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speculation: pro and con (again) September 24, 2010

Posted by Bradley in : financial regulation , trackback

This week the UK’s Business Department announced a review of corporate governance and economic short-termism and the Independent Commission on Banking published an issues paper and call for evidence which identifies as one concern excessive risk-taking by banks:

This separation of the costs of risk and the benefits of reward produces inefficiencies through the distortion of resource allocation and risk management; it incentivises excessive risk-taking.

And Adair Turner gave a speech in which he reiterated his concern about whether financial practices were all socially useful and said:

underlying all of these problems, and far more fundamental, were prudential rules and an entire philosophy of market regulation — embraced by policy makers throughout the world — which failed to identify and adequately address the dangers of excessive leverage and maturity transformation, and which too confidently relied on supposedly efficient and rational markets always to produce good results.

Last week the EU Commission published its proposals on short-selling and CDS and noted that one of the reasons for short selling is speculation. The Commission doesn’t say this is bad, but does suggest that disorderly markets (which may be in part the result of speculative short selling) are a Bad Thing:

in extreme market conditions there is a risk that short selling can lead to an excessive downward spiral in prices leading to a disorderly market and possible systemic risks.

In contrast, the bottom line of the ISDA Research Note on speculation published this week is:

In theory, a market could exist in which intermediaries match hedgers, investors, and borrowers with each other. But such a market would be costly and inefficient without the liquidity and price discovery provided by speculators hoping to profit from their investments in information. As discussed above, the news borne by speculators, especially short sellers is not always welcome. But the alternative is a world in which markets would function in a slow and costly manner.

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