Speculative Trading and Crises

Abstract

Speculative trading, in particular short-selling of stocks and credit default swaps (CDSs), has been blamed for playing a direct role in bringing down financial firms in the past years and Greek bonds this year. This paper investigates the mechanism through which short-selling and other naked trades can cause failures of financial firms and state financing. We develop a rational expectation equilibrium model of self-fulfilling bank failure and show that the mechanism of speculative attack on sovereign debt is essentially the same. In stark contrast with the received wisdom, we show that the fundamental problem of short-selling is that it leads to an increase in uncertainty and information asymmetry on the firm's fundamental value. The exacerbation of information asymmetry leads to an increase in both downside and upside risk. Debtholders who have a concave payoff, however, only care about the downside risk and thus run, making default and failure become self-fulfilling, while speculators gain from the failure. Interestingly, we show that the short-selling of financial stocks essentially involves two coordination problems, or two runs: aggressive run among speculators and conservative run among creditors. We use the global game methodology to model these two runs. Importantly, we find that the two runs interact with, and reinforce each other, which makes the bank very vulnerable under attack. Our work also contributes to the theoretical literature on global games by developing a model that simultaneously endogenizes strategic complements, information structure and payoff structure.