Vast profits for unpleasant people?

Business Standard, 11 December 2023

When Saddam Hussain invaded Kuwait on 2 August 1990, the price of crude oil went up in a short period from about $40 to about $90. There were rumours at the time that some persons connected with the Iraqi regime had established positions on crude oil derivatives ahead of time. An investigation was triggered, which did not uncover evidence in support of the claim.

More recently, two American law professors wrote a fascinating paper, Trading on terror?, where they suggest there were unusual speculative positions in Israeli securities prior to the 7 October 2023 Hamas attack through which some people (potentially Hamas) made vast profits from the financial markets turmoil that followed the attack. In the event, there were mistakes in these calculations, and there was no large position or profit. With the proliferation of intricate data from derivatives exchanges going out to academics, many invasions and terrorist attacks are studied by academics seeking to write sensational papers, but no such insider trading episodes have been substantiated in the literature.

Let's linger with the thought. If you were a bad actor, Is it efficient to layer position taking on derivatives markets on top of a military or terrorist surprise?

Derivatives trading for would-be invaders

If you are a state actor -- e.g. Saddam Hussain about to invade Kuwait, e.g. Vladimir Putin about to invade Ukraine, perhaps Xi Jinping dreaming a big invasion -- the magnitude of resources involved is extremely large. Russia's invasion of Ukraine has a direct military cost of over $100 billion a year, and a much larger overall adverse economic impact (e.g. through reduced oil export revenues, e.g. through the departure of the intellectual and the business elite). To get back a profit of $100 billion from a 20% change in prices would require a position of $0.5 trillion. The most deep and liquid derivatives markets do not support such positions. Therefore, such insider trading is not interesting to a state actor.

Derivatives trading for terrorists

What about non-state actors? For a terrorist group like Hamas, $50 million is material. Putin's government contains many individuals that might like to pocket $50 million from such trades and then flee from Russia. Could insider trading, with short selling on derivatives markets, be used in this fashion by terrorists or personnel in governments that mount invasions? If this is true, might financial markets information contain early warnings about terrorist attacks or invasions?

An array of trigger words has been deliberately introduced above: "insider trading", "short selling", "derivatives markets", "terrorists" and "personnel in governments that mount invasions". In India, hand waving around such terms can kick off grim actions by government agencies. The quick summary, however, is that under minimal levels of capability at the exchange, these scenarios are far fetched.

The people who do not know finance entertain claims of vast sums of money that were mysteriously conjured through the working of financial markets. But derivatives markets are a zero sum game. The profit of one person is the loss of another. There is a finite list of members of the exchange. If a few people make vast profits, this would immediately pop up as a vast movement of funds towards a few members. All profits and losses are measured in the information systems of the exchange and all money moves through banking channels. Nothing can be hidden.

Consider a terrorist attack on Bombay. For insiders to profit from it, the following steps would happen (a) There would be an unusual build up of certain kinds of positions on Nifty derivatives, prior to the event, (b) When Nifty declines after the attack, there would be an unusual payout of funds to certain traders who operate through certain securities firms. There are no shadowy profits made out of thin air, as is imagined by the people who do not know finance. Everything that happens is backed by facts in the information systems at the exchange. Both patterns in this insider trading scheme (unusual positions and unusual profits) would jump out of the data to the surveillance staff of the exchange.

Insider trading at any significant scale is dangerous for the perpetrator because it is so easy to see, ex post, in the data. After the event (e.g. when Nifty crashes or when one stock price moves sharply), it is easy for the surveillance teams to see hot spots of positions and payoffs. Any significant activity is easy to catch, under minimal levels of capability at the exchange.

Could terrorists or government insiders take the chance, and put in trades, hoping to profit in the event that the exchange is sloppy and fails to see this activity? The trouble is, considerable resources have to be put in, up front, in order to establish derivatives positions. Futures positions require margins. Buying options requires paying for them. Implementing the strategy thus requires resourcing -- that would not come readily for a terrorist group or a government insider -- and has a high chance of generating a -100% return when it gets caught by the exchange staff. The men with guns tend to know little finance, and establishing such a conspiracy then involves leakage of information which is also dangerous.

Reel life

Fanciful claims about vast profits from financial markets trading belong in conspiracy theories pushed to an unsophisticated audience, and in fiction. In the 1997 bestseller novel Dragon Strike by Humphrey Hawksley and Simon Holberton, when Chinese generals plan a war in the South China Sea, they plan to hit the futures markets as well. Just before the shooting begins, they will go long the dollar and oil, and short the yen. The Netflix adaptation writes itself: we can readily envision the hushed scenes with indecipherable screens. But in the real world, this is generally not a realistic strategy.

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