Financial Market regualtion
Bubbles and manias in securities markets: Is regulation an answer?
Barrister Tureen Afroz
Speculation is a common phenomenon in securities market. Speculation refers to buying or selling of a 'financial asset' with the aim of making a 'quick profit'. Speculation should be contrasted with long-term investment, 'in which a financial asset is retained despite short-term fluctuations in its value.' In securities markets, the speculators play an important role. It is believed that frequent buying and selling of financial assets by the speculators provides liquidity to the securities markets. This benefits longer-term investors, too, as it enables them to get a good price when they do eventually decide to sell their financial assets.
However, the history of popular thought concerning securities markets in Anglo-American culture reflects that the common people were 'suspicious of (securities) trading' and 'hostile to (securities market) speculations'. This is due to the fact that too much speculation is at times not good for securities market. Intense and excessive speculation may result in 'bubble' or 'share mania'. In securities market, a bubble or share mania occurs when speculation in a financial asset causes its price to increase, thus producing more speculation. The price of the said asset then reaches absurd levels. A sudden drop in prices usually follows the bubble. This situation is commonly referred to as a 'crash' or a 'bubble burst'.
Such incidents of 'bubble and burst' are not new in markets. It dates back to the Tulipomania of 1636-37 when in Netherlands demand for tulip bulbs reached such a peak that enormous prices were charged for a single bulb. In this bubble, speculators from all walks of life bought and sold tulip bulbs and even futures contract on them. Allegedly, some tulip bulb varieties briefly became the most expensive objects in the world, until the bubble burst in 1637.
Similarly the South Sea Bubble refers to an unhappy experiment in the 18th century English public finance. The South Sea Company was set up in 1711 with the hope that it would one day challenge the financial strength of the Bank of England and the (British) East India Company when it came to providing loans for the government to support the national debt. The company had a monopoly on trade with all Spanish territories, South America and the west coast of North America. In 1713, the Company received the right to supply slaves to the Spanish colonies. In 1720, the government encouraged investors to trade governments stocks for South Sea Company shares and as these boomed, more and more people speculated in them (forcing the share price higher). In July 1720, with company shares at a vastly inflated, unrealistic and unsustainable level, confidence collapsed (as did the share price). Investors lost considerable amounts and some even committed suicide.
In the Indian sub-continent, there was a steady growth of stock exchanges from the late 19th century through the mid-20th century. By 1830, business on corporate securities in bank, cotton textile, jute, tea and coal industries took place in many of the major cities of Indian sub-continent. It may be mentioned that Mumbai, Ahmedabad and Kolkata became the major centres for such securities trading. In 1830, 6 persons in Mumbai, involved exclusively in securities trading, called themselves as 'share brokers'. The 1850s witnesses a rapid development of commercial enterprise and brokerage business attracted many men into the field. As a result, by 1860, the number of brokers increased to 60.
Similar to the South Sea Bubble and the Tulipomania in Europe, the Indian sub-continent experienced a Share Mania during 1861-65. The 'Share mania' in India begun when the American Civil War broke out in 1860-61 and the cotton supply from United States was stopped. The number of brokers increased to about 200 to 250. However, at the end of the American Civil War, in 1865, a disastrous slump begun. The Share Mania of 1861-65 resulted in tremendous losses in India. Most brokers actually went bankrupt.
In the post-independence era, the 1996 Share Market Crash in Bangladesh can also be attributed to the excessive speculation in the securities market. It tremendously eroded investors' confidence in securities market. It has almost been 10 years and the market is still struggling to restore such confidence.
Now, what can regulation do to control speculation in the securities market? Or more specifically, can regulation at all do something to control securities market speculation?
History accords that the initial securities market regulation in England was inspired by a regulatory objective of suppressing securities trading activities in the society. The aim of such regulatory measures was essentially to avoid any kind of speculation in the financial markets. For example, the first statute to regulate the securities market in England was named: Act to Restrain the Number and Ill Practice of Brokers and Stock-Jobbers 1697. Another example could be the promulgation of Bubble Act 1720, which was tended towards prohibiting the creation of the companies and prohibiting the issuance of securities. Also during the early years of American securities markets (which began to operate in 1790s) suppression of securities trading remained a strong regulatory objective is the US securities regulation.
Similarly after the Share Mania of 1861-65, the Government of India enacted special legislation to deal speculation problem in securities market. The Act XXVIII of 1865 was accordingly passed by the Government of Mumbai to control speculative activities in the securities market. This Act is claimed to be the first and the earliest legislation relating to the Stock Markets in India.
It is argued that in the securities market, regulation should be introduced to control speculation only up to a certain extent. Speculation brings in liquidity to the market and is helpful for market growth. Therefore, even though over-speculation should be avoided, a moderate level of speculation is always desired in any securities market. Regulation, having the purpose of driving speculation out of the market altogether and thereby, suppressing the securities trading activities, will not benefit the economy in the long run.
The author is an Assistant Professor of Law at BRAC University School of Law.