Betting the Business

Financial regulators are often in the position of attempting to proscribe or regulate certain types of trading activities. The Dodd-Frank financial reform legislation prohibits banks from proprietary trading. Futures regulators are often in the position of trying to distinguish hedging from speculating.

The task of sorting the different types of activities can be difficult. Cynics of all stripes exaggerate the impossibility of the task. Some belittle efforts to regulate by claiming that the different types of trading aren’t really different in any essential way, so that all regulations come down to arbitrary and ultimately counterproductive regulations. Others hype the ability of traders to evade any regulation by means of crafty relabeling, so that the regulation ultimately has no effect. These discussions are often poisoned from the start by the partisan nature of any debate about government regulation, so that it is impossible to get into a substantive discussion about real distinctions in different types of trading. But the need to make distinctions isn’t unique to the regulatory sphere. It is a general feature of good governance. Even corporate managers are tasked with defining the types of trading that the company’s own risk managers will be allowed to pursue on behalf of the shareholders.

Francesco Guerrera of the Financial Times called attention to a paper of William Silber’s in which he documents the distinctive footprint of proprietary trading. This is exactly the type of substantive discussion that is needed. Making the distinction is difficult, but that doesn’t make it impossible, and the distinction is critical.

Every non-financial corporation that seeks to hedge risks using derivatives needs to be able to make a similar distinction between hedging and speculation. It will want to prohibit its traders from conducting speculative trades. And all proprietary trading is speculation, so that’s a good place to start. The relevant footprint distinctions are going to be a little different from what Silber highlighted, since he was addressing financial institutions. But the idea will be the same.