In 2014, at €700 trillion, the notional amount of outstanding derivative ­contracts that were traded over the counter¹ exceeded the size of the underlying cash markets by more than five times. This goes against the better instincts of many outside the financial sector. It seems an unnatural state where the tail is wagging the dog. None other than the successful investor Warren Buffet famously wrote in the 2002 annual report of his investment vehicle, Berkshire Hathaway, “In my view, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.”² When suspicions over the lethal nature of derivatives were seemingly vindicated by the central role credit derivatives played in the Global Financial Crisis (GFC), the popular image of the financial crisis that we painted earlier in Chapters 3 and 4 was of bankers pulling smoking, toxic credit instruments out of their back pockets. These instruments were thrown into a crowd of bewildered consumers and the bankers were last seen grabbing the money and sprinting away. The argument was made that the time had come to ban the use of these weapons of mass destruction.

More prosaically, others believe that the business model of banks involves taking advantage of asymmetric information, that is, overcharging clients for complex instruments that are far more complex and opaque than required or can be reasonably understood.³ Investors, nursing heavy losses following the meltdown of the credit markets in 2008–9, paraded fat prospectuses that were weighted down with reams of impenetrable legalese on the subject of credit derivative instruments they had purchased and that was before getting to the small print. How, they asked, could anyone be realistically expected to understand it all? While it may seem incredulous that professional investors bought instruments they did not fully understand, they also alleged that there was deliberate misinformation. In April 2010, the SEC brought a charge against Goldman Sachs for defrauding investors by misstating and omitting key facts in the case of the Abacus credit derivative product.⁴

Following the GFC, and indeed almost every financial crisis, financial innovation is viewed with suspicion. It becomes almost a byword for egregious profiteering by wily bankers at the expense of innocent customers. It is no surprise, that there is a loud clamor for the implementation of radical changes as to what financial instruments can be traded, how they are traded, and how they are treated once traded. This is considered essential for ­consumer protection and upholding the integrity of financial markets.

Here we will reexamine that debate from the added perspective of systemic resilience. With this in mind, one extra concern is the rise of over-the-counter (OTC) derivative instruments especially in the credit markets over the past two decades. This has contributed to the widening gap between gross and net exposures. A bank may sell $1 billion of financial insurance to protect a buyer against General Motors defaulting on its debts and then buy $970 million of the same financial insurance. It earns brokerage fees on gross transactions of $1.97 billion but only runs a modest net exposure in the event of a default of $30 million, or 1.5 percent of the gross exposure. Normally it is net exposure that matters. These are a small fraction of gross exposures and they appear to be a more sustainable ratio of the size of the underlying cash markets. However, in crisis mode, when panic is inescapable, rumors create uncertainty over the ability of the counterparties to these transactions to honor their side of the commitments. It is then that gross exposures loom large. Today these gross exposures have reached a size where they can easily ­swallow any financial institution.

In the case of the Lehman Brothers default in September 2008, the gross notional volume of derivative credit contracts that triggered payments was estimated to be $400 billion. In the aftermath of Lehman’s collapse, the money markets froze, liquidity disappeared and panic set in that many counterparties would not be around to fulfill their side of these contracts. At this point losses could indeed have been close to $400 billion at Lehman and much more elsewhere. Years later, when the crisis had abated and bilateral trades among counterparties were netted out and the differences honored, the actual net exposure was a payout of only $6 billon.⁵ My point here is that small net exposures belie the systemic nature of the problem. Unless mitigated, the gap between gross and net exposures in the derivative markets represents, and is a measure of, the size of a systemic risk when market’s freeze.

In response to such concerns, politicians have contemplated aloud the possibility of banning some derivatives. They have also voiced concern as to whether all instruments should be publicly traded. Should new derivative products be subjected to regulatory approval before being offered for sale—even on the wholesale markets? Bankers have predictably opposed these proposals. They argue that such restrictions would strangle capital markets, creating “missing markets” causing welfare losses. Additionally, manufacturing and exporting companies would experience increased costs of hedging their revenues or liabilities as a result of interest rate swings, fluctuating foreign exchange or commodities prices. These higher costs may encourage them not to hedge, thereby adding to financial risks. Ably supported by their bankers, executives from the airline industry have pleaded with the EU Parliament and US Congress to have derivative contracts for hedging jet fuel prices exempt from regulations requiring these contracts to be centrally cleared. They cite studies indicating that central clearing could add as much as 10–20 percent to the cost of the hedge—a cost they must pass on to the airlines’ customers.

Regulators have sought a middle road. The emerging regulatory framework for OTC derivatives being promoted by the Financial Stability Board does not seek to ban all instruments or force them all onto exchanges.⁶ Its three-pronged approach attempts to: (a) improve transparency by mandating the reporting of all trades, (b) end market abuse behavior, and (c) reduce systemic risk by requiring vanilla derivative options to be centrally cleared and exchange traded. Where they are not centrally cleared holders of these derivatives would be compelled to have minimum levels of cash against their exposures. Is this a compromise born of weakness toward the industry or emerging from populist pressure? What are the fundamental principles that should guide reaching the right balance? These questions are the subject of this chapter.

Political Pressures Postcrash

The GFC created two very different groups of zeros. Workers at the bottom of the employment ladder were forced to accept new, zero-hours contracts with no guarantee of future hours or pay.⁷ Financial sector employees, who retained their jobs, salaries, and fat mortgages, benefited from the collapse in mortgage rates to near zero. Disparities in the lives of victims and perpetrators seem stark in the popular narratives, but reality is more complex and blurred. In the crisis, many subprime mortgage holders tragically lost their homes. However, in the preceding boom they had accessed subprime mortgages. This enabled them to purchase homes that they would never otherwise have been able to do. The picture is further obscured by who actually spoke up. Those who have weathered the troughs usually stay silent. The voiceless often bear the greatest losses and the loudest may actually be complaining about something entirely different. There are more than fifty shades of grey when it comes to finding the losers and winners. Despite these ambiguities, in the heat of crises, policy makers’ hesitancy is often interpreted as a reluctance to act or even—such is the politically combustible atmosphere—as complicity. Faced with billions of taxpayers dollars being diverted from social programs and defense budgets to save banks, politicians need to deliver urgent, decisive, and bold action. The final bill for the GFC across the EU and the United States will be in the trillions of euros. The public demands that the culprits be seized, locked behind bars, and repayment or other restitution made.

Across newspaper headlines and in the eyes of wronged consumers, the “crime” looms large, obvious and the (often foreign) bogeyman is writ large. A popular parable was of foreign speculators, this time London-based hedge fund managers. The story goes that they used derivative instruments to sell local stocks they did not own in order to press down company share values to the point of triggering bank covenants. These covenants required the company to issue more shares which would stop the shares from rebounding thus ­making the original selling a self-fulfilling prophesy.

While speculation was rife over the role of this short-selling, several studies were unable to find clear evidence that short-sellers were targeting financial institutions and their loan covenants in a material way.⁸ This lack of evidence was especially clear in comparisons of the performance and trading of nonfinancial stocks. Maria Stromqvist of the Swedish Riksbank summarized these studies well when she said, “To simplify somewhat, we can say that the hedge funds have been affected more by the present financial crisis than they have affected it.”⁹ Moreover, this kind of behavior was already unlawful, or, where not specifically so, could be captured within the catchall of market abuse or other prohibition. It is not clear we need something new to deal with this kind of abuse when it occurs. Further, despite the amount of ink spilled on short-selling, the equity derivative market is only a small fraction of the credit derivative market. Remember that it was in the credit markets that the main action of the GFC took place.

Yet, for governments faced with the political pressures described, it was tempting and even understandable that they should choose to outlaw short-selling with a swashbuckling draw of the legislative axe. In the GFC, especially around the middle of 2009, many countries, including the United States, United Kingdom, Italy, Korea, and Spain, issued emergency orders that banned short-selling of financial stocks. The practical effect of these bans is unclear. Some studies suggest that the volatility of financial stocks did fall.¹⁰ What is certain is that the bans failed to save Lehman Brothers from collapse in September 2008 and failed to prevent the calamity that followed. Yet, two years after Lehman’s failure, amid the European credit crisis, the German minister of finance announced a broadening of bans of naked short sales to include euro-denominated government bonds, the credit default swaps (CDS) based on those bonds, and shares in Germany’s ten leading financial institutions. In November 2012, in an attempt to coordinate a number of similar but different initiatives across Europe, the EU adopted a regulation that included a ban on uncovered (“naked”) CDS shorts on member states’ sovereign paper.¹¹

The idea that it was financial innovation and complexity—so well embodied in Goldman’s Abacus CDO and the industry’s creation of “CDOs-squared”—which previously tripped up global finance has spawned further proposals. Eric Posner and E. Glen Weyl have argued that finance should have the equivalent of a Food & Drug Administration to rigorously test new innovations just as new drugs must be tested and approved before doctors can prescribe them.¹² As with drugs, such testing might take years, at which point those instruments that were approved would then be sold with their appropriate health warnings. This idea has been gaining momentum. It was a major part of the debate surrounding the Dodd-Frank Wall Street Reform and Consumer Protection Act that was signed into US federal law by President Obama on July 21, 2010. The Consumer Financial Protection Bureau that it created may well take up this task of pre-release testing of financial products. Many in Europe would like the European Central Bank’s new single supervisory mechanism to include EU-wide vetting of the financial instruments within its remit.

But banning toxic instruments and cautiously approving others is still not enough for many. Those suspicious of markets and searching for further ­decisive action are persuaded that the reason all instruments do not trade on exchanges is solely the traders’ desire to avoid the transparency that might squeeze their profit margins. In Chapter 5 we pointed out that a lack of information is often an issue when financial markets are in panic, though not always legitimately so. In the GFC an information shortage surrounding the size, nature, and location of bank exposures to credit default swaps contributed to the high uncertainty that effectively closed the ­interbank money markets.

Add to this mix the numerous stories of shady activities taking place between financial institutions or even within them in the “dark pools” of liquidity. On July 28, 2014, a class-action lawsuit was filed in New York against Barclays for allegedly engaging in a scheme wherein the bank provided high-frequency trading firms it traded with confidential information on the large buy-and-sell intentions of its institutional clients. Barclays allegedly offered to manage the large buy-and-sell intentions of its institutional clients off the public exchange, because they were so substantial that, were they to be announced on the public exchange, knowledge of their trading intentions would push the market against them. If you publicly announce buying a significant number of BP shares, for instance, it would send BP shares up making the cost of buying them increase. However, if your bank or broker were to quietly buy them off-exchange in internal netting arrangements which are called dark pools, only announcing the purchase at the end of the day, you would be spared the inflated price. By allegedly providing information on these trades to its high-frequency trading (HFT) clients (who may have traded more often and paid greater commissions than its institutional clients), Barclays defeated the purpose of the institutional investors trading off-exchange. If proved it would mean that the HFT clients were allowed to front run—that is, buy ahead of—institutional clients and profit at the latter’s expense. It was like putting its institutional investors into a dark pool and giving only the HFT clients a torch. Prior to the lawsuit, Michael Lewis’s book Flash Boys caught the public’s imagination with gripping tales of banks routinely allowing their HFT clients to feed off their institutional consumers.

Politicians have demanded that all trades be conducted in the bright glare of exchanges. Some argue that if traders dealing in complex instruments have to avoid the scrutiny of exchanges, or prevent instruments from being centrally cleared and settled, then it is better that these instruments are not traded at all. Traders must either make pricing, quantities and terms transparent or forgo the possibility of trading. This proposal benefits exchanges, many of which are no longer mutuals but rather for-profit entities. They are keen on rules that proscribe trading off exchanges or require the central clearing of transactions. Most clearing houses are either owned by exchanges or partner closely with them.¹³

However well-intentioned, the proposals examined above are flawed for a number of practical reasons and also for quite fundamental ones. Banning existing, complex derivative instruments, subjecting new derivatives to testing and approval, and requiring all other derivatives to be exchange traded, will not achieve the intended goals. Regulators are right to be moderate. Let us consider what these fundamental flaws are and suggest ways to achieve the greater financial stability we seek.

A Fundamental Defense of Complexity

It is a commonly held belief that complex products are obscure, unnecessary and socially useless. The only apparent benefit is to bankers pocketing outrageous fees from these transactions. There is an element of truth behind some of these claims. However the argument against complexity is overdone and driven more by fear than fact.

Risk management is not about simply avoiding risks or having simple instruments. Risks are all around us and without taking risks there are no returns to be had. As I have argued in earlier chapters, managing risk appropriately is in large part about how you accurately match assets and liabilities. If I have sold casualty insurance (e.g. a medical or motor plan) to someone who may need to be paid out at short notice, it is highly risky for me to invest the bulk of my portfolio in illiquid assets like real estate, however simple those assets may be. My need for liquidity necessitates holding highly liquid instruments. Alternatively, a pension fund manager obliged to make a series of cash payments in 20 years time should not be in the market for such simple instruments like government bonds. They are expensive (providing a low return) and offer something the manager does not need to pay for, namely overnight liquidity. Government bonds appear safe and simple but actually increases the risk that the fund will need additional member contributions to afford future payouts. Long-term liabilities should be matched with long-term assets not simple assets. If existing liabilities are complex and changing, forcing the purchase of simple assets will result in unmatched risks. Eschewing complex assets in a complex world generates risk.

Moreover, regulators, however wise, sagely dictating which instruments to approve and which to ban, is not going to create the stability we crave. Almost all complex derivative instruments are built from a combination of simple, seemingly safe, financial instruments. I have yet to encounter a complex derivative instrument that cannot be built using the simplest derivatives such as puts and calls. As in architecture, where there are also common building blocks, financial complexity and simplicity are not as easy to distinguish as might first appear. At the heart of the GFC was a boom in housing finance driven primarily through the relatively simple instrument of a ­mortgage. Few complained about not understanding the nature of mortgages—especially since they have, in some form, been around for literally thousands of years.¹⁴

In Chapter 3 we observed that bankers didn’t throw instruments of mass destruction into a crowd of bewildered customers only to then hightail it. The spectacle was that they ran toward them, all the while trying to stuff as many of these explosive instruments into their own pockets as possible. The real problem of the originate-and-redistribute model for the banks that failed is that they did not redistribute enough. They tried to hold on to as many credit instruments as possible, all the while believing in the alchemy of computer models that suggested they could reap returns without risk. Banks created numerous off-balance-sheet, SPVs to enable themselves to hold more of these instruments and to do so in a more leveraged manner than their balance sheets and regulatory capital-adequacy requirements would have otherwise allowed.¹⁵ They really were more fools than knaves.¹⁶ Annointing specific instruments as “safe” or “bad” is not going to save us. It could even worsen the situation. Instruments are not born from original sin. They become dangerous through excessive, concentrated, or distorted use. The easiest way to create concentrated, excessive and distorted use of an instrument is for the government to declare it “safe.”

Why We Need Over-the-Counter Markets or Even “Dark Pools”

Exchanges work best for instruments where the size of the trade is small relative to the market and therefore the announcement of a bid to buy shares will not push the price higher, or the announcement of an offer to sell will not push the price lower. This captures most of the market for ordinary shares of large, publicly listed companies. An announcement to buy €100 of Sanofi shares is not going to push up the market price. This is why, without any initial regulatory mandate, the main venue for trading equities became public exchanges. However, in markets where the instrument being traded is large relative to the market, where the announcement of a bid or offer, like that of buying €100 million of Sanofi shares, would move the market away from the bidder or “offerer,” trades ended up being negotiated over the counter. Exchanges protect buyers and sellers whose trades cannot move a market with transparency and equal treatment. However, this transparency effectively undermines the interests of large buyers and sellers whose trades, or merely their announcement to trade, move the market against them. This is why they go off-exchange.

Imagine an exchange for residential houses that cleared at the end of every day. There would be enormous swings in housing prices depending on the daily match of supply and demand for houses of certain sizes, styles, conditions and neighborhoods. The seller of the same product would receive dramatically different prices depending on which day he announced his intention to sell. Indeed, the announcement to sell could itself create an immediate loss. The market, recognizing his need to sell an asset for whom there are not many ready buyers, pushes the price lower—a loss that might not have occurred had there been private negotiations with potential buyers over several weeks. That the vast majority of labor, goods and services are not traded via public exchanges is not the result of historic accident or regulatory lapses. It is the natural result of most markets being dominated by large and lumpy trades in things that are defined by a multitude of different attributes, rather than small trades of standard things. The more heterogeneous and lumpy the instruments, the greater the likelihood that they are traded “over the counter” and not on a public exchange.

In aggregate, bond and currency markets are large, but the bulk of trading takes place off-exchange. Bond and currency markets are really comprised of several, modestly sized subsectors. While a company might issue one type of share, it may have several different bond issues outstanding, each with unique maturities, coupons and tax treatment. The market capitalization for all bonds may be large but the market for each specific type of instrument—for example, bonds with an AA credit rating that mature in 18 months, that have a greater than 5.5 percent coupon, paid semiannually, gross of withholding taxes, and that are issued in US dollars—may be tiny relative to the overall market of bonds. In the case of government bonds, such as those with two-year, five-year and ten-year maturities, the majority of trades take place on a few “benchmark issues.” Even though the vast majority of issues outstanding were once benchmark issues, they are no longer so. Last year’s ten-year bond has become a nine-year bond. The market for these “off-the-run” instruments is more specialised and less liquid. Once those looking for a standard representation of long-term interest rates are removed, demand falls off a cliff, leaving quite a rarefied group of investors looking for an asset that matches a nine-year liability.¹⁷ Consequently, even these instruments are often ­negotiated between buyer and seller rather than traded on a public exchange.

At over $5 trillion a day, the currency market has a higher daily turnover than any other market. Yet the majority of currency transactions are for a forward, future, or swap, where a specified amount of foreign exchange is delivered on a specific date and time.¹⁸ These instruments are also largely negotiated over the counter between buyer and seller. The market to receive a million Brazilian reals in return for Argentine pesos at the close of business next week Thursday at 4.00pm Atlantic time is best negotiated and unannounced, lest others, aware of the buyer’s need for Brazilian reals at that precise moment, squeeze the supply against them.¹⁹ Contrary to their depiction in several economics textbooks, markets are not passive places where market participants pursue their activity independently of one another. They are dynamic places defined by ­strategic behavior.

Evidence for this theory of trading venues is found even within the same market, where the historical and regulatory influences were similar. In equity markets, exchanges are the dominant venue for small trades that have no price impact. Large trades are made off-exchange, bilaterally over the counter, or in dark pools and often later reported, through the exchange, as a negotiated trade that is then cleared and settled exactly as an exchange trade. The negotiated market in equities can be as large as the exchange-traded market.

There have been several previous attempts to put bond and currency markets on an exchange that have failed because of the issues discussed. What has emerged instead are electronic venues where market makers quote indicative prices for small trades as a signal of where they may be open to offers and bids for larger negotiated trades which are then afforded the same electronic trail of confirmations and settlement as quoted trades. The same argument applies to a derivative instrument designed, for example, to hedge the near-unique currency needs and risk-tolerances, of an exporter. Forcing these instruments onto exchanges would increase volatility. Given the unique nature of the supply and demand of these bespoke transactions, announcing bids and offers would force the market to appear whenever it is not being used and disappear when needed.

In essence, the liquidity characteristics of different transactions are revealed by the chosen trading venue. Instruments are traded where there is greatest liquidity. Consumers are not looking for the greatest opacity although opacity sometimes enables liquidity.²⁰ Where the instrument is large relative to its market, the greatest liquidity will not be on an exchange that is likely to sap liquidity and could lead to missing markets. Although dark pools may be abused and this must be stopped, they are not a sinister subplot but a necessary evolution of shifting large blocs of shares with the least market impact. They should not be banned or made impossible. To force consumers away from their revealed preferences is a mistake.

Being traded OTC rather than on an exchange is not equivalent to being unregulated. OTC is not trading under-the-counter. Post-trade reporting is, in many cases, now mandatory for OTC trading. This should be the required norm. Consumer protection regulation in the housing market, for instance, is extensive in many countries. It matters not how a house is sold—online, through bilateral negotiation, or traded by some form of auction. Regulation of the market is independent of the trade venue. More can be done to protect investors trading in dark pools, but that does not mean that we should hoist the public exchange model onto markets that have, with good reason, evolved differently.

Conclusion

The arguments presented are not meant to imply that we should ignore the derivatives markets as a potential source of financial instability. Rather the argument being proffered is that we must be more watchful over behavior that creates systemic risks rather than being too particular about instruments or trading venues. Instruments and venues come and go, but the underlying behavior that causes financial crashes is constant.²¹ In Chapters 5, 6 and 7, I have proposed incentivizing behaviour that strengthens the financial ­system. Beyond that, behavior that uses any instruments—derivative, complex, or simple—to create false markets or undermine market integrity should be ­illegal. Huge damage was done through mortgages, the simplest and most familiar of instruments.

In the crisis, regulators were also blindsided by a lack of information. Post-trade transparency must be a requirement independent of whether instruments are traded on exchanges or not.²² Under the European Union’s 2004 Markets in Financial Instruments Directive (MiFID), market-making firms are already obligated to report off-exchange trading in instruments that are also traded on EU regulated exchanges. It is not a great leap to require post-trade reporting of all trades regardless of where they are traded. Failure to report these trades should carry stiff penalties—including the legal unenforceability of the transaction.

Banks may have a built-in bias toward selling complex instruments (with their fatter profit margins) that are not best traded on an exchange, where a simpler, more liquid, set of instruments could suffice. Many believe that this is the driving force behind bank behavior.²³ Complex instruments are harder to clear and settle centrally, making it more difficult to limit exposures and risks. This can also make resolutions more difficult, which represents a potential threat of systemic risk. We can internalize this social externality by requiring firms to set aside capital for holding instruments that are not centrally cleared and settled—irrespective of trading venues. This proposal would act like a tax on complexity rather than a ban. Simplicity and central clearing would be incentivized and banks would only trade complex instruments where necessary.

Competition authorities are rightly concerned that since many exchanges own clearing houses, any regulation that incentivizes central clearing of instruments will allow exchanges to capture the market in trading venues. To address this, the authorities can promote the “interoperability” of clearing houses, where counterparties choose where they clear their transactions independently of where they trade them.²⁴ Clearers would be required to grant fair access to third-party trading venues. This would also deliver greater financial stability by maximizing the netting across a wide range of related instruments—­irrespective of where the best place to trade those instruments is at any one time. Forcing trading venues and clearers to fight separately for business could also deliver better services and lower user costs. This would be competition-supporting horizontal integration of the industry as opposed to competition-reducing vertical integration. In one swoop, we could boost competition and financial stability which, as discussed in Chapter 4, is more rare than realised.²⁵

Another more controversial suggestion for limiting “excessive” complexity of behavior would be to place a tax on all small transactions of instruments issued within participating countries, or carried out by residents, including OTC derivatives. A lesson of the last decade is that low transaction costs are good but near-zero transaction costs are questionable. The reason is that these near-zero costs allow huge edifices of circular transactions to take place—much more than are involved in the underlying transaction. These are always hard to unwind in an orderly fashion even if the transactions were simple. A small transaction tax would focus minds on the underlying value of each transaction and limit socially useless transactions. It would be a tiny price to pay if it preserved innovation and risk-reducing complexity.²⁶ We consider the merits and difficulties of this idea in Chapter 13.

In this chapter, I have set out a short theory of trading venues that reflects the revealed preference for trading liquidity. My proposals try to strike a balance between trading liquidity, innovation, consumer protection and systemic risk. While it remains in some flux, the emerging regulatory regime for OTC derivatives is close to what I propose. The focus should be squarely on regulating behaviour through the macroprudential tools presented in Chapters 5 and 6, accounting tools in Chapter 8, financial transaction taxes discussed in Chapter 12 and on the mandatory reporting, central clearing and settlement of trades described in this chapter. Behavior, not instruments and trading venues, is key to containing systemic risk and protecting consumers.

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¹Derivative contracts traded over the counter refer to those financial contracts whose value is derived from the value of equity, credit, interest rates, and currency instruments and are not traded on a public exchange but between two different firms or individuals.

²In testimony to the US House of Representatives Committee on Oversight and Governance Reform on November 12, 2008, another accomplished investor, George Soros, commented about derivatives: “The risks involved are not always fully understood, even by sophisticated investors, and I am one of them.”

³One champion of this view is Joseph Stiglitz, who won the 2001 Nobel Prize in Economics for his work on information asymmetries. This is well illustrated by the 1994 case of Bankers Trust and Procter & Gamble. Bankers Trust sold Procter & Gamble a derivative contract where it would pay Procter considerable sums if its bet that US and German interest rates would continue falling came right. Conversely, Procter would have to pay considerable sums to Bankers Trust if the bet went against them. The contract was highly complex and leveraged. Small changes in interest rates could chalk up heavy payments. After the US Federal Reserve began raising interest rates in February 1994, Procter quickly amassed losses of over $150 million on the contract. Procter then sued Bankers Trust for selling it an instrument that they claimed they could not be expected to understand. Edwin Artzt, Chairman of Procter & Gamble, was quoted in the New York Times on 14 April 1994 proclaiming that, “Derivatives like these are dangerous and we were badly burned. We won’t let it happen again.”

⁴In a press release of April 16th, 2010, the US SEC alleged that the marketing materials for Abacus, structured and marketed by Goldman, indicated that the portfolio of mortgage instruments underlying the credit derivative obligation, or CDO, was selected by an independent expert in the credit risk of mortgages—the ACA Management. However, according to the SEC, in a clear and undisclosed conflict of interest, the Paulson hedge fund, which had taken out positions in the CDO that would allow it to benefit if the mortgage portfolio defaulted, played a significant role in selecting which mortgages should make up the portfolio. Gordon Gekko, it seems, had nothing on John Paulson.

⁵See generally Depository Trust and Clearing Corporation (DTCC) notices on the Lehman default on their website.

⁶See Financial Stability Board, Implementing OTC Derivatives Market Reforms, October 25, 2010, www.financialstabilityboard.org/publications/r_101025.pdf.

⁷The 2013 British Labour Force Survey finds that the total number of employees on zero-hours contracts rose 25 percent over 2012 and had risen more than 150 percent since the end of 2005, the last full year of the last boom. See British Labour Force Survey, Office of National Statistics, Colchester, Essex. 2013.

⁸See Arturo Bris, Short Selling Activity in Financial Stocks and the SEC, July 15th (2008) Emergency Order, IMD, August 12, 2008, www.imd.org/news/upload/Report.pdf.

⁹Maria Stromqvist, “Hedge Funds and the Financial Crisis of 2008,” Economic Review, 1/2009, pp. 87-106, Sveriges Riksbank, March 2009, www.riksbank.com.

¹⁰See Bris, Short Selling Activity, 2008.

¹¹Regulation (EU) No 236/2012 of the European Parliament and of the Council of 14 March 2012 on short selling and certain aspects of credit default swaps.

¹²See Eric A. Posner and E. Glen Weyl, “An FDA for Financial Innovation: Applying the Insurable Interest Doctrine to Twenty-First Century Financial Markets,” Northwestern University Law Review 107, no. 3, 2013. This article is based on an earlier version called “A Proposal for Limiting Speculation on Derivatives: An FDA for Financial Innovation,” which was circulated as a white paper and carried much influence with US legislators during the passing of the Dodd-Frank Act.

¹³Exchanges are in a delicate position as high-frequency traders also contribute a large proportion of their revenues.

¹⁴The first mortgages were not on houses but on holdings of commodities. The centralization of harvests in state warehouses in Ancient Egypt and Mesopotamia led to the first mortgage contracts. Roman law allowed a creditor to seize the land of a nonperforming borrower. A couple thousand years later, mortgages have become more common on land and property but they are still common on commodities. In one of the earliest records of a mortgage, in 1766, Pierre Berger gave a mortgage to Francis Latour in St. Louis, Missouri. The goods covered were a quantity of deerskins.

¹⁵See Viral V. Acharya, Philipp Schnabl, and Gustavo Suarez, “Securitisation Without Risk Transfer,” Journal of Financial Economics 107, no. 3, pp. 515–36.

¹⁶Given the choice, many bankers I know would rather be seen as knaves than fools. I guess this is because knaves at least have a shot at redemption.

¹⁷See Jeremy J. Graveline and Matthew R. McBrady, “Who Makes On-the-Run Treasuries Special?” Journal of Financial Intermediation 20, no. 4 (October 2011), pp. 620–32.

¹⁸See Bank of International Settlements, Triennial Central Bank Survey of Foreign Exchange and Derivatives Activity in 2013, last modified December 2013, www.bis.org/publ/rpfx13.htm.

¹⁹It is alleged that when the highly leveraged hedge fund, LTCM, ran into difficulty in September 1998, it asked its bankers for help. They offered to do so on condition that they could get a detailed view of the portfolio. The banks then established positions that would profit from LTCM’s need to bail out of certain positions, like its losing long yen, short dollar position, and backed out of any support. LTCM then found that, with the market knowing its positions, it was impossible to get out of them.

²⁰See Michael Mainelli, “Liquidity: Finance in Motion or Evaporation” (lecture, Gresham College, London, September 5, 2007), www.gresham.ac.uk/lectures-and-events/liquidity-finance-in-motion-or-evaporation.

²¹See Avinash Persaud, “Will the New Regulatory Regime for OTC Markets Impede Financial Innovation?” Financial Stability Review 17 (April 2013), www.banque-france.fr/fileadmin/user_upload/banque_de_france/publications/Revue_de_la_stabilite_financiere/2013/rsf-avril-2013/24-PERSAUD_Avinash_D.pdf.

²²See Nigel Jenkinson and Irina S. Leonova, “The Importance of Data Quality for Effective Financial Stability Policies,” Financial Stability Review 17 (April 2013), www.banque-france.fr/fileadmin/user_upload/banque_de_france/publications/Revue_de_la_stabilite_financiere/2013/rsf-avril-2013/11-JENKINSON_Nigel.pdf.

²³However, this is not as clear-cut as some believe. From my experience, corporate treasurers often find it hard to justify to their boards the cost and value of hedging their financial risks and exposures. They go out of their way to ask for and choose “zero-cost” options as hedging instruments over more expensive options. Of course, these instruments are only zero cost because they have more risk. The cost of insuring against a risk has been offset by the premium received for acting as an insurer for another risk. For instance, if a Swedish exporter of cars to South Africa makes additional profit when the rand rises against the krone, and losses when the rand falls, it could cheapen the cost of buying insurance against the rand falling, by selling insurance against and giving up some of its profits from, a rise in the rand. But the added challenge for the corporate treasurers is that they were frequently too embarrassed to admit they did not fully understand their exposures. This embarrassment is accentuated by the fact that companies often chose older men to be their safe pair of hands at the Treasury and banks chose highly intelligent young women to sell derivative instruments to them.

²⁴See Avinash Persaud, “Comment: A Historic Turning Point for Market Structure,” Financial Times, June 2, 2011, www.ft.com/intl/cms/s/0/026b91b0-8c37-11e0-b1c8-00144feab49a.html#axzz3HODqP8Zm.

²⁵Competition and financial stability are often, surprisingly, at odds with each other. For a further discussion of this, see Charles A. E. Goodhart and Avinash Persaud, “Not Far Enough: Recommendations of the UK’s Independent Commission on Banking,” VOX, May 13, 2011, www.voxeu.org/article/uks-banking-commission-has-not-gone-far-enough.

²⁶Opponents of financial transaction taxes argue that they are not feasible and because they are large relative to trading costs, they would collapse trading, which would increase volatility. In Chapter 12, I explain why these arguments are wrong.