Do speculators have a destabilizing effect on the financial system?

By Investopedia Staff AAA
A:

A speculator is anyone who trades derivatives, commodities, bonds, equities or currencies with higher-than-average risk in return for higher-than-average profit potential. Speculators can include individual investors, institutional investors, hedge funds, pension funds, investment banks, index funds and exchange-traded funds (ETFs), and can participate in any financial market. The key role of speculators in the market place is to add liquidity by providing buyers and sellers with partners for their desired trades. Liquidity maintains order within the financial markets and is the key driver behind efficient exchanges. Speculators add huge amounts of money to the markets, and the more money they invest in the market, the more liquid it becomes. An efficient market (very liquid) allows for buyers and sellers to trade with one another with relative ease without causing large shifts in prices.

Speculators in the past have come under much scrutiny for the unpredictability of the markets, namely the sharp peaks and valleys associated with prices in the commodity markets. While speculators have been labeled as greedy and irresponsible during times of high gas and food prices or sudden currency devaluations, it is important to mention that speculators are not solely to blame for these sharp increases or decreases in value.

Financial systems are guided by countless micro and macroeconomic factors, along with the movement of financial markets. Increased demand for commodities, equities and currencies will almost certainly drive the value of these items upward, and with increased demand comes more buyers. Without a comparable amount of sellers in the marketplace it becomes illiquid, creating an inefficient marketplace which could lead to even higher prices. Speculators, by taking on the increased risk of adding large sums of money to the market place to create liquidity, demand increased profits for those risks. It has been argued that speculators actually have a calming effect on the market place due to their large positions and constant need to balance those positions. As well, speculators allow countless individuals and institutions to protect their investments by providing a willing trading partner in hedging strategies. (For more on commodities, read An Overview Of Commodities Trading.)

Although speculators are an integral part of the financial landscape, it should be noted that there have been many cases of speculators manipulating the markets illegally to profit from the results. Such speculation can be difficult to monitor and can drastically affect the financial system. Speculators are a very important component to the marketplace, but speculators who partake in "excessive speculation" can definitely have a destabilizing effect on the financial system.

To learn about speculating read our related article Arbitrage Squeezes Profit From Market Inefficiency.

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