Simon Fowler's Blog

rLiving Day 25: Derivatives! (Directness, Power, Purpose)

Posted by Simon on May 26, 2010

[This is a fairly long post attempting to examine derivatives from a relational perspective. Fun, huh! It’s becoming evident, three hours into it, that I ain’t an economist! And that there’s more to say.]

Why weren’t derivatives regulated?
In the comments of Saturday’s post Nick told me about Brooksley Born, former head of the Commodity Futures Trading Commission. Back in 1998, having become increasingly concerned with the lack of transparency of over-the-counter derivatives, and in particular ‘swaps’, the Commission issued a “Request for Comments” report. The report is a first step towards new regulations. One day later, strong objections to the report were made by the chairman of the Federal Reserve (Alan Greenspan), the Treasury Secretary (Robert Rubin) and the SEC Chairman (Arthur Levitt) strongly objected to the release of the report.

So the three most powerful people in US finance opposed a preliminary investigation into the derivatives market. Born, apparently, wasn’t even permitted to take a closer look, let alone issue new regulation.

Why regulation should be a tool of last resort
[UPDATE: the original heading was “Why regulation sucks”, a hastily invented and unfortunate choice given the reaction “regulation” talk causes.”]
Now, I don’t honestly know what “Regulation” means when someone says the word. But it seems like people want it used like a very blunt and unimaginative hammer for constraining any excessive human nail. And even if it’s successful at that, it is ill-designed to foster virtuous innovation, creativity and trusting relationships. “Law” does have a place in fostering trust, I guess, by letting everyone know where the boundaries are. But by placing the locus of moral restraint on the law rather than in the human heart and in human relationships, one underestimates what the human heart is capable of and opens up a Pandora’s box of deceitful ingenuity that requires more law.

Regulation and a lack of transcendent moral authority
I’m so sorely tempted here to make an argument for God, or rather an argument for the inevitable trajectory of a society that rejects God or a transcendent moral authority. [And please, if you’re atheist, don’t get bent out of shape about that proposal. I would guess and expect, if you’re reading this, that you’re a person of high moral sensitivity and fortitude (not to mention a person with exceptional taste in blogs!).] But I speak about those for whom the absence of a transcendent moral authority is license to … well, create fraudulent, exploitative, derivatives. I mean if the accepted norm in a society is that morality is self-determined, that’s fine if what you self-determine is righteous and good (namely, you, dear reader!), but for everyone else? What then? More laws, more regulations (that affect everybody, even the righteous) ironically taking us back to something akin to the religious legalism from which we thought we’d liberated ourselves. Most claims for human enlightened progress assume a level of goodness and righteousness that empirically does not exist even in the best of us, and even if it does, it’s only in those who make the claim. [Oh man, looks like I did make an argument. I think I’ll be in for some fire for this paragraph.]

Regulation as “oversight”: observation of actions
The key word for the role of the CFTC, and for regulation in general, is ‘oversight‘. Over. Sight. Looking over … someone is watching! Regulation does provide specific permissions and prohibitions (the creative spirit killer), yes. But the main thing seems to be about disclosure, as with Sarbanes-Oxley for example. That’s what screams “you can’t be trusted with each other!”. No gentleman’s handshake for you two! The authority needs to know, for the sake of everyone else.

Relational analysis of derivatives.
So the big question I want to ask is: how do we create a different form of oversight that is built right into the financial relationships embedded in entrepeneurial activity and human exchanges of labor, material and time? First we have to examine the system relationally.

From Wall St to Farmer Bob. Or, Financial Risk Management made easy (for me to understand)
Farmer Bob wants to harvest a field, but he can’t afford a tractor. A friend has some money to lend him, but with a few other friends they pool it together to help the farmer. Suddenly the farmer’s productivity sky-rockets, he’s even employing more people, developing better farming techniques, trying out organic methods. Only he doesn’t, the tractor blows up. All his friends lose their money. Except they don’t. They get together with yet more friends so that some of the bigger pool of money goes to this farmer, some goes to a milliner, some goes to a guy who’s invented something called a yPed. Two out of three succeed so the larger group still receive a return on their investment. Except they don’t. A tornado rips the local economy to shreds so they lose everything. Except they don’t. They get together with another group of folks out west and pool money to share in even more diverse enterprises: the confidence that a failure at one farm or one town won’t make them bankrupt encourages more people to invest their money in helping more people farm and make hats and yPeds.

And so it goes, the world of financial risk management and economic expansion. Through the eyes of a non-economist.

Financial risk and relational proximity.
In this whole scenario, you can see the possibility of accountability between the people with money and the people who use money to do something creative, productive. There’s a relational proximity between them, though growing more mediated and distant the bigger the pool becomes. There’s no ‘derivative’ pool of money that’s speculating against potential future scenarios. There IS financial speculation, but it’s “invested”, it has a stake in the end product.

Directness. It seems the greater the distance between the lender and Farmer Bob, the greater the chance that the lender will forget there’s a human being trying to make something good at the other end, and will instead only think, “how am I going to make money?”. Equally, there’s a greater the chance Farmer Bob won’t remember there’s a human being who’s risked their money with them. Purpose/Commonality. In other words, there is no longer a shared understanding of the source and purpose of the money. So relational distance (what I’ve called elsewhere, mediated relationships) contributes to a lack of mutual, intrinsic moral accountability – so now you need ‘oversight’, the law, from someone who’s not invested in either party or the relationship. There’s even greater relational distance now because the people ‘with the money’ (e.g. Wall St traders) are not even using their own money, they’re using money invested by millions of people. The traders stand in between million’s of other people and Farmer Bob.

Power. That shift in moral accountability and sense of relational investment is made more problematic by this big pool of money now being concentrated in fewer hands (e.g. Wall St traders). There’s now an enormous power asymmetry. The people with the money, who now have a lesser sense of moral accountability to Farmer Bob, can now dictate terms. The distance means their only purpose is “make more money”. The fact that Farmer Bob needs a tractor is irrelevant to them now (especially because there’s just no way ALL tractors would fail at once, or that ALL resale prices of tractors would drop at once, that would NEVER happen!). The only way to redress the power imbalance in this case is for all the farmers, and everyone else who needs money to buy houses or tractors, to get together as a community (consumer action? social media?). Or else there’s regulation.

So relational distance (directness) causes a loss of shared purpose (purpose!) and a greater possibility of power imbalance (parity).

And I think I’m done.

Except I’m not.

None of this horrid scenario would have been possible if there was no interest charged on loans. An interest charge essentially enables the lender to make money out of money. They’re being paid to lend money. So interest creates a loss of shared purpose right at the get go. If, however, the lender received money from the success of the business, THEN, lender and Farmer Bob have shared interest. Bob gets his tractor, lender gets his money because Bob is successful. Yes, pool money with others, pool with even more others, spread the risk. But keep the source of investment income in the form of business productivity, dividends. Not interest.

Now I’m done. For now.


3 Responses to “rLiving Day 25: Derivatives! (Directness, Power, Purpose)”

  1. Kate said

    This is going to take some time to digest. My initial response, specifically to “regulation sucks,” is that you’re missing something, namely the role of law in creating (or pre-dating, anyway) moral behavior. Many laws are pushed through ahead of society’s wishes.* Civil Rights would be an obvious example. These laws did NOT reflect majority thought at the time (I didn’t witness it, but have read a fair bit on the subject); the laws forced more moral behavior than society was “ready” to exhibit.

    What do you think?

    * in the U.S., anyway – assume my total ignorance of other countries’ laws

    • Simon said

      It’s taking a while for me to digest also! And the ‘regulation sucks’ subtitle was an unfortunate choice (and a last minute decision to add subtitles), not conveying the nuance I intended in the paragraph. In the paragraph, I do concede that it can succeed in constraining excess (or, creating moral behavior), but at a cost. Because of that cost – and this was the main thought behind the paragraph – law/regulation should be a last resort tool, not the first impulse for every ethical infraction.

      Civil Rights is a perfect example to consider. The heart and soul of the Civil Rights movement reads like a moral and spiritual revival, but the eventual legal effect of that revival ensured the next generation grew up taking equal rights for granted. So in that sense, it created moral behavior. But – and this is a genuine question – did it create a moral heart? Did it actually change the way white Americans see black Americans, and vice versa? Did it create a sense of moral and ethical equality in both? Did it ensure that most blacks today barely even think about being of less worth than whites, and the converse for whites? (And I hope everyone forgives me if ‘whites’ and ‘blacks’ are politically offensive terms to use here.) And even further, did it change the way people perceive, value and treat ‘difference’? The legal route that almost all ‘civil rights’ questions take these days – taking the Civil Rights movement as an apparent precedent – seems to illustrate my point, that the law has become the only language and locus of moral restraint. The possibility that people might just “work it out”, that there might be confession, forgiveness, compromise, slow steps of trust-building, seems like a quaint dream.

      None of that invalidates your point though, that the law has created a certain kind of moral behavior for which we ought to be grateful (and shudder that the law was ever necessary.) The existence of powerful national legislative and judicial institutions seems sadly necessary. I just wish it was the last, not the first, resort.

      • Kate said

        No, I don’t think the law changes anyone’s heart. But it does change their behavio(u)r. Sometimes the heart leads, and sometimes it follows. :shrug:

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