The IPE of Financial Derivatives Beyond Crisis
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This chapter reviews analyses of financial derivatives that have addressed market contingencies, crisis and control. Given the central role of financial derivatives in the Global Financial Crisis, International Political Economy (IPE) has understandably focused on speculation and asset price inflation. Concomitant to this has been a concern with regulatory privilege and capture. Recognising the significance of these engagements, this chapter draws attention to the longer-term significance of financial derivatives for IPE, identifying this significance in terms of a new form of ownership and relations between fiscal and financial systems.
The world’s first complete set of written laws, discovered on a buried tablet by French archaeologists at Susa, Iraq, in 1902, contained an option contract. Written 3800 years ago, paragraph 48 of the Code of Hammurabi (1792–1750 BC) determined that debtors would not pay interest for a year in the event of crop failure. For Dunbar (2000, 24), this was the first derivative. The ensuing history of derivatives (Swan 2000) is strewn with scandal and speculative outburst—the seventeenth-century Dutch tulip mania, the eighteenth-century South Sea bubble, the nineteenth-century manipulation of grain prices on the Chicago exchanges, the bankruptcy of Orange County and collapse of Long-Term Capital Management (LTCM) in the twentieth century, to the implosion of Enron and the Global Financial Crisis (GFC) in the twenty-first century. The leverage embedded in derivative products and the opacity of derivative markets confounds regulation, incubates speculative excess, and catalyses crisis. Warren Buffett’s (2003) nomination of derivatives as ‘financial weapons of mass destruction’ was not misplaced. In these terms, the GFC could have been a final denouement in a long saga of excess and instability. However, the Bank for International Settlements’ measure of the size of the derivatives markets provided semi-annually suggests otherwise. At the end of December 2016, the notional amount of over-the-counter (OTC) derivatives outstanding was estimated at $483 trillion. Gross market values, or the cost of replacing existing contracts, stood at $15 trillion (BIS 2017). Markets for financial derivatives remain the biggest markets in the world. Derivatives are both durable and systemic.
IPE’s engagement with financial derivatives is now relatively well developed. Given the central role of derivatives and structured finance in the GFC, much of this engagement has focused on issues of crisis and control and consequently been framed in terms of speculation. Engagement with issues of regulation naturally follows, with issues of capture and regulatory privilege rising to the fore. Given that derivatives markets have catalysed crises generating large direct costs and regressively distributed indirect costs, a focus on the politics of regulation is of central concern. This chapter provides an introduction to these engagements mapping how relationships between speculation, crisis, and financial derivatives have been depicted in IPE and cognate disciplines and how questions of regulation are addressed. The significance of these relationships and questions is plain, given the ramifications of the GFC. Equally, the durability of financial derivatives markets begs the questions of what is important about financial derivatives beyond crisis and what crisis tells us about this importance. The chapter suggests that the peculiar form, liquidity, and flexibility of financial derivatives lay at the heart of the GFC and carries longer-term implications for IPE. The chapter points to these implications in terms of the changing character of ownership and interactions between financial and fiscal systems.
Practical presentations of derivatives markets begin with a definition of financial derivatives as financial contracts, the value of which is a function of change in some underlying asset price or indicator. The markets are dissected into a series of discrete products forms. Futures and forwards commit a holder to buy or sell (call or put) some asset on a given date at a specific price. Options provide holders with rights but not obligations to buy or sell an asset. The largest product form, swaps, allows exchange of one unwanted income stream or price exposure for another, more desired. To enter a contract, buyers pay a very small proportion of the total value of the potential exposure to the change in price of the underlying asset. An initial small outlay entails a leveraged exposure and may subsequently generate very large payments. The basic derivative forms manifest in a series of product markets. Derivatives can reference anything from changes in the rate of inflation, the cost of borrowing, changes in the value of a currency, the price of a share, the probability of repayment, the volatility of markets, the performance of a national economy, or the vicissitudes of the weather. They are traded (opaquely and privately) on OTC markets and more transparently (but in lower volumes) on Exchange-Traded (ET) markets.
The perception of discreet forms and product markets, however, deflects recognition that derivatives are not secondary to markets in the so-called primitives (the underlying bonds, equities, currencies, indicators etc.) and in turn secondary to some underlying real economic process. Derivatives are not simply a ‘fantastic system of side bets’ (Bernstein 1996). Ambiguity as to whether prices in derivatives markets are a function of prices in underlying markets or vice versa is not incidental (Helleiner 2018). Financial derivatives are not only instruments for taking on leveraged speculative positions or hedging a real exposure to, for instance, the value of the euro in six months. Derivatives are more fundamentally transformative in terms of being integral to ownership and challenging perceptions of discrete markets, of functional and operational distinctions between finance and production, and regulatory orders constructed on the basis of capital having a readily identifiable—and national—time, space, and identity.
The chapter is short and cuts to the chase. It first introduces work on market infrastructure. Largely conducted under the banner of the social studies of finance, this has been heavily drawn on in IPE to provide understanding of the plumbing necessary for global trade and insight, contrary to the mainstream, into the contingencies attached to this plumbing. Crisis is addressed and heterodox analyses from IPE juxtaposed with a pre-GFC mainstream view of derivatives markets as completing and perfecting. The chapter then examines issues surrounding regulation, pointing to concerns raised by IPE scholars prior to the crisis and analyses of post-crisis regulatory dynamics. The chapter then turns to the systemic importance of financial derivatives beyond crisis and control. Here, the chapter responds to the question of the historic significance of derivatives beyond an understanding which depicts a cancerous outgrowth from a nominal ‘real economy’, arguing for a perspective on derivatives that depicts them as integral to financialised capitalism.
Contingencies and Crisis
IPE has drawn on its extended multidisciplinarity in the analysis of derivatives to comprehend the mechanics of the markets and, more critically, the contingencies market operations rest on (Lépinay 2011; Mackenzie and Millo 2003; Mackenzie 2005, 2007; Riles 2011). In ‘opening the black box of global finance’ Mackenzie and Millo mapped the emergence of the market on the Chicago exchanges and associated regulatory skirmishes, tracing the operationalisation of options pricing theory and how operationalisation entailed adjustments that demonstrated that the markets did not mirror an exogenous real economy but produced the world ostensibly described. Contra naturalising depictions in orthodox finance, for Mackenzie and his collaborators markets are ‘engines not cameras’ (Mackenzie 2006). For instance, Mackenzie (2007) breaks down the barriers to social enquiry embodied in the ‘Efficient Market Hypothesis’ and based upon the constructed efficacy of modern financial theory and its enforcement through arbitrage. Drawing on the collapse of LTCM, Mackenzie shows that arbitrage, far from a risk-free exercise conducted by atomistic economic agents, is embedded in a ‘Grannovetterian’ sociology which propelled ‘arbitrage flight’ and unravelled a superportfolio imitating LTCM’s positions in the wider market. Crucially, Mackenzie concludes that the capacity to insulate ‘the economic’ from ‘the social’ is limited.
This work unsettles and decentres an orthodox appreciation of financial derivatives that clings to a sparse and somewhat utopian framework. Alan Greenspan (2003), then seemingly at the height of his powers, predicted, ‘Financial innovation will slow as we approach a world in which financial markets are complete in the sense that all financial risks can be efficiently transferred to those most willing to bear them’. Ranielli and Hualt (2007, 13) refer to a regulator commenting on the attitude of American regulators to the credit derivatives market: ‘They see the new product as something good, like a new way of exchanging, a way to complete the market in Arrow-Debreu fashion. This is the American way of seeing things and particularly that of Alan Greenspan who has boasted the merits of credit derivatives’. These perspectives perceive financial derivatives markets as technical expedients that fulfil the tautology of perfect markets embedded in an idealised context of freed finance. The social studies of finance approach in demonstrating the limited traction of dividing the economic from the social not only opens up for an IPE of derivatives but points to an inherent potential for miscalculation and crisis.
This has been the core concern for IPE. The narrative is familiar. Derivatives have frequently been central to frauds, market manipulation, rule avoidance, and crises. They are the veritable ‘wild beast of finance’ (Steinherr 1998). Frequent crises both corporate (Worldcom, Enron, Parmalat, American Insurance Group) and international (Russia, Thailand, South Korea) have shown that the plumbing of international finance is running awry and a state-led regulatory overhaul is urgent and necessary (Dodd 2000; Eatwell and Taylor 2000). Those without faith in completion and perfecting see an unregulated and dysfunctional private casino, the operations of which harbour systemic risk, manifest in the GFC, and perhaps libidinally produced (Gammon and Wigan 2015).
Irresponsible loans and ill-considered borrowing in the US housing market deflated a long-term asset price bubble. Crisis spread as newly recognised and dense linkages between assets, markets, and institutions forged by a globe-spanning web of derivatives contracts acted as transmission mechanism. Asset values and the solvency of a range of institutions were thrown into doubt. Large derivatives’ positions exacerbated this doubt as leverage that had generated outsized returns became an immanent liability. The value of securities and the ability of counterparties in derivatives markets to meet obligations became highly uncertain. The financial system entered into deep freeze as low borrowing costs and default levels and ‘non-inflationary constant expansion’ (NICE) could no longer be assumed. Trust evaporated, markets and institutions ceased to function, and governments stepped in to the breach, injecting billions of dollars into failing institutions and exposing themselves to the potential of trillions of dollars in losses (Blackburn 2008; Spagna 2018). The incommensurability of risk and uncertainty (Knight 1921) took concrete form, and the promise that a derivatised financial system could perform the alchemic feat of converting an unknown future into stable probabilities proved illusory (Erturk et al. 2008; Langley 2010). Financialisation with derivatives had driven a remarkable shift from public to private. ‘Market inflation involving a complex admixture of leverage, cheap borrowing, artificial liquidity, market concentration and opacity ensured, once the crisis emerged, the subjugation of public authority to the imperatives of private market actors. That private losses have become public liabilities, central banks have been willing to accept the products of private innovation as near money equivalents and the response has been restorative rather than substantively disabling is a measure of this shift from public authority to private imperatives’ (Wigan 2010, 110).
The shift to private authority was noted early on. A series of derivatives debacles in the first half of the 1990s raised concern as to the destabilising propensity of derivatives. The reaction to these debacles was circumscribed by the G30’s 1993 report on the regulation of OTC, off-exchange and privately negotiated, derivatives. The report, ‘Derivatives: Practices and Principles’, ring-fenced the regulatory response in terms of self-regulation through market mechanisms. As an instance of what Tsingou (2015) has coined ‘club governance’, where informal groups of public and private actors generate shared understandings of responses to financial system problems, the G30 report constituted the basis upon which subsequent standards, regulations, and best practices were formed. The G30 initiative inspired the formation of the Derivatives Product Group (DPG), bringing together six major dealers in an effort to avoid external regulation. The 1995 DPG report, ‘A Framework for Voluntary Oversight of the OTC Derivatives Activities of Securities Firm Affiliates to Promote Confidence and Stability in Financial Markets’ took on the G30 recommendations adding detailed prescriptions and pre-empting legislative action in the US. The report left the regulation of derivatives in the hands of the regulated, updated best practice to account for the fact that the ‘historic cost’ of a derivative (the contract fee) bears small relation to current value, and delimited the problematisation of derivatives to immediate concerns remediable by incremental risk management improvements. The emphasis on self-regulation and regulation and reporting consistent with the volatility of derivative positions was to iterate in the subsequent development of the New Basel Accord and the role of the London-based International Swaps and Derivatives Association in developing a model contract and best practice for the industry (on the role of the International Swaps and Derivatives Association, see Morgan 2008). The Basel Accord updated rules governing the maintenance of bank reserves to guard against bank insolvency.
Basel II substituted private and dynamic risk management for static reserves held against the eventuality of the default by bank borrowers. Following the 1996 amendment of Basel I to incorporate into the calculation of regulatory reserves’ market risk, or the risk to a bank resulting from adverse changes in the level or volatility of market prices, Basel II dictated that a bank could enjoy lower capital reserve requirements insofar as it could demonstrate on the basis of privately designed risk management systems that insolvency would be avoided by the careful calibration of risk via taking on and laying off exposures with derivatives. For instance, the Basel Accord allowed for reduced capital reserves if a bank substituted an exposure to a corporate borrower with one to an Organization for Economic Cooperation and Development (OECD) bank by laying off that exposure to that OECD bank via a credit default swap. This had the consequence that banks were incentivised to create credit and redistribute it. The originate-to-distribute banking model subsequently severed the link between risk and responsibility. Relationships to borrowers were converted to relationships with derivatives counterparties (Wigan 2010). In turn, convergence in risk management practices ensured that market participants increasingly used broadly the same daily internal risk assessments and price sensitive risk limits. These require reductions of risk exposure in line with increases in probability of default and lead to a pro-cyclical hedging dynamic. As Value-at-Risk (VaR) systems show that some predetermined limit is approaching, market participants either sell contracts, thus pushing yields wider, or hedge their positions by shorting in the cash equity or bond markets. Both exacerbate crisis. ‘As long as market participants herd, which they have been doing for as long as markets have existed, the spread of sophisticated risk systems based on the daily evolution of market prices will spread financial instability, not quell it’ (Persaud 2003a, 223, cf. b).
Derivatives and Regulation
The regulatory capture of public agencies and policy by powerful banks in unprecedentedly concentrated markets is in the frame here. ‘“Multilevel regulatory capture” characterised the global financial architecture prior to the crisis, simultaneously feeding off and nourishing the financial boom in a fashion that mirrored the life-cycle of the boom itself’ (Baker 2010, 647). Lobbying, low political salience as markets boomed, intellectual capture and revolving doors between public and private employment roles coalesced to form fertile grounds for excess and irresponsibility (ibid.; Seabrooke and Tsingou 2009). On the basis of these dynamics, IPE has focused in derivatives on the emergence of unprecedentedly speculative and unanchored financial markets. The Keynesian concern that financial markets should not be permitted to take on the guise of casinos returned to the fore of the debate in the immediate aftermath of the GFC (Skidelsky 2009). Toporowski (1999) came early to this position in proposing that immanent in the derivatives trade is the ‘end of capitalist finance’ as the microstructure of markets generates asset price inflation, decoupled and unsustainable spread contraction, and consequent systemic implosion. Far from perfecting and completing, derivatives promote an overblown financial sector, which carries an imminent threat of systemic implosion and heightens volatility.
The predominant perspective in IPE suggests that since the breakdown of the Bretton Woods System, finance has arisen in monstrous form and proportions to disentangle itself from the strictures of the real economy of production, services, and trade, and parasitically reengineer distribution away from societal needs. Here, the rise of the finance is a distortionary and threatening and derivatives are the ‘functional form of speculative capital’ (Saber 1999, ix). The Minskyian view similarly focuses on asset price bubbles and financial fragility. Financial derivatives increase the latent leverage in the system at contract inception since the contract price is far less than the value of the underlying assets or exposure. Further, each contract will generate a series of further contracts as sellers and buyers partially hedge their positions with other sellers and buyers. One contract therefore inspires a series of closely related contracts. Consequent systemic financial fragility means that the development of a fragile financial structure results from the normal functioning of the economy, and financial capitalism is fundamentally flawed. Each success at crisis containment leads to further risk-taking (Dymski 1998; Kregel 2008).
Despite promises of systemic change and regulatory overhaul at successive G20 summits, in the wake of the GFC, outcomes have reflected incremental, rather than the originally envisioned revolutionary change. Regulatory change occurred with the 2010 Dodd-Frank in the US and the creation of pan-European regulatory and supervisory bodies. The Financial Stability Forum was upgraded to the Financial Stability Board, pro-cyclicality and excessive risk-taking has been partially addressed by, for instance, more closely aligning compensation regimes with the financial cycle of asset price inflation and collapse, the imposition of a ban on proprietary trading in the banking sector, the so-called Volcker rule, new rules for governing how the collapse of financial institutions is managed in resolution regimes have been put in place, and a philosophical shift has occurred with the arise of macroprudential thinking (see various contributions in Moschella and Tsingou 2013). The macroprudential turn marks a change in approach from a reliance on the individual risk management practices of market participants and the notion that what is rational from the perspective of each institution is rational and optimal for the system overall. Macroprudential regulation contrastingly recognises that individually rational decisions can lead to negative outcomes in aggregate. When all market participants deploy similar risk management practices in the same markets, price changes at the system level can develop in such a way that individual institutions and markets overall become fragile and unstable. In consequence, the re-regulation of global finance was originally envisioned to account for these system-wide effects.
The results, however, remain uncertain. For instance, while banks under Basel III are now required to build up reserves in the good times to guard against the bad (pro-cyclical capital buffers), the definition of optimal risk management practice remains in the hands of institutions at the individual level. Correspondingly, macroprudential thinking has yet to translate into a wholesale shift (Baker 2013). At the same time, the rise of intermediation outside the traditional banking system has continued unabated, and the ‘shadow’ banking system has grown. IPE has not been slow to note the systemic threat carried by a credit system involving activities and entities outside of the regulated banking sector and without access to the liquidity support afforded that regulated sector (Ban and Gabor 2016). In addition to re-regulation being gradual and incremental and wholesale change absent, as the memory of the GFC fades, so elements of the post-crisis regulatory package are being unravelled; at the time of writing, Donald Trump has promised to repeal various aspects of the Dodd-Frank Act to ostensibly bolster the competitiveness of US financial markets, and the UK is threatening to create a ‘Singapore on Thames’ in the event that the European Union fails to provide a soft landing for Brexit (see Vickers (Chap. 18), this volume).
Assessments of post-GFC regulation that specifically targets the operations of derivatives markets and their infrastructure are similarly lukewarm. The G20 post-crisis regulatory agenda at the outset aimed more to improve the operations of the market than fundamentally challenge it. Promises to force standardised OTC derivatives to be cleared by central counterparties, require higher capital reserves held against derivatives that are not centrally cleared, ensure that all standardised derivatives be traded on organised exchanges, impose position limits (‘bet size’) on derivatives referencing commodities and require that all trades be reported to trade repositories have been implemented. The intentions here were to reduce systemic risk, by minimising uncertainty as to where the instabilities may lie in derivatives markets, and reduce counterparty risk, or the chance that payments would not be made. Central clearing and moving contracts onto organised exchanges would increase transparency and reduce opportunities for market abuse arising from information asymmetries between the major dealer banks and their counterparties. At the same time, centralisation would ensure the retention of margins requisite to position size. Trade repositories would provide supervisory authorities and market actors with more information and a clear picture of the market developments. Position limits in commodity derivative markets would dampen the volatility of commodity markets (see Sneyd and Enns (Chap. 35), this volume). Helleiner, Pagliari, and Spagna (2018, 1–27) argue that the agenda and implementation process has been subject to delay, fragmentation, and inconsistency as market centres feared loss of competitive position and significant private influence on detailed rule formulation, and implementation remains a feature of the post-GFC environment. At the same time, re-regulation in the form of centralised trading only applied to standardised contracts while the vast majority of the markets trade in bespoke contracts. Similarly, position limits were only ever envisaged to be applied to commodity market, not the asset markets where market abuse was most prevalent and instability arose (Ibid.).
Explanations of the absence of wholesale regulatory change vary, but emphasis in terms of proximate causation should be placed on two absences and one presence. Change agents are largely absent in global finance. Regulators and market participants tend to share the same expertise, background, and world views. Similarly, while the immediate post-crisis period witnessed considerable demand for radical change from a public angered by the distributive consequences of the GFC, on the supply side was a notable absence of voices willing and able to advocate on the highly technical issues involved. Present were veto players with significant political influence and the financial resources necessary to ensure their voices were heard first and loudest (Moschella and Tsingou 2013; Baker and Wigan 2017). A more structural explanation of limited regulatory ambition, fragmented implementation and dilution over time rests in understanding derivatives markets as integral to the current era of financialised capitalism and therefore durable and systemic.
Beyond Crisis and Control
The systemic and durable character of financial derivatives demands responses to the question of their historic role. Bryan and Rafferty (2006) lead the way here, suggesting that the significance of the markets lies not so much in speculative propensity as transformative force. When money and prices were left to the determination of market forces after the collapse of the Bretton Woods monetary and financial order, but stable prices and exchange rates failed to materialise, derivatives stepped in to the breach. Derivatives are an anchor that provides moment to moment stability for market participants, so that in a world where the promise of market delivered price stability proved illusory, stability became a commodity embodied in the derivative contract. By binding the present and the future and blending geographically and functionally distinct assets, derivatives are a new form of capital. The ability to mix asset forms and switch readily between them means that finance transcended older categories upon which the conceptual apparatus deployed to comprehend it has been constructed. For instance, the distinction between capital and credit is not easily upheld when a single contract blends both, and one can easily, and at will, morph into the other. Similarly, financial derivatives call for a reconceptualisation of ownership (ibid.; see also Wigan 2008, 2009).
Ownership and property with derivatives take a third form, which substitutes as its object, change for growth and decouples property from production. Veblen (1924) pointed to the emergence of this process with the rise of limited liability and ‘absentee ownership’ where ownership abstracts from the physical (productive) activity it ostensibly refers to and capital is afforded an independent (corporate) personality. Owners switch readily between assets on the basis of fluctuations in market prices and their dispersal is one step removed from the underlying production process. This ownership form superseded direct ownership where labour is alienated from its product and the means of production, but the owner remains manager, overseeing directly the productive process and tying her fortunes to the long-term competitive position of the product. In this, the relationship between the owner and the production process is sticky and difficult to exit. Absentee ownership via corporate equity markets in contrast entailed that, ‘the visible relation between the owner and the works shifted from a personal footing of workmanship to an impersonal footing of absentee ownership resting on the investment of funds’ (Veblen 1924, 59).
Derivatives as a third form of ownership represent a second level of abstraction from the underlying productive process. In synthesising ownership of aspects of asset performance (Das 2005), derivatives sever the link between property and tangible assets. In doing, derivatives also escape the exigencies that arise from direct or absentee ownership. The notion of risk that underlies derivatives markets is informative here. Risk is not danger but variance, and derivatives valorise variance. As such ownership has no necessary connection to positive economic performance. In these circumstances, systemic meltdown may for the owner be positive and sustainable growth negative. In the GFC, many investors profited enormously from the collapse in the US housing market, taking positions through credit default swaps on collateralised debt obligations that banks had packaged to move mortgage loans off the balance sheet (Lewis 2010). This is symptomatic of a systemic shift where individual financial market participants are no longer wedded to positive economic performance as the liquidity and fungibility of financial assets abstracts from what has hitherto been considered the ‘real economy’. By synthesising underlying asset performance, derivatives break through previous limits on financial production with the creation of contracts only limited by extant risk appetite in the market (Wigan 2010). The financial system in consequence may function unencumbered by the direct imperatives of industrial capitalism and competition between individual capitals in the production process.
The income tax system of virtually every country that is advanced enough to have one seeks to maintain… different rates of tax for different sources of income – between income from capital and income from labour; between interest and dividends; between dividends and capital gains; between personal and corporate income; between business income paid out and business income retained; between income earned at home and abroad; and so on.
At the same time… securities can be used to transmute one form of income into another – in particular, higher taxed forms to lower taxed ones… (1991, 5–6)
The gap between concepts underlying regulatory apparatus and how financial derivatives can be strategically instrumentalised has been extensively exploited by the financial sector. The Structured Capital Markets division of Barclays reportedly contributed as much as £ 1 billion a year to Barclays’ profits by selling complex structured products which had the effect of reducing tax charges or providing synthetic deductions—accounting items that can be set against taxes due (Lawrence 2013). In 2014, Barclays and Deutsche Bank were investigated by the US Senate for facilitating large-scale tax avoidance. The scheme in the frame entailed selling hedge funds basket options products used to conduct over US$ 100 billion of trades and producing more than US$ 35 billion in profits. Effectively, innumerable short-term trades were packaged in one large option, exercised after 365 days and qualifying gains as long term. Short-term capital gains are subject to up to 39% tax in the US. Long-term capital gains are subject to 20% tax in the US. By conducting short-term trades in the basket structure, leverage limits and federal taxes were avoided, short-term capital gains were converted into long term, and the hedge funds were able to access the banks’ leverage ratio of 20:1, rather than the 2:1 leverage ratio applied to brokerage accounts held at US dealers (see Bryan et al. 2016 for fuller explanation).
The significance of these examples for IPE and the IPE of derivatives concerned with regulation and control goes beyond that derivatives are used for regulatory arbitrage. More importantly, financial derivatives demonstrate that financial innovation has rendered obsolete regulatory tools resting on a conceptual apparatus built for another era and prior forms of capital. While issues of crisis and control rightly occupy the attention of scholars and public policy, carrying significant implications for those parts of society burdened with associated costs, it is issues of historical transcendence that point to the longer-term significance of the largest markets in the world.
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