Dodd-Frank Wall Street Reform and Consumer Protection Act, Speculation, Speculative trading, Financial markets
Corporation and Enterprise Law | Securities Law
People are often optimistic. Nearly fifty percent of marriages end in divorce, but one survey found that 100 percent of individuals planning to get married believed they would never get divorced. Most people think they drive better than the average driver, and at one university, ninety-four percent of professors placed themselves in the top fifty percent in terms of teaching skills. We often seem to think we are like the youth of Garrison Keillor’s fictional hometown Lake Wobegon, where “all the children are above average.”
This is not always a bad thing. Optimism can be advantageous. Without optimism, Columbus might not have discovered the New World and Steve Jobs might not have started Apple Computer in his parents’ garage. Indeed, without optimism, many of us might not be able to rouse ourselves from our beds each morning to face the day. But optimism poses dangers as well. This Article examines one of the more costly and intractable problems that can arise from optimism: the problem of regulating optimism-driven speculation in financial markets.
Part I shows how optimism-driven speculative trading can be a kind of market failure that predictably generates economic losses to society. It begins by defining the difference between risk and uncertainty, and demonstrating how uncertainty (unlike risk) permits subjective disagreement over future values. It then offers a simple model of markets in which relative optimism generates disagreement-based trading in financial instruments and derivative contracts by speculators who hope to profit from predicting future events more accurately than others do. It notes how this sort of disagreement-based trading has received relatively little attention in the modern economic literature, which instead tends to implicitly (and somewhat misleadingly) assume that “speculative” trading is driven not by subjective disagreement in the face of uncertainty, but by differences in traders’ risk aversion and liquidity needs, or differences in their access to certain, but costly, information. Nevertheless, disagreement-based speculative trading represents a form of market failure that deserves attention. Part I demonstrates how transactions driven by uncertainty and disagreement can generate net economic losses by increasing traders’ risks, eroding their returns, and distorting consumption decisions in a fashion that leads to boom-and-bust cycles.
Part II then turns to a second, and still more daunting, challenge raised by the phenomenon of dangerous optimism: the challenge that societies that rely on democratic governance face in attempting to use law to limit the social costs of disagreement-based speculation. Part II shows how, just as optimism in the face of uncertainty leads to adverse selection among participants in speculative trading markets, it also leads to adverse selection among participants in democratic political systems. In particular, optimism systematically stunts the development of constituencies that favor reining in costly speculation, both before and after social losses have been incurred. This suggests that democratic institutions may be fundamentally unsuited for dealing with the economic problems that can arise from optimism-fueled financial speculation. Part II develops this argument by examining the history of the regulation of derivatives, perhaps the quintessential speculative financial market. History supports the view that only relatively undemocratic institutions—in particular, courts, independent agencies, and private self-regulatory bodies—have proven successful at stemming social losses from speculative trading. It also offers cautionary lessons into the likely success of the newly enacted Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) as a regulatory response intended to ward off future speculative crises like those we have just experienced.
Stout, Lynn A., "Uncertainty, Dangerous Optimism, and Speculation: An Inquiry Into Some Limits of Democratic Governance" (2012). Cornell Law Faculty Publications. Paper 719.
Published in: Cornell Law Review, vol. 97, no. 5 (July 2012).