REDUCE RISK: LEARN TO LOVE
SPECULATION
Any attempt to curb speculation could damage markets and dash
investor confidence.
We may, as President Clinton has said, be in the midst of the worst
financial crisis for 50 years. But in one respect it is the same as the others.
Everyone is blaming the speculators; those agents of evil whose
machinations bring markets crashing down, enriching the few and
impoverishing the many. Somewhere, probably in George Soros'
basement, stands a huge pile of gold; the ill-gotten gains of his gang of
wheeler-dealers.
But, as in previous crises, people are wrong to blame the speculators.
What are they suggesting? That if we could only curb or banish these awful
people, the world would be a better place? A world where decent folk
could go fearlessly about their business, where markets would move ever
upward, and rewards would be justly earned? If ever these hopefuls got
their way, they would be disappointed.
The speculator doesn't just make the world go round; he might even be
described as a force for good.
Like all figures of hate, speculators are a shadowy lot. Apart from the
ubiquitous Soros, most people would be hard-pressed to name one.
They're rather like the Wizard of Oz: much feared, but ordinary when you
actually get to see one.
Recently, I happened to be in the London offices of Long Term Capital
Management (LTCM), the hedge fund recently bailed out of trouble amid
much controversy. Half of me expected the place to look like a bomb site,
with shell-shocked victims sifting through the rubble. The other half
expected to see sinister figures with wicked grins, exulting over the huge
gains they could still make from the recent bail-out. But the place was
calm. The trading room contained rows of screens with dealers pushing
buttons and conversing in an orderly way. I was ushered into an adjoining
room with a large glass partition through which I could watch what was
going on. And over a cup of tea, I had a civilised conversation with their
chief quantitative analyst about the problems of recruiting good graduates.
Pity, in a way. I would have liked to report that the floor was spattered
with blood because it would aptly reinforce my case that speculators are
not all winners, and that by being both winners and losers they make the
markets a better place.
Why do some people think speculators are bad? I can think of three.
First, the true definition of a speculator is someone who is not
fundamentally interested in the commodity in which he trades. A gold
speculator isn't a miner, he doesn't make jewellery, and he doesn't fill teeth.
He is merely a middleman or a bystander who trades in the hope of making
a profit.
The business case for the middleman seems straightforward. He oils the
wheels of the market, filling the gaps, making prices and taking some of the
risk off producers and users by providing a counterparty. The objection
most people would make is that the middleman or speculator takes a profit
off "real" traders without getting his hands dirty. But that's more of a moral
question, and not a reason for getting rid of him. Many "real" traders are
also speculators.
Remember Procter & Gamble losing US$200m in the options market? If
there is a real business problem here, it is that the middleman can
sometimes become too powerful; he comes to dominate the market to the
point where everyone has to deal with him - at his price. But again, this is
not a reason for banning speculation; it is a monopoly issue which should
be dealt with accordingly.
True, it is not easy to tackle monopolies in a fast-moving global
marketplace like foreign exchange, but maybe that is a matter which should
go on the world leaders' agenda as they try and design the "new financial
architecture".
The second reason is linked to the first: because they are not end-users,
speculators don't care whether the price of a commodity goes up or down.
So they profit from crashes as well as booms. They may even welcome
crashes. Words like loyalty, commitment, long termism and integrity seem
absent from the speculator's vocabulary.
The accusation is true. But why should it be wrong? Is it because people
think that, basically, all markets should head steadily upwards, and that
anyone who has an interest in their going down is antisocial? Surely not. In
the UK - and SA - the press always reports a rise in house prices as good
news, ignoring the impact this will have on hopeful buyers. It also reports a
rise in commodity prices as bad news, ignoring the benefit this will bring to
producers. Far from balanced reporting, they are making a judgment as to
who should benefit from a market movement, a tendency which lies behind
every attack made on speculators.
All markets are a balance between those who want prices to go down and
those who want them to go up. The speculator is the fulcrum of that
see-saw. By taking up a middle position, he is able to supply two-way
liquidity, and cushion the risks for end-users. The danger is that a
speculator may want to drive markets to extremes, but he will be taking
enormous risks, and until LTCM came along we tended to hear more
about the gambles that paid off than those that didn't. The P&G debacle
frightened many away.
The third reason is that the shock waves from speculation don't just
damage the markets directly but can spread to innocent bystanders. We've
heard a lot of this recently from countries, including SA, who feel their
currencies have been unfairly battered. True, but surely these waves would
spread regardless of who brought about the initial shock, be it speculators
or "real" business people who had lost confidence in a particular currency.
The issue here is the speed and mobility of international capital markets, as
well as the lack of sophistication among analysts who fail to distinguish
between currencies that are genuinely in trouble, and those who just get
lumped in the "troubled" category for no good reason.
There may be a case here for putting a brake on the more violent forms of
short-term international capital movements - as the IMF is now proposing
- but not for putting shackles on the speculators, even if you could
successfully define them. Much of the evidence suggests that speculators
only win when they take on a genuinely overvalued currency; they lose if
they get it wrong. Examples are their failure to bring down the French
franc, but their success in driving sterling out of the European exchange
rate mechanism.
If there is a problem with speculation, it lies beyond the bounds of these
objections; in the fact that modern trading techniques allow speculators to
exert greater leverage than before. With little capital, hedge funds can gear
up enormous positions in the options market and literally swamp the
underlying markets. And because they themselves are so top heavy, they
are constantly in peril of collapsing if markets move further and faster than
their risk models expect, so they can blackmail the rest of the market with
the threat of their own collapse.
That's wrong. A further problem is that options enable speculators to trade
on the direction of the market, and on its volatility - how much it moves up
and down.
Because end-users don't like volatility, they are prepared to sell it cheap to
speculators who do. Volatility is a bargain. So we end up with speculators
who may not just want the market to go down, but also to bounce around
a lot on the way. That is also damaging.
But before we rush out and ban options trading, we must realise that that is
only one side of the coin. The real value of options speculators is that they
are prepared to trade risk and provide counterparties to those who are
risk averse.
Markets may seldom have been as volatile as they are now. But nor have
people had a greater range of risk traders to sell their risk to. The question
is which came first: the volatility or the options traders? The answer must
be the volatility, because otherwise no one would have had the bright idea
of inventing options.
So we shouldn't kill the options traders; it won't get rid of the volatility. But
it would leave us without ways of protecting ourselves against market
swings. In fact it is hard to think of any measures against speculation that
wouldn't damage markets, reduce investor confidence, and end up making
things worse than before.
Many of the real problems with speculation have to do with different
questions: excessive leverage, market concentration, poor regulation and
the morality of making lots of money. Sort these out, and speculation could
even become a socially acceptable occupation.
By: David Lascelles
David Lascelles is co-director of the London-based Centre for the
Study of Financial Innovation which can be reached on
www.csfi.demon.co.uk.
fm.co.za
|
