by that time, thanks to the transatlantic cable, which allowed for virtually instantaneous communication between England and America and crucially contributed to establishing an extremely close connection between the price of cotton in different and distant markets, another kind of contract—contracts for shipment or for future delivery—had acquired such an importance and had evolved in such a manner that in 1871 the same Association made a clear distinction between contracts for specific cotton shipments and general contracts in terms of cotton of standard quality for shipment to be made in named months (Rees 1972: 89-91).2
The latter distinction was essential to the development of hedging operations (i.e., protection of farmers, merchants and consumers from price fluctuations) as a different activity from that aimed at actual cotton delivery.3 Hedging consists of a set of practices which allow both a subject who owns or will own a quantity of cotton of a specific quality and means to sell it at a precise date (or when opportunity arises) and a subject who wishes to purchase cotton (not necessarily in the same quantity, of the same quality and at the same future date as the other subject may allow) to take protection against fluctuations in the price of cotton even if they cannot directly agree an exchange of commodities because none of them is in the position of providing a suitable counterpart to the other. The subjects who allow to bridge the gaps between these two parties may be called speculators, and the instrument they use is the contract for future delivery of cotton of standard quality, which we have just seen to have emerged as a result of improvements in transport and communication technologies.
In order to obtain such a protection, the subject who owns cotton may sign a sale contract for future delivery, while the subject who wishes to purchase cotton at a certain future date may sign a purchase contract for future delivery, both at specified prices. If they cannot directly match these contracts, speculators find two opportunities to offer their own services. For instance, if a cotton merchant (the same would apply to a cotton producer) has acquired 100 bales of cotton of x quality, the futures market allows him/her to hedge against this purchase by selling for future delivery 100 bales of cotton of standard quality at a named date (i.e., signing a futures contract), where reference to standard quality makes easier to place such a contract in the market—but, as a rule, the
2 Cotton futures exchange were established in New York in 1870, in New Orleans in 1880, in Liverpool and Le Havre in 1882. The first cotton futures exchange, however, seems to have been the Alexandria Cotton Exchange, active from 1861 to 1961 (Baffes and Kaltsas 2004: 154-64).
3 Of course, the same applies to any commodity for which similar market arrangements exist.
subject who buys the contract is not interested in actual delivery. If, on or before delivery date (maturity) specified in the futures contract, the merchant finds a buyer for the 100 bales of cotton of x quality, then the futures contract may be closed out by buying back the same contract—i.e., paying or pocketing the difference between the current futures price for cotton of standard quality and the price specified in the futures contract (in fact a Cotton Market Clearing House—later Liverpool Cotton Bank—was established in Liverpool in 1876 exactly for this purpose). If the latter price is higher than the former (i.e., if, assuming that approaching maturity spot and futures prices tend to converge, spot prices have gone down), the merchant makes a profit on closing the futures contract; but such a profit is approximately offset by the loss in the sale of the 100 bales of cotton of x quality, which must be sold at a price lower than expected (i.e., lower than the one agreed in the futures contract); the opposite would be the case if prices had gone up. The merchant will make no profits nor losses due to price fluctuations, and for the conduction of his/her activity may rely on ordinary commercial profits as calculated with regard to the price accepted in the futures sale contract.
Exactly the same would apply (mutatis mutandis) to the case of a spinner who wishes to purchase a certain amount of cotton at a future date.
Crucial to these developments—to facilitate the operation of the whole system—was the distinction between two markets: one dealing with transactions in specific types of cotton in view of its actual delivery, the other dealing with transactions in a general type of cotton which may lead to actual delivery, but where the parties involved are more often interested in closing the contract before actual consignment. Obviously, the existence of a common system of grading cotton by quality, which, in general, is essential to the good functioning of a market, is also a premise to the use of the latter type of contracts, because it allows to establish a known relationship between x quality and standard quality.
The same separation and development of two such markets also allowed, on the one hand, bull speculation (speculation based on the expectation of an increase in prices) to free itself from the need to accept actual delivery of the produce, and, on the other hand, bear speculation (speculation based on the expectation of decrease in prices) to emerge, given that, otherwise, it would have been restricted to those who actually owned a stock of cotton and to the magnitude of that stock (Rees 1972: 92).
Obviously, in principle, what facilitates speculation also makes hedging easier, because an active speculative market may make it easier for the hedger finding a subject interested in the purchase or sale of the necessary contracts. Indeed, Hubbard suggests that, when a thorough examination of all the outstanding contracts of firms active in the
New York Cotton Exchange could be accomplished, only 15 per cent of market operations could be described as purely speculative (e.g., futures purchases guided by an expectation of future price rises which could be fostered by events such as a report on a drought in an important cotton growing area), while the remaining 85 per cent could be described as strictly trade business, i.e., hedging (Hubbard 1928: 318-22).4 This happened in 1914, just after the outbreak of WWI, when, in a particularly severe market crisis, brokers were willing to disclose any aspect and motive of their positions and allowed them to be scrutinized in the greatest detail, and also in 1918, just after the Armistice, when a similar investigation was undertaken. Indeed, a keen observer (and actor) of the cotton market such as Hubbard strongly maintained that the two poles around which every component of the cotton trade rotates are producers and consumers (i.e., farmers and spinners). A significant part of the activity of those engaged in futures markets must simply answer the two symmetrical needs of producers and spinners.
Nevertheless, purely speculative behaviour, even if covering only a limited portion of total exchanges, may exert an extremely strong influence on short term price movements, if not on longer period trends too (see for instance Hubbard 1928: 392-4).