It has always been part of financial markets, from their origins in 17th-century coffee houses to the Great Crash of 2008by John Kay / March 14, 2017 / Leave a comment
Published in April 2017 issue of Prospect Magazine
In a modern capitalist economy, almost everything is for sale, including risks. Markets can transfer known risks to people or institutions who can handle the risk more effectively. The cost of rebuilding my house if it is destroyed by fire is beyond my means. For an insurance company with many properties on its books and many shareholders, by contrast, the loss is easily manageable.
Trade in risk may be motivated by such insurance—the prudent management of risk—but it may also be about wagering: that is, individuals backing their own, distinctive, perception of the nature and likelihood of an event. People trade risk because they see the same risk differently. I think Arsenal will win the match, but you favour Chelsea. So we take bets on the outcome, and one of us will win and the other will lose. We have divergent opinions, or information, or we believe we do. In the long run, of course, it is only the bookmaker, or the house, that wins.
Financial markets accommodate both prudent insurers and reckless gamblers. They provide investors with an opportunity to diversify their portfolios, and allow gamblers to bet on future movements in interest rates. The coexistence of the two can allow speculators to make profits by stabilising prices—buying when markets are fearful, and selling when they are greedy. But when the gambling motive overwhelms the insurance motive, speculation becomes destabilising and then risk, far from being minimised by careful management, becomes concentrated in the hands of those who understand least what they are doing. And when regulators perceive insurance when they should see wagering, their actions magnify a crisis rather than minimise it. Such destabilising speculation, mischaracterised by regulatory authorities as prudent risk assessment, is what caused the global financial crisis of 2008.
The coexistence of insurance and gambling goes back to the earliest days of markets in risk, and the interaction of the two has been central to financial history. But it was four developments in the second half of the 17th century that combined to frame the way we think about risk, and the institutions we have for dealing with it, through to the present day.