In the Observer, 23rd December 2012, Will Hutton writes an article entitled: "Bank rate-fixing scandals reveal the rotten heart of capitalism: The magnitude of the banking scam must be realised and tough action taken." Well, most non-bankers can all fall in behind that principle, but the idea of "tough action" being taken under the present regime is a forlorn hope. The banks have been fined billions but these sums will be spread over their accounts and ultimately it will be their smaller customers, or the tax payer, that will pick up the fine. The Libor rate fixing was criminal by any normal standards but no banker will go to prison or even face a criminal court.
So far, so familiar. Hutton's article is not bad but I doubt whether he made the mechanics and the enormity of the Libor scam clear to many. There are few who do not agree that the huge problems we have with banks and finance started with the Reagan/Thatcher reforms of the 1980s which opened the door to the creation of "innovative financial instruments". These totally changed the way banks operate.
Meanwhile, the Libor scam may have revealed the "rotten heart of capitalism", but how exactly did it work? What exactly are "derivatives" which Hutton mentions?
"Derivative" has become a dirty work. The great US investor, Warren Buffet, famously called them "weapons of mass financial destruction". But what did he mean by this? And was he right? Let us take it from the beginning.
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The first thing to understand is that from 1992 until 1997 there were fundamentally just two sorts of derivatives: traditional derivatives and credit derivatives. In 1997 an additional layer was added onto the whole system and these are called "synthetic derivatives", but let's leave these aside for the moment. I will just note in passing that, unlike traditional derivatives but like credit derivatives, they are wholly malign. I will come back to them, for they are the crucial recent driver of the magnification of financial "instruments" that truly make bankers the "master of the universe" and drive the increasing inequality between the superrich and the rest of us.
Traditional derivatives are as old as trade and so, far from being "innovative", go back to the earliest western civilisation 5000 years ago. Most would agree that "credit derivatives", invented by contrast in 1993, are not really derivatives but were given that name as a handy way of aligning them with a traditional entirely respectable trading practice.
Many of us at some time will engage in a traditional type derivative even if we do not realise it. Suppose you agree to sell your house for -200,000 to a buyer. As we know, the actual final sale (completion date) at the moment of making the agreement to sell may be four months away, and during that time the price may have changed -- up or down. But, in order to effect the sale, you and the buyer agree to sell in four months time at today's price. Welcome to the world of derivatives.
The crucial element that has entered into this deal is time. Time must be writ large in understanding derivatives, for it is what makes a derivative a derivative. If all trading was effected at the moment the price was agreed there could be no derivatives. When you buy a good in a shop and pay cash or with a bank card the price is agreed and the exchange takes place there and then. This is a derivative-free piece of business because it is instantaneous. There is no element of time.
Let us think a little more about your sale of your house with the four month delay. Included and implied in this deal is what is known as a "swap". The swap referred to is a "swap" of risk. Each party is taking on a level of risk for the no one knows for sure what the market price of the house will be in three month's time. As a seller you accept the risk that the price will go up and you will be out of pocket. The buyer likewise accepts the risk that the market price will go down and so he or she will have paid too much. You are in effect "swapping" risks, and it is crucial to understand that the risks are real for both parties.
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Now let's move on to another kind of derivative swap and one that is probably the most common in the modern financial world -- the "interest rate swap". Although an interest rate swap may seem different to the swap involved in the house sale, the principle is exactly the same. After all, with a loan you make a series of service payments and so you can think of an interest swap a series of swaps just like the one you did with the house. And note we are still in the world of traditional derivatives and these are the good guys. The bad guys are credit derivatives and synthetics and these we will come to in a moment.
Suppose you are a medium size business (and this would include one with, say, 5,000 employees) and you want to take out a loan. The only deal on offer from your bank is a variable rate interest loan and the interest rate is, say, 2% over Libor, the London Interbank Offered Rate. Libor is a benchmark for bank lending and is, or was, considered independent of any particular bank's interests and so, for all practical purposes, an objective measure.
But it may be that you are not happy with the variable rate loan. You have many unpredictable aspects of your business, the sales market, supplier prices, new onerous regulations, etc, and so the last thing you want is yet another uncertainty with a variable rate loan. This is where interest rate swaps come in very useful, and millions of them are transacted every year worldwide.
You approach a derivatives broker who finds for you an investor, called a "counterparty". This counterparty will take out a loan with whatever arrangement they can find (or more likely already have one in place). Now there are two elements to any loan from a bank -- the principle, i.e. the sum you borrow, and the interest repayments. An interest rate swap is exactly what it says on the tin. You do not swap each other's principles -- only the interest rate part. Your counterparty pays your variable interest rate and you pay him or her at a fixed rate of interest. Hey presto! You have converted a variable rate with all its attendant risks into a fixed rate.
So what is the catch? The catch is, of course, that the counterparty will require a fee for taking on your risk. You pay a fixed rate of interest plus a fee to the counterparty. There is also the matter of the broker's fee but nevertheless the stability that the deal affords to your business you judge is worthwhile and, as I have said, there are millions of such deals in existence. Interest rate swaps of this kind are a useful and constructive way of passing risk on from your business, which does not want interest rate risk, to businesses and individuals that want to take on such risk for a profit. They are not in any sense "weapons of mass financial destruction". They have a constructive role to play in a modern economy.
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Now, for the purposes of understanding the Libor scam, we do not need to go beyond normal traditional derivatives into so-called credit derivatives for they played no part in it. The basic principle of these is that they provide protection, not against the market, but against creditworthiness of a debtor. I would argue, incidentally that this is not a legitimate trading activity and should be banned outright -- credit derivatives are indeed "weapons of mass financial destruction". Buffet was right in relation to credit derivatives.
We saw in the interest rate swap how the counterparty to the agreement, by taking on your risk, entered into what they considered a good deal. It could go sour, if interest the Libor rate went against them, i.e. went up lumbering them with paying a higher rate whilst you in your business still enjoyed the fixed interest rates plus fees, safely insulated from turbulence in interest rates.
What normally made the deal good for the counterparty is that they were doing hundreds and thousands of these deals on a daily basis and so if they saw deals from the past going bad they could simply raise their fees on new deals, much as traditional legitimate insurance companies, raise their premiums on new contracts to finance payouts on older contracts where those payouts were more than expected. This keeps the insurance company in business and enables it to honour its obligations.
But let us pause for a moment. Who exactly are these "counterparties" we have been talking about? Well, you've guessed it. They are the big banks themselves and other big financial players like hedge funds who place the mega funds of the mega rich to maximize gains. And who brokers these deals? Right again. The world's biggest banks. So there is a nice cozy set up with the big banks controlling the swaps contracts and they themselves are not only the broker but often the counterparty as well. Ah, and there is one more element they are involved with determining -- the Libor rate.
Now, remember that the swap you entered into as a medium size business fixed your costs well enough whilst the counterparty took the risk on variability in interest rate -- and this variability was based on the Libor rate. So if only the counterparty could somehow engineer the Libor rate to be lower than it really should be they would increase their profits many times and by the way fleece their customers to whom they sold the derivative. This is the Libor scam laid bare, whereby the counterparties, the big banks, manipulated the Libor rate to profit fantastically and rip everyone else off.
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But that sounds on the face of it like a criminal act. The counterparties like to think of themselves as investors and so they are, up to a point, providing a useful stability to ordinary business. But there is also a sense in which they are speculators, or putting it more starkly, gamblers and I will come back to this in a moment in discussing synthetics.
Consider for a moment what undoubtedly is a gambling business -- a bookmaker. Suppose you, as the punter, put your money on a horse. What you absolutely have to know in this bet (or speculation) is that the bookie is unable to influence or fix the outcome of the horse race. Of course, there have been many scandals involving people being paid to dope horses and jockeys being paid to deliberately hold back their horses to fix the result. Such activities when discovered are straightforwardly criminal and people have gone to jail and had their careers finished when they have been caught.
The banks fixing the Libor rate to gain from their derivatives positions is exactly the same in principle. So why have there been no criminal prosecutions? The only answer to that must be that the criminal justice system and their political overseers are corrupt. The global banks are so powerful that the law officers and politicians dare not challenge them. That is the world we live in. That is the extent of the mess we are in and the injustice we live under. But there is a further massive sting in the tale for the ordinary citizen. This is where we must return to "synthetic derivatives".
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You have to hold onto your hat to swallow what these are about, because they sound so outrageous and so are so obviously dangerous and destabilizing that it is difficult to believe they were ever allowed to be considered legal -- and, of course, they still are.
Interest rate swaps, as we have seen, are good business for the counterparty and so understandably they would like more business like this. But unfortunately there are only so many businesses, in the example like yours. out there looking to swap variable rate interest rates for fixed rate loans. This excellent business seems to have hit a ceiling. The counterparties cannot go on getting richer and richer. Damn it!
But never underestimate the inventiveness of the banks and the complicity with them of the regulators. Enter in 1997 the perfect answer to generating more business: "synthetic derivatives".
The interest rate swap business, as I said, seemed to hit a ceiling when there were no more parties for the counterparties to deal with. There were not enough ordinary businesses seeking to swap a variable interest rate for a fixed one. It is a fundamental law of business that any deal needs two -- the party and the counterparty. But, with the introduction of synthetics, this 5000 year old economic principle was about to be violated and the financial world was about to suffer its biggest ever shake up. And the global inequality of wealth was about to be rocketed into the stratosphere.
The name "synthetic" is a good one. Because what these deal do is effectively make the party to the counter party non-existent, unreal. This is brilliant, because it removes entirely the ceiling on the number of swaps that the counterparties (for all practical purposes the banks) can create. By divorcing the deals completely from the real economy in this way, there was literally no limit to the number of swaps that could be created
This is what lies behind Hutton's comment "What makes your head reel is the size of this global market. World GDP is around $70tn. The market in interest rate derivatives is worth $310tn." The value of the market is over four times the value of all the normal world productive output. Clearly there has been a complete delinking of these financial operations from the real world economy.
The recent growth of the derivative market has been made possible, above all, by synthetics. The need for a business to create an interest rate swap, as described above, put a limit and the number of swaps. But without the need for a party to the counterparty there is literally no limit on the amount of deals that can be done. It needs to be pointed out that there are other forms of synthetic instruments that have contributed to Hutton's figures but the principle of them is always the same.
Let's be clear. Synthetic trades are pure bets. There is no longer any question of providing "insurance" for a normal business giving them protection. Synthetic trades operate without being dependent on the real economy -- but they nevertheless have an overridingly important significance for it.
An increasing amount of money is being made on the increasing number of synthetic contracts. But where is that increasing amount of money coming from? There is not space here to go into the way the whole financial edifice is constructed but ultimately that money can only come from one place -- where real wealth is created, i.e. the productive working economy. This means it is the economic activities of those who make goods and provide productive services that ultimate must rise up the inverted pyramid to be channeled into the ever swelling coffers of the global superrich whose financial affairs alone can exist in the rarified economic world of synthetics.
The line of causation may take some tracing but ultimately the crushing poverty and wasted lives that we are seeing in Greece and Spain and elsewhere throughout the world is in large part a result of allowing to develop this whole massive layer in the world economy that contributes nothing productive but only serves to redistribute of wealth from those working in productive trading jobs to those who manipulate the system and play with the lives of the rest of us.
The freebooting activities of the global banks and their customers are at this time continuing at a pace. Their activities are sometimes definitely criminal and are sometimes practices that in a sane world would be treated as criminal. It is doubtful whether the managers in the banks recognise or are very interested in the difference. With regard to their own fortunes and right to remain at liberty (i.e,. not behind bars) there is certainly no discernible difference. They have no reason to regret the Libor scam or of the turning of the world financial system into an unregulated casino.
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The solution to the problem does not come down to the bankers and their clients. And it does not even come down to the politicians in their pay, whether in accepting donations to their parties or in accepting lucrative packages in their post political careers. The only way to solve this problem is through the constitution.
We must create an iron wall between the government on the one hand and and banks and multinationals on the other. To achieve this, under the constitution it must be illegal (i.e. criminal) for anyone who enters into government, either as an elected politician or as a high ranking civil servant, to, ever subsequently during their entire lives, accept any money or employment with a bank or multinational. This is the only way to get politicians to serve the people who elected them and get civil servants to serve the people for whom they work.
This measure will ensure that the idea of public service will be kept pure and will mean what it says it means. Public servants will have to build their careers in public service alone. They will no longer be able to keep an eye out on the immediate prize of channelling money from banks and multinationals towards their political advancement or the later prize of a lucrative place on the boards of them. Violation on these will mean prison. That is how we must construct the iron wall.