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May 30, 2012

Banks’ Hyper-Hedging Adds to Risk of a Market Meltdown

JPMorgan (JPM) Chase & Co.’s lost billions remind us that modern finance has changed the world, and not in ways that we should celebrate. Nothing demonstrates this more than the use of hedging.

It is debatable whether hedging makes individual banks such as JPMorgan “safer,” and very debatable whether it makes them, on balance, more profitable over time. But even supposing that hedging does, or can, assist individual firms, their trading has an unseen and pernicious effect on markets overall. Just as football players armed with kryptonite-strength helmets hit more aggressively, leading to more concussions, hypertrading by firms — each thinking of their own preservation — has exposed markets to meltdowns and routs.

Market participants themselves are mostly unaware of their effect on the group because they have grown up in a culture that celebrates trading — hedging, in particular. The attitudinal change, fostered by technology, has been gradual but vast, and only visible if one steps back and remembers how things were.

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