A Normative Analysis of Market Speculation

It’s my general contention that the two conventional justifications of the stock market come up short. The first rationale is that the market offers allocative efficiency for the broader economy, signaling where to invest. Investments become increasingly warranted when prices go up because the underlying assets, and their expected returns, are increasingly believed to be tending upward. The second rationale is that initial public offerings (IPOs) grant worthy companies a necessary and socially beneficial injection of capital. I want to dismiss the latter out of hand. Empirical data suggests that less than 10% of corporate funding comes from IPO capital. But the first rationale deserves further treatment.

For clues about whether this holds true in the stock market as a whole, we can look at a specialized sect of trading called derivatives trading. Derivatives are financial instruments that basically allow traders to place bets on underlying market forces. In the same way as profits in horse betting  are determined by the outcome of the race, profits in the derivatives market are determined by the outcome of some financial event (e.g. the rising or falling of interest rates). This practice has  social utility as a hedging function. For example, if a firm is destined to lose a large amount of money if interests rates go down, they can hedge against that loss by entering the derivatives market. But as is commonly reported, the derivatives market – specifically the trading of collateralized debt obligations – helped precipitate the bursting of the housing bubble and helped usher in our current economic conundrum. Lynn Stout, Professor of Law at UCLA, suggests that the passing of the Commodities Futures Modernization Act of 2000 (CFMA), which removed regulations of speculative trading in the derivatives market, “caused the exponential growth of the derivatives market” that “set the stage for the 2008 crises.”

It was not hedging but speculative trading – trading that does not serve a hedging function, trading between two parties holding dissimilar beliefs about what is going to happen to the underlying asset or event – that grew in the wake of the CFMA. The purpose of this type of trading is what economists call rent- or profit-seeking. Accordingly, and in any case where two parties make bets against each other, no value is created. The speculative behavior on Wall-Street, therefore, serves only a redistributive, i.e. personal, not societal function. So if speculation in the derivatives market lacks social utility, and has in light of its harm been regulated by the Dobb-Frank Act, what normative implications does this have for the broader economy? This takes us back to the question of whether the stock market serves an allocative function. Some academic literature suggests that it does serve some allocative function, but the benefits of that function are outweighed by the costs. Stout says, “the costs of commission, spreads, research and analysis, and portfolio administration, when considered at the margin against the benefits of liquidity and efficiency, appear to make speculative trading a costly market failure.”

Accordingly, it may be worthwhile to reduce speculative trading in the market. There are a few ways to do that: through regulation, through taxation. But as Americans I think we could agree that this infringes on our personal freedoms to too great a degree, and only for an end which has very complicated and controversial undertones. So what can we do to reduce the market failure of speculative stock trading? The reasoning goes that traders purchasing stock in a long position do so because they think the current holder of the stock is undervaluing its future returns. Similarly, the current holder thinks the buyer is misinformed. Preventing traders from attempting to take advantage of those they perceive to be less informed – by reducing the disparity of expectations in the market – would accomplish this goal. This could be achieved through more comprehensive disclosures of management, financial and other firm information by publicly traded companies, with the goal of converging trader expectations and reducing speculative trading.

Unfortunately, increased disclosure may also trigger cost savings on stock research and analysis at the margin that, due to the elasticity of speculative trading demand, consequence a disproportionately large increase in demand for speculative trading. If the increase in trading due to a reduction in marginal costs outweighs the decrease in trading due to converging expectations, increased disclosure, availability and accessibility of information would be a net harm. While more research needs to be done, the current empirical evidence suggests price disparity is reduced by a mandatory disclosure system.