Speculation is not a four-letter word
The term "speculation" is treated with mistrust in India. Here I will try to clarify four different issues which are typically mixed up in the common perception about "speculation": (a) Counterparty risk, (b) Market manipulation, (c) Insider trading, and (d) Speculation. It is the first three which are evils. Speculation -- appropriately defined -- is unambiguously a valuable feature of financial markets.
For decades, speculation has been implemented in Indian markets through long or short positions which do not do delivery versus payment after the transaction was carried through. These markets are actually forward markets, in that the trade pertains to delivery and payment at some date in the future.
Forward markets generally suffer from counterparty risk. This is the risk that a buyer will declare bankruptcy if prices have dropped too much in the days following the trade. The buyer will then not carry through his side of the trade, which leaves the seller without recourse. The other kind of bankruptcy -- a seller bankrupted by rising prices -- is also possible.
Traditionally, counterparty risk was heightened by practices like badla and poor understanding and enforcement of margins. Counterparty risk at the level of one member sometimes turned into payments crises for the full exchange, when the default of one large member generated a series of cascading defaults, bringing the entire trading activity to a halt.
Counterparty risk in forward market trading led many observers to conclude that "speculators produce market risk". Given the poor organisation of markets at the time, it was certainly true that almost all counterparty risk was associated with speculation. However, the conclusion that we should draw from this is not that speculation is evil, but that counterparty risk is evil.
Today, in India, the scenario on counterparty risk has evolved greatly. Clearing corporations exist that guarantee the trade, and thus eliminate counterparty risk. For example, the National Securities Clearing Corporation (NSCC) becomes the legal counterparty to both legs of a transaction at the NSE -- if one leg declares bankruptcy, the other leg will be unaffected. Under such an institutional environment, counterparty risk is absent.
With such procedures in place, speculation and counterparty risk are clearly delinked. The discomfort that people have about counterparty risk need not translate into discomfort with speculation.
Market manipulation is the activity of trying to force prices in a certain direction. For decades, speculation and market manipulation have gone hand in hand. There is no question that market manipulation is an unethical and illegal activity.
There are broadly two classes of market manipulation: market-based manipulation, and information-based manipulation. "Market-based manipulation" includes buying up a huge number of shares on the market so that prices of illiquid stocks shoot up. Market-based manipulation also uses "short squeezes" to trap short sellers. "Information-based manipulation" influences market prices by manipulating news. This may include selective release of news, orchestrated dissemination of false rumours coupled with extreme projections, etc.
In either event, the objective of a manipulator is to force prices away from the equilibrium price on the market.
Market manipulation is undoubtedly a social ailment. At exchanges, procedures like price limits, market surveillance, detection of circular trading, etc. would be valuable insofar as they make manipulation harder. But we should be clear that speculation is not synonymous with market manipulation which is a criminal activity.
Traditionally, a great deal of speculation is based on leaks of news from company insiders. In this sense, insider trading has been closely associated with speculation.
Today, rules about insider trading have been formulated, and their implementation is likely to become increasingly stringent. Thus, while it is true that speculation has often gone along with insider trading which is a criminal activity, all speculation is not insider trading.
If speculation does not involve counterparty risk (with trades guaranteed by a clearing corporation), and if it is neither manipulative, nor based on insider information, then what is speculation?
Speculation is assimilating available information about a security, and forming an assessement about whether the price is expected to rise or to fall. If a speculator thinks that the price will go up, he buys the security. If he thinks that the price will go down, then he sells the security.
Speculation makes market prices incorporate a wealth of information and analysis about a company. A market that rapidly translates company knowledge into stock price is an efficient market. Therefore, speculation makes a market efficient.
If market prices are slow to reflect information or analysis, speculators could grab the opportunity to buy or sell, and profit whenever market prices catch up with this information. But as a consequence, the more rapidly speculators act on their information, the more rapidly is news assimilated by the market. Therefore market efficiency comes about through the actions of speculators alone!
Market efficiency is the most important single "deliverable" of financial markets from the viewpoint of the overall economy. Efficient markets reward good managers and direct investment into companies with good prospects and divert funds from companies with poor prospects. The market which is efficient is a good planner which runs the country.
Through market efficiency, speculators are the vital driver of any good financial market. The greater the supply of speculators, the better the efficiency of the market.
A concern is often expressed about ignorant speculators, who are also called "noise traders". Do the actions of noise traders serve to destabilise markets?
A successful speculator is one who correctly buys when the stock is undervalued and sells when the stock is overvalued. These transactions done by a reasonably large number of speculators corrects the value of the stock. Hence a successful speculator makes money and improves market efficiency.
In contrast, a noise trader often buys when the stock is overvalued, and sells when the stock is undervalued. Hence noise traders tend to take a market away from market efficiency. But noise traders steadily lose money, and would exit the market after making large losses over time. Loss is a natural quality control procedure that filters out inferior information sources from the market. The more competitive the financial market, the faster losses accumulate, the faster are noise traders removed from the market.
An example of this is seen in the context of people using "technical analysis" or "chartism". They use no scientific foundation to test, develop or extend methods and are considered noise traders. In India, chartist ideas were enormously popular in 1992 as compared to today: chartists have made losses and exited the business. In contrast, speculation based on fundamental analysis is more consistent with an economic understanding of investment. This has a larger "market share" amongst India's speculators today. Competition in the market has winnowed out inferior traders without explicit controls or regulations against chartism.
Speculation is the foundation of a well functioning capital market, which produces market efficiency. Speculation needs to involve neither counterparty risk nor criminal activities like market manipulation and insider trading. Our assessement of speculation should not be clouded by our well-founded hostility towards those evils.
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