Short termism in Financial Markets

There has been an immense focus on the Financial Sector in the years since the 2008 Financial Crisis, and rightly so. It was the worst since the Great Depression of 1929 and systemic risks in the financial sector contributed heavily to the depth of the recession. Since then there have been Libor scandals, misselling claims, rogue trades and countless other examples of market manipulation.

The regulators now have their work cut out to fix the financial system. This is no easy task: the financial system is simply too large and misaligned with its Economic role. The system today is complex; involving derivatives, high frequency trading, huge leveraging, swaps, puts and calls, some of which add real economic value but others add very little and cost the economy heavily though risk and volatility. A recent IMF study has suggested that there is a tipping point past which the costs of financial development exceed the benefits, which most advanced economies have already crossed.

Rather than repairing the system itself, regulators are doing their best to realign incentives: The Fair and Effective Markets Review, published on 10 June 2015, recommends tougher sanctions on market abuse and greater accountability for those participating in the markets. Also proposed are bonus claw backs, which could mean senior manager’s bonuses can be taken from them at any time over the following ten years if it is discovered that their actions caused subsequent harm to the system.

It is good to focus incentives on the longer term and discourage short-termist behaviour. A long-sighted financial system is the ideal, but incentives alone cannot create it.  It might seem obvious that the answer is The Tobin Tax: placing a small levy on each transaction made in the markets and suddenly short term trades become unprofitable, trading volumes reduce and favour long-term oriented trades. The available literature on the Tobin Tax is mixed and inconclusive, with some models suggesting that lower volumes may harm liquidity and actually increase market volatility. As with all issues in Economics, the answer is not easy, but steps will have to be taken to make trading work for the long term.

Chris Bailey

Chris is an analyst at Volterra, currently on a year’s placement from the University of Bath.

Image: Monopoly Money [Explored] by Jason Devaun licensed under CC BY 2.0

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