On the costs and benefits of speculation

Darrell Duffie writes “In defense of financial speculation” in the WSJ (via Alea):

George Soros, Washington Democratic Sen. Maria Cantwell and others are proposing to curb speculative trading and even outlaw it in credit default swap (CDS) markets. Their proposals appear to be based on a misconception of speculation and could harm financial markets.

It is interesting that he opens his defense by eliding from a discussion of speculative trades to a discussion of speculators:

Speculators earn a profit by absorbing risk that others don’t want. Without speculators, investors would find it difficult to quickly hedge or sell their positions.

The problem with this elision is that when “speculators” are taking on economic risk that investors do not want, their trades don’t meet the definition of a speculative trade and thus are rarely covered by laws proposed to restrict speculative trades.  For example, when a law requires purchasers of CDS protection to own the underlying bonds, nothing prevents bond investors from hedging with or selling their positions to “speculators”.

A speculative trade take place when (i) the transaction (like a standard derivative contract) is zero-sum — whatever one party gains the other necessarily loses and (ii) neither party to the transaction has an existing economic exposure that would be hedged by the transaction.   In other words, a speculative trade occurs when both parties to the trade are speculators.  Typically regulations to control speculation focus on speculative trades and are careful to exclude hedging transactions.

The only defense of these transactions is:

Speculators also provide us with information about the fundamental values of investments. When the fundamentals appear favorable, they buy. Otherwise, they sell. If their forecasts are correct, they profit. This causes prices to more accurately forecast an investment’s value, spreading useful information. For example, the clearest evidence that Greece has a serious debt problem was the run-up of the price for buying CDS protection against the country’s default.

The argument rests on an assumption that more accurate prices mean that information is more “useful” and that this has some social value.  It’s possible that this is true, but it certainly hasn’t been demonstrated.  What were the costs of inaccurate pricing in the bond market before CDS contracts allowed speculators to express themselves?  We know that bond markets functioned well enough to develop dramatically from the 18th through the 20th centuries.  But somehow the incremental information created by CDS contracts is supposed to have some great added value.  How do we measure this?  To whom does the added value accrue?  Does the public actually benefit or do the speculators themselves capture all the gain?  These questions need to be answered before one can conclude that any increase in the accuracy of prices created by speculation outweighs the costs of such speculation.

Duffie fails to take into account the largest cost created by speculation.  He focuses only on market manipulation, but the real cost of speculation is the cost to the judicial system of enforcing speculative trades.  Remember that these are trades between two speculators — these trades do not interact directly with the real economy or contribute to economy’s productive capacity.  On the other hand under current law these trades are enforceable contracts.  Judges on the public payroll must spend weeks if not years adjudicating issues related to these contracts.

A successful defense of financial speculation will require a careful demonstration that the social benefits that derive from the incremental pricing accuracy due to speculative trades outweighs the social costs of expending public resources on the enforcement of speculative contracts.

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