Duffie on speculative trading
by Linda Beale
Duffie on speculative trading (Part one of a series)
In today’s Wall St. Journal, Darrell Duffie, a finance professor at Stanford’s business school, argues “In Defense of Financial Speculation” (Wall St. J., Feb. 24, 2010, at A15). (Rdan here…AB posting is Feb. 26)
According to Duffie, speculators are beneficial. Here’s his argument.
1) speculators absorb risk that others don’t want, permitting investors to hedge their positions
2) speculators provide information about invetments–if they buy, fundamentals appear favorable; if they sell, fundamentals are not. That information helps market prices be more accurate.
3) speculation–defined as “accurately forecasting an investment’s fundamental strength or weakness”–is not the same as manipulation–defined as “when investors ‘attack’ a financial market in order to profit by changing the value of an investment.
Duffie admits that speculation “is not necessarily harmless. If a large speculator does not have enough capital to cover potential losses, he could destabilize financial markets if is position collapses.”
Are Duffie’s arguments strong enough to think, as he suggests, that curbing speculation in the credit default market isn’t necessary? Note that item 2 stems directly from the “efficient markets hypothesis”–that markets price items appropriately through sharing of information. But what we know suggests this isn’t true. We have an entire vocabulary for talking about the fact that without stabilizing intervention and protective regulation, market pricing–and the kinds of speculation that Duffie praises–tends to lead to market bubbles. The housing markets are a good example. People thought that housing was a good investment. Speculators got into housing to “flip” houses to make a profit. Other speculators bet on the housing market through collateral debt obligations and other types of mortgage backed securities. These were often tied with credit default swaps, which the counterparty banks saw as a “safe” bet that meant steady premiums without any payback day. The speculation is what made the housing market into a bubble. And when the bubble burst, many of the speculators had to be backed by the government to keep the financial system going. Prices weren’t an accurate reflection of value. They were only an accurate reflection of the casino mentality estimation of value. And the increased speculation in housing didn’t mean there was more accurate evaluation of fundamental values. It meant, in fact, that there was less and less accurate information, as lenders eager for loans to securitize accepted shoddier products and pushed for shoddier lending standards and as the securitization market’s key characteristic–the lack of a relationship between lender and debter–became the key variable that made speculative investment in housing too easy because the loss risk could, theoretically at least, be offloaded to the investors, guarantee counterparties and other third parties. Combine the speculative “casino” mentality with the lack of relationships between lending banks and buying families and you have a winner take all casino system where nobody but the winners are served. Here, that ended up being the big investment banks.
What about item 1–the hedging function that speculators serve by taking risks that others want to offload. Well, our system treats that as a plus. It is one of the factors that permits securitization and one of the factors that permits globalization of the risk–spreading it around in little pieces of losses. We tend to think that being able to hedge the potential future risks of a business is a definite priority. If we need energy a year out, we can buy futures. But is that really a plus? Would we be better off if the lender continued to bear the risk against the lender’s equity capital? Odds are loans would be harder to get but surer to pay off. And, yes, we’d need some ability to lubricate the pipes during financial difficult times. But notice that all of that speculative hedging function hasn’t done much to ensure that small businesses and working families are able to borrow now when they should be able to. So if it doesn’t function well when there is a financial crisis, why think that it is really working well when there isn’t?
And item 3–that speculation is ok, it’s just market manipulation that we have to worry about? Duffie suggests that there is a bright,easily definable line separating the two. I’d argue that there is not. Speculation becomes manipulation when it is too big, when there is too much risk and not enough capital to absorb it, when it creates a deceptive appearance of rationality but represents irrational exuburence. Speculation is just manipulation writ smalll–since speculation is a bet against what appears to be a market trend and making the bet can shift the market. Casino gambling doesn’t really look to fundamentals; it looks to perceptions of fundamentals. So long as the odds are breaking the gambler’s way, the gambler doesn’t care whether it’s rotten at the core or not. And of course, one of the problems with financial derivatives generally, and their use as speculative instruments in particular, is that they make it possible to finely tune financial scams–shadow banking systems can exist for countries (and the globe), and shadow financial realities can exist, since derivatives can be used as subterfuge. Financial transparency is one of the keys to maintaining democratic institutions without permitting country and system to be captured by ruling oligarchies.
Maybe I’ll wake up tomorrow and regret this post. Perhaps I’m a Luddite in tax prof clothing. But I can’t shake the thought that globalization–the idea that corporate entities should be able to operate their business world-wide without any “barriers” from the nations themselves–is at the heart of our systemic economic problems. The rage at the base of the tea party movement is real–it has been misdirected at government, as though government were the source of the problems, when it should have been directed against the Big Business mentality that casts morality aside and considers profit the only god–community, workers, and product quality/service be damned. The tea partiers’ rage itself is real, because people are so fed up with having no real choices, at being at the mercy of multinational corporations that set their own terms and, often, have near monopolies. This is especially true with health insurance, where the lightly regulated industry is made up of a few giants who often dominant their markets, leaving a typical person little ability to “shop” for a better deal. Even where you shop, once you create a business relationship you are in many ways at the mercy of the corporate giant. They change prices when they please, they charge ridiculous add-on fees for services that cost them only a small fraction of the fees they charge, they hide information and manipulate their clients–from cable providers to banks to mortgage lenders. They are no longer local, and they no longer care about your community or you as a client. It seems to me that if we want businesses that are more responsive to the typical person, we need businesses that are smaller, not businesses that are bigger. We need more Mom and Pop stores and less Wal-Martization of the country. Because in the long run, a company that is run like Walmart–to make the biggest profit possible for its owners, come hell or high water and without concern for the communities or people in them–may be able to offer goods at lower prices but it also offers jobs at lower pay. If we had those same goods sold by smaller stores that hired in the community and lived in the community, we might pay more but the employees would be paid more. In the long run, that is the secret of quality of life–having a population that has decent jobs so that they can afford to buy life’s necessities and a little more.
I suspect that there will be many others who join Duffie in defending financial speculation. But I find that his arguments about risk absorbing and pricing information fall short of convincing. If speculators really absorbed risk, there would be no worry about the risks falling back to the taxpayers. But in the case of the financial crisis, it was the taxpayers, ultimately, who got hit with the risk. There were many times more credit default swaps on debt than there was debt outstanding, creating an illusion of a well-diversified financial system with supports all around. But AIG held a significant percentage of the counterparty risk, and all the banks were dealing with AIG or some other counterparty that held significant amounts of risk. All that speculation didn’t do more than link us all together in one big Ponzi scheme. And while there was lots of information about what the speculators were buying, the result wasn’t widespread increase in fundamental knowledge–instead, it was “he’s getting rich with those mortgage-backed securities, I need to get in on that too” or “Bear Sterns is making lots of money with its securities packages; maybe I can get some of those subprime mortgage deals going for my bank” or “look at how much he made flipping that house in just two months; I gotta get some of that”.
Linda Beale crossposted with ataxingmatter
The bigger problem is leverage limits, and not speculation. Leverage is regulated in certain instances, and others it is not. Housing was HIGHLY leveraged, to the point where people did not have to put any money down.
great post Ryan
I’ve been toying with the idea that the financial casino ought to be separated from the financial marketplace with only limited and deliberately damped interaction between the two. What am I talking about?
There is a legitimate need to be able to trade shares in companies, bonds, and commodity futures in a marketplace. No argument about that. What I’m suggesting is that the marketplace that does that possibly does not need to be the marketplace where (most) speculation takes place. Let’s call the first market the marketplace and the second, the casino. What I’m suggesting is that the marketplace deals in real securities and commodities, and only in the amounts that might participants have or can plausibly acquire in reasonable ways. e.g. you can sell your corn crop four months before it is harvested. You can not sell 50 million barrels of crude oit that you don’t have and couldn’t store or process if it were delivered.
In the casino, on the other hand, you can sell and buy anything that isn’t purely fraudulent and possibly a few things that are. Futures, commodities, stocks, weird warrants, incomprehensible insurance policies … whatever. The only rules are that all transactions are public, clearly fraudulent activity results in jail time, bets in the casino on the marketplace are against index prices, not actual commodities and securities, and that companies in the marketplace can only bet in the casino through true arms length transactions with intermediaries they do not own or control.
Workable? Maybe A good idea? Perhaps. Worth discussing I think.
Great Post! Especially the remarks about EMH. It’s definitely what John Quiggin tags as Zombie Economics. A defunct idea neither alive nor dead.
***2) speculators provide information about invetments–if they buy, fundamentals appear favorable; if they sell, fundamentals are not. That information helps market prices be more accurate.***
Why are speculators better at price discovery than those who actually want to own/no longer own the investment? Do they actually bring some magic element of otherwise hidden knowledge to the marketplace. How do we know that the speculation doesn’t, on average, obsfucate price discovery?
I’m not convinced on all of the economic benefits. A similar argument is made for short sellers providing price signals for the market, not convinced on that one either.
But I’m hesitant to restrict this too far as long as 1) it is not with my money, 2) people have enough capital to cover their bets, 3) it is transparent and 4) does not overwhelm the market as we have seen recently.
“Perhaps I’m a Luddite in tax prof clothing.”
It looks that way.
“if they buy, fundamentals appear favorable; if they sell, fundamentals are not”. Logical flaw — appearance is not reality !
Duffie: “speculators provide information about invetments–if they buy, fundamentals appear favorable; if they sell, fundamentals are not. That information helps market prices be more accurate.”
This guy’s definition of speculation is unusual, isn’t it?
Duffie: “speculation–defined as “accurately forecasting an investment’s fundamental strength or weakness”–is not the same as manipulation–defined as “when investors ‘attack’ a financial market in order to profit by changing the value of an investment.”
Yup. Now the question is, what is the difference between a speculator and a fundamentals investor? It seems like this guy doesn’t know the difference.
Not sure separating the markets would work, as I do not see that as the problem in speculation. The problem is margin/reserve requirements, and the ability to take gigantic positions that exceed ones net worth or reserves.
Let’s take AIG for example. They kept writing naked CDS contracts, with liabilities that far exceeded their reserves – now the taxpayer is acting as their reserves.
Let’s look at the housing market – buy a house with no money down. If there were a 20% down payment requirement, we probably have avoided the bubble in the first place. Does not mean you cannot have one, but at least it would have been more mild, after all we did have the tech stock bubble, despite stock margin requirements being quite high.
Now in using your $50 million oil example, if you want to safeguard the parties involved and prevent someone from amassing an excessively large position, then higher margin requirements might do that. In the futures markets margin can be low. Margin rates there are 5-15% set by exchanges, and brokers.
The you have the problem of interest rates that are so low, people borrow at near zero, and then purchase big speculative positions.
Price discovery can be a strange beast. In fact many CDS contracts had the opposite problem, in that the contracts were under-priced! I’d say speculators add more to liquidity. Of course, the more liquid a market usually the better the prices (tighter spreads).
***Not sure separating the markets would work, as I do not see that as the problem in speculation. The problem is margin/reserve requirements, and the ability to take gigantic positions that exceed ones net worth or reserves. ***
I don’t completely disagree. I think what I’m really looking at is the feasibility of separating conservative long term/value investment from gambling without preventing or even discouraging gambling.
People enjoy gambling on sports, horses, dice, cards, stocks, bonds, and which spider will reach the ground first. Can’t stop ’em. Probably shouldn’t try. So why not give them a financial casino where they can do any preposterous thing they wish, but try to limit the damage to those who wish to play there?
I think the housing market thing is a non financial market issue in that one can have a real estate bubble with no assistance from modern financial markets. “The expence of living is greatly advanc’d in my absence. Rent of old houses, and value of lands… are trebled in the past six years.” Ben Franklin 1762 ( http://www.theedwardbulwer-lyttoninstitute.org/uploads/1/7/5/8/1758444/real_estate_bubbles__preventing_further_occurrences.pdf ) That bubble busted in 1764.
I don’t think there is any way to keep people from misestimating the value of real property. There’s always some reason that things are different this time. A rational down payment policy would moderate things, but given that bankers appear to be, on average, remarkably stupid people, it’s hard to see how bubbles can be avoided. And frankly, I think if the problem in the US were just that some banks made a lot of ill-advised loans, I think this would just be a pretty much normal cyclic recession. The problem is that a superstructure of huge leveraged bets was built on top of a speculative housing bubble and pretty much everyone that was supposed to be investing was also gambling … on housing.
The points that Duffie offers are conventional, but the convention was all part of the huge love-fest with finance. Many of the bald assumptions behind the easy conclusion that financialization is good for you have remained assumptions. I have trouble with Duffies assumptions.
Point 1 – WHY do speculators absorb risk others don’t want? Is it because they have skewed incentives – they can get richer than most if they guess right, but are likely to fall only to a sort of upper average level of material welfare if they guess wrong? Are they “absorbing risk” into their financial entity, but not taking commensurate risks themselves? If so, then they are really just recycling risk back to their own creditors and investors, while pretending to absorb it.
Point 2 – What VTC said. Why do we believe that, with all the private and institutional investors in the world, there is a paucity of information about the value of assets until speculators price them? Do speculators provide unique information that some other investor could not provide? This is really a claim about processing information – speculators are smarter than everybody else. Why would we believe that? Does greater risk may one smarter? I’m willing to believe that, but see point 1. If speculators aren’t really at greater risk than other investors, why would we think they are smarter?
Point 3 – Just plain silly. Defining speculation as guessing better than everybody else grants speculators a sort of halo. Other investors just bumble around, while the heroic speculator accurately forecasts. Baloney, until proven otherwise.
If the assumptions are a mess, then the conclusion is very likely a mess. I note that “speculators provide liquidity” is missing. That has long been a standard part of the excuse to allow speculation, but since we have recently seen that speculators don’t provide liquidity when we need it most, that bit had to be jettisoned. Why should we think the other claims are more solid? Simply because they have not proven disastrous within recent memory?
All investment involves speculation. Even if you buy a CD or T-Bill you are speculating that the bank and govt will pay you back. Not a big risk, so the returns are <1%. If you go longer term to get 1%+, you are speculating that rates won't rise and destroy your investment.
Back in the crash of 2008, I had a position in an inverse (oil down) ETF called DUG. During the crash DUG went from $25 to $100 and largely offset the losses in the rest of the portfolio. I also bought puts on financials. Buying puts allows me to hedge my positions when I get worried, instead of selling the stocks.
***All investment involves speculation. Even if you buy a CD or T-Bill you are speculating that the bank and govt will pay you back. Not a big risk, so the returns are <1%. If you go longer term to get 1%+, you are speculating that rates won't rise and destroy your investment. ***
All true. The problem isn’t that the market is risky. It is that leverage multiplies risk and speculation is associated — fairly I think — with the use of lots of leverage. When the speculators misprice risk and there are not adequate solvent counterparties offsetting them, there is the potential for disaster that goes far beyond the insolvency of a few unlucky/improvident/demented speculators.
Speculation with ones own resources is harmless, or at least places the incentives squarely where they belong in order to induce “efficient” consideration for loss. Duffie’s arguments do not touch upon the malicious aspect of speculation, which stems from the ability to take on leverage with limited liability. This ability has the potential (as I think we’ve seen) to trump completely the argument that speculators absorb “risk that others don’t want”. By their practices, taken as a whole, this group may create more risk than it absorbs.
People and institutions should be able to speculate as much as they want with their money or money that somebody else has turned over to them to manage. I don’t know what’s wrong with Linda or anyone else that would think otherwise.
Speculation is a zero sum game so how can it do damange to the overall economy?
You don’t believe in fiduciary responsibility, do you?
Yes I do, and I’m not sure you understant the term “Fiduciary”
Ze Bubble…She is a very, very good thing, yes?
Just now able to join this debate. sorry.
But sammy. There is a big difference in the kind of risk one takes when one buys a corporate bond (whether in the primary market from the issuer or in the secondary market). That risk is dependent on the corporation’s success or failure, and the fact that someone holds that bond means that the corporation has that money to use in its business (hopefully to succeed with). With credit default swaps, you may hold the “reference” bonds but they may be purely naked bets. The risk is magnified–the corporation isn’t getting any new funding, this is just betting going on among speculators. So it is not productive (any more than the gambling at a casino is productive) and it enhances risk, in that there is a broad network now of counterparties weighing in on one side or the other of the bet, and it may (generally does) have an impact on the corporation itself (for example, making it harder for the corporation to get additional financing, as in Greece’s current crisis situation). It’s that naked bet using derivatives that multiplies the systemic risk, and that is the speculative side of the market.
Let’s forget that you seem to think that there is something “wrong” with anybody who disagrees with you and explore this a bit. You say that “people and institutions should be able to speculate as much as they want with their own money”. That sounds like an a priori ideological position–ie, a libertarian approach that says whatever anybody wants to do is fine. But even most libertarians admit that there are limits to individual liberties when they butt up against the rights of others. To phrase the question under discussion in more libertarian terms, how would you answer the question whether “speculation”–the kind of naked, casino betting that goes on when a credit default swap market has an aggregate notional principal amount that is several orders of magnitude bigger than the underlyings–brings about the kind of harms to others because of the systemic risk that means that it should be limited? That is, we have seen the results of untamed speculation–near catastrophe generally, and actual catastrophe for those thousands who have lost their jobs, their homes, their savings in this Great Recession. Doesn’t the correlation of untrammeled speculation with unmitigated disaster for many individuals mean that even a libertarian would consider the need for appropriate boundaries for speculative behavior? I’m not sure what I think the limits should be; I’m in fact raising the question about size, financial innovation, and speculation as an interrelated set of issues that we need to graple with. But it seems to me rather an “ostrich with head in sand” attitude just to recite the same old mantras about individual freedom and responsibility in the face of the disastrous impact of casino finance on the global economy.
Is it because they have skewed incentives – they can get richer than most if they guess right, but are likely to fall only to a sort of upper average level of material welfare if they guess wrong?
Bingo. I think that’s a lot of the problem. The risks are asymmetric and at worst bounded by zero on the left, and more often bounded by some “sort of upper average of material welfare if they guess wrong.” I wonder if these speculators would be so bold with other people’s money if this country adopted the Chinese attitude toward white collar criminals…line ’em up in front of a firing squad and then give the families a bill for the cost of the bullet. I think that would do a lot to center risk around a more symmetric position.
What’s wrong with you Linda, don’t you know that speculation is a zero sum game? So how does a zero sum game bring down an economy? The idea that speculation brought down the economy seems to me like an idea only an ignorant crackpot ideologue could love.
I don’t know your investment experience but like Hillary Clinton last year I did some speculation in the crude oil future market (Hillary made her money in Cattle). I made money, I lost money, made some more, lost some more, and then quit because the long term idea I had did not pan out to the extent that I hoped and after that I had no basis to continue trading. Whatever I gained on one trade someone lost, and vice-versa. Moreover, the market was being manipulated by cartel but I left with no tears since I knew all this beforehand. It was fun; you should try it some time. There’s no need for crack when you can trade in futures contracts.
Let’s think positive. When I made money it was generally because someone had wanted to lock in a price today for some oil that they intended to buy some months in the future, so I sold them some futures contract and then bought them back closer to the delivery date. If the price went down I won. If the price went up the person with the long contact won and I lost.
Imagine if the future’s market did not exist. In that case I would be out of the market. However, the person that wanted to hedge their acquisition price would not be able to do this. However, by engaging in the business requiring a petroleum product by default they are speculating in the market. Let’s say for an airline buying jet fuel, jet fuel prices fall they win and when they rise they lose. They probably don’t want to run a airline/jet fuel speculation business and only want to run an airline. With derivatives they make their business less speculative with respect to jet fuel prices. So if you do away with derivatives you increase speculation in everyday businesses.
Linda, you’ve failed to demonstrate how derivates add systemic risk to the banking industry. The only think I can think of is that by spreading risk around it induced the overall banking industry to make too many real estate and other consumer loans. The easy real estate loans likely fueled a bubble, and it’s the popping of the bubble that’s the problem, not the zero sum game derivatives.
So my advise to you is to do some speculation to learn first hand what you’re talking about and leave behind the crazies at the left wing water cooler
Hiding? We all know you don’t have clue about what you’re talking about.
LOL….Linda has finished her IMF presentation in Washington DC and is finishing her book as well.
She posts way below her resume.
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