It is not turning out to be a good year for the financial markets. First we have America’s largest corporate failure with the collapse of Enron, brought about by an elaborate system of fraud which concealed massive losses. Now we have a rogue trader working in the US for an Irish bank, who has been responsible for the loss of almost three-quarters of a billion dollars of his employer’s money, through fraudulent trading.
Early evidence suggests that, once again, a trader was able to conceal losses that might have cost him his job or damaged his bonus, with a series of phony trades. As in gambling — which is what a lot of this international market trading amounts to — the trader keeps on trading, hoping that he will be able to pull off the coup that will restore his fortunes. Bigger losses lead to bigger bets which lead to bigger losses until his position becomes unsustainable.
There was a time when market trades had a logic to them. If a company knew that it was going to have to settle a bill in, say yen, in six months’ time, and it expected the value of the yen to increase during that period, it made sense to buy the currency straight away, if it was cheaper. Then along came market gurus who spoke of concepts such as opportunity cost. They produced sonorous statements such as "Anyone who does not hedge their investments is speculating". The inference here is that speculating is a dangerous thing to do. The fact that any hedge itself involves speculating, because you take a position that is designed to protect a future value, was conveniently ignored.
Then the markets moved to a further absurdity. You could hedge a position both ways using option contracts. Thus, whichever way the market moved, you would be covered, exercising one option while writing off the modest expense taken on the opposition option. Inherent in this thinking was the concept of risk-free investment. Common sense dictates that there is no such thing. But clever young men with Hewlett-Packard programmable calculators, the favored trading weapon of the 1980s, could demonstrate that thanks to a series of sophisticated trades, it was a reality. The complex world of derivatives took off and once launched, sustained itself by becoming ever more complex and convoluted.
It has indeed now reached the stage where only a relatively few hyper-clever traders or, more normally, powerful computer programs can recognize what is really happening in the markets. This is because there is no longer any underlying logic to virtually any trading that is taking place.
Time and again, top executives interest themselves only in the bottom-line figures that emerge from their trading rooms. They have no deep understanding of how those profits are created. They probably could not grasp what is going on if they were told. They merely hope against hope that nothing will go wrong. Unfortunately, time and again, it does go wrong, despite all the regulation and controls that are supposed to be in place and to be enforced. Maybe it is time to reconsider the wilder shores of speculation. Rather than stripping out risk, as the financial industry promises, maybe it is time to strip out speculation for speculation’s sake.
