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(en) Anarkismo.net: Financial Weapons of Mass Destruction by Paul Bowman

Date Fri, 19 Sep 2008 09:29:28 +0300

Everything comes tumbling down ---- With financial giants toppling at rates that
shock even seasoned financial commenter, many of us are left wondering, how did
this state of affairs come to pass. What is becoming obvious is that the
financial markets have become increasingly complex. In this article, Paul Bowman
looks the nuts and bolts behind the economic headlines, explaining what is it
that is being sold and why nobody seems to be able to stop the chaos from
unfolding. ---- This is the first part of a series of articles investigating the
capitalist financial markets from a critical perspective. With such a large
topic it is tricky finding a route into the subject and a plan of enquiry. The
chosen road is to start with a look at the financial markets, particularly
focusing on the mechanics of some of the instruments that have led to a
momentous transformation of the workings of global financial markets in the most
recent decades.

At first sight, this approach may seem odd, perverse even, like examining the
internal workings of a clock as a prelude to discussion the social relations of
time. However this "inside-out" approach is justified by the fact that as well
as a system of social relations, capitalism is also a system with internal
mechanics. Those mechanics evolve in response to the historical development of
struggles over exploitation, but what new directions the new mechanics make
possible in terms of capitalist strategies, in turn, shape the new struggles of
today and tomorrow. The next article in the series will place these market
mechanics in their fuller historical context. But for now let's start by
investigating the mechanics of capitalist financial markets.
Financial Weapons of Mass Destruction
by Paul Bowman

This is the first part of a series of articles investigating the capitalist
financial markets from a critical perspective. With such a large topic it is
tricky finding a route into the subject and a plan of enquiry. The chosen road
is to start with a look at the financial markets, particularly focusing on the
mechanics of some of the instruments that have led to a momentous transformation
of the workings of global financial markets in the most recent decades.

At first sight, this approach may seem odd, perverse even, like examining the
internal workings of a clock as a prelude to discussion the social relations of
time. However this "inside-out" approach is justified by the fact that as well
as a system of social relations, capitalism is also a system with internal
mechanics. Those mechanics evolve in response to the historical development of
struggles over exploitation, but what new directions the new mechanics make
possible in terms of capitalist strategies, in turn, shape the new struggles of
today and tomorrow. The next article in the series will place these market
mechanics in their fuller historical context. But for now let's start by
investigating the mechanics of capitalist financial markets.
Mechanics of the Markets
Commodity Markets
Commodity markets are the most direct descendants of the markets for physical
goods that long pre-existed the rise of capitalism. Capitalist commodity markets
are not, however, markets for all produced goods, but more specifically for
either food and agricultural products or industrial raw materials. These are
products that must be "commodifiable" in capitalist terms - i.e. the volume of
different batches of the same good must be interchangeable in usefulness and
value for all practical purposes. Such that one barrel of a particular grade of
crude oil is substitutable by any other barrel available in the market.
Similarly for bushels of wheat, tonnes of iron ore, coal or soybeans.
Commodities are traded in Commodity exchanges, historically physically located
at the major transport hubs where agricultural or raw materials were brought for
onward shipment. In modern times these physical located exchanges, with their
trading pits and shouting traders employing arcane hand-signals have been mostly
supplanted by electronic trading systems linking office-based traders around the
Capital Markets
Stocks and Shares

Capital markets are where capitalist joint-stock corporations go to raise funds
for investing in their business. To do so they sell equities or stocks in their
business. This is different from raising money by getting a loan in that the
sale price of the equities sold does not need repaying and does not enter the
company accounts as a debt - instead it is recorded as part of the company's
capitalisation. In return for the money the buyer of company stock gets a part
of the ownership of the company and a periodic share of the operating profits
(what's left over after all costs and loan debt repayments have been made) and
(usually) voting rights in the company's annual general meeting which elects the
board and chief executives. There are many different types of stock which may
differ a bit from the above description, but the details are not important to
our investigation.

Generally speaking, buyers of stocks do so for one of three reasons. First to
get income from the shares of profit regularly paid out as dividends to
shareholders. Second, more rarely, as part of an attempt to get enough of the
companies shares to either take it over (by getting 51% or more of all available
shares) or to get enough to become a serious player in the big shareholders who
get to influence the direction of the company. Finally, and the most usual
motive for a lot of the day to day trading that goes on in stock exchanges, as
part of a speculation of the short-term future moves of the stock price up or down.

Leaving aside speculation, which we will return to later, and governance
matters, the feature of stock which most interests those long-term investors
aiming to own the stock for the income from dividends, is something called the
P/E ratio. This stands for the Price/Earnings ratio which is calculated by
dividing the price of the share by the annual earnings its owner is entitled to.
For example a share worth 100 euros which pays a annual dividend of 10 euros has
a P/E ratio of 100/10 = 10, that is it will take 10 years to get back its face
value in earnings. P/E ratios, also known as the "earnings multiple" or just
plain "the multiple", can vary between different industries e.g. finance vs.
coal mining, due to the different periods investments take to deliver a return
for practical reasons, however the average P/E ratio across all stocks in a
given market is monitored closely by market watchers. If you've ever heard an
analyst or news reporter talking about a marker being "overvalued", what that
means is that they reckon that speculative trading on the face values of stocks
has driven the price relative to earnings up to an unrealistic level. In this
case they will be looking at P/E ratios much higher than the average rate
predominant in the rest of the worlds markets. For example some over-exuberant
speculation in East Asian markets in the 1990's drove some P/E ratios as high as
over 100 - i.e. it would have taken over a hundred years to earn back the face
value of the stock through dividends. Sure enough those markets crashed - or
went through a "market correction" in the panglossian jargon of the uncritical
market-fundamentalists. Currently the "rule of thumb" level for "correct" P/E
accepted by the commentators is 18, substantially higher than the 10 it used to
be in the 1980s.


However a company does not necessarily want to issue more equity every time it
needs a bit of extra cash. For one thing every time it issues extra equity it
dilutes the share of profit due to holders of existing shares as well as pushing
their face value down - a good way to piss off all your shareholders if you do
it too often. For another reason, needs for extra money can often be for
temporary measures, ranging from sums needed for a few extra months to cover,
for e.g. temporary increase in operating costs due to rise in input costs, to a
few years for projects like opening a branch in a new company or whatever.

One option for credit is to go to a bank or other financial lender and take out
an overdraft or loan like an ordinary punter. However, another option that large
and established companies have, one certainly not open to the ordinary
individual, is to issue debt securities or bonds. These are effectively IOUs due
to be redeemed in full at some fixed point in the future, called the "maturity"
date for the full amount of the face value or "principal". The company who
issues the bond is the borrower, the buyer of the bond is the lender. In
addition to the promise to repay the principal on maturity the issuer also
agrees to pay regular interest payments to the bondholder. Bonds are freely
tradeable securities and their value relates to their face value, modified by
how much interest is still due to be paid before maturity (compared to other
rates of interest available) modified by any estimate that the issuer may
default on the bond. As well as corporations, bonds are also issued by
governments, both local and national, as well as supra-national bodies such as
the European Investment Bank for e.g.

The long and short of it

Having introduced our two basic categories of securities we need to look at the
way traders operate in the financial markets to make money from speculating on
the changes of the face-value of securities, be they stocks or bonds.

The first strategy is if a trader thinks the price of stock is going to rise
over the next period, he can buy at the current spot price and wait to see if
the price goes up. If the price rises, he picks a good time to sell and sells
the stock for the new, higher price, taking a profit from buying cheap and
selling dear. This strategy, in some ways analogous to backing a winner in
betting terms, is called "going long" or taking a "long" position on a stock,
for reasons that will become clearer in a minute. What are the potential losses
and gains with this strategy? The maximum possible loss is the loss of all money
invested if the stock should suddenly become worthless due to some catastrophe.
On the other hand, unlike in betting where the maximum win is fixed at the
outset, the maximum win on this strategy has no defined limit. Nothing prevents
the value of the stock tripling, expanding a hundred-fold or more. It's rare but
there's nothing preventing it from happening.

Similarly, just as in betting you can "pick a loser" and lay a bet - i.e. take
the other end of someone backing a horse (or whatever) to win, so in market
trading of stocks, a trader can "short sell" (or just "short") a stock. To do
this he obtains some stock, usually by borrowing it for a limited period, (for
which he pays a small loaning fee), sells it in the market, waits for the price
to fall and "covers the position" by buying it back at the lower price, in time
to give it back to its rightful owner. If the stock has fallen in price then the
trader pockets the difference in price as profit. Of course, the other side is
that if the price unexpectedly rises rather than falling, the trader suddenly
needs to find additional money to that gained by the sell, to buy back the now
more expensive stock in order to return it to the lender. An important feature
of this strategy must be pointed out. Because "shorting" is the inverse or
"inside out" of going long on stock, the maximum loss and the maximum gain
position is reversed. The maximum a trader can gain on shorting a stock is
limited by the face value of the stock. However, the maximum he can lose on a
short sell, is unlimited. I'll repeat that because it's important. The maximum
amount of money you can lose on a short sell is unlimited.

So why is "long" called long and "short" called short? Well, because of the
activities of traders (and computer programs called "bots") speculating on share
price make the face value fluctuate up and down a fair amount within the trading
day and over the week, people who are confident that the performance of the
company or the state of the surrounding global economy, is such that their share
price will rise on average over time, need to have a little patience in holding
that stock for that growth to happen. They're in that position for the long
haul. On the other hand, traders looking to make some money over a temporary
fall in share price due to a planned company announcement expected to contain
bad news, may take a short position for only a few hours, until they reckon the
share price is going to start bouncing back. Having said that, the short in
short selling is commonly understood to refer to the fact that the seller is in
deficit to the owner of the stock, rather than the length of the time period
involved. Often short sellers are actually borrowing the stocks they are
shorting from people holding them as part of a long position (or for the
earnings, as many institutional investors like pension funds do). At first sight
this seems crazy. Why would someone owning stock that they want to rise, lend it
to someone trying to make money from the price going down? Because of the
different time-frames of the different positions. The holder doesn't care if the
share price goes down temporarily today, as long as it has risen by the amount
they're hoping for in six months time. Also the short seller has to pay them a
fee for the loan, so you're earning additional income from your shares above the

One important consequence of this is that the naive hope that watching stock
market crashes on the news means that capitalists in general are losing money,
is sadly mistaken. Sure some individual capitalists may be taking a bath, but
that downward line on the graph is the effect of other capitalists making a
killing. Which ever way the market goes capitalists continue to make money and
capitalism is as healthy in a crash as it is in a boom. The same, unfortunately,
cannot be said for the working class, but I'm getting ahead of myself. However,
for this reason, short sellers are often singled out for particular ire during
market crashes as the "unacceptable face of capitalism". This "good capitalist,
bad capitalist" dichotomy is completely baseless and is often cynical hypocrisy
on the part of those who wish to defend capitalism in general - by implying that
capitalism has an acceptable face, for example - by deflecting popular anger
onto an ill-defined set of "nasty capitalists". Short selling is simply the
inverse operation of taking long positions on stock, to impute a difference of
moral reprehensibility on one and not the other is spurious.

Double or quits? The use (and abuse) of "leverage"

One of the effects of the gains from short selling being relatively limited, is
to encourage the use of what's called leverage. Financial leverage is analogous
to physical leverage. You're trying to set up a mechanism to magnify a given
movement by a order of magnitude or so. This can be achieved in financial
trading by a number of different means, some of which we'll look at later in the
section on derivatives. One method is to borrow money to buy the shares you are
planning to go long or short on. This means you may be able to multiply the
shares you buy by, say, ten times what you could have afforded with your
original stake. So if things go the way you predicted you multiply your gains by
ten. However, if things go wrong, and bear in mind that they can go wrong by
many multiples of your shares original face value in a short position gone
wrong, the size of the yawning void is also ten times as bad.

Consider you start the day having spotted a stock in some third-world groundnut
co-operative that got overvalued last year due to being briefly the pet project
of some Hollywood starlet. Their quarterly results are due today and you're damn
sure that the cold light of reality will bring their stock down from its current
100 per share. With your current stake (say half a million) you could afford to
just short 5000 shares (500,000 + 100) but that only gives you a lousy 50,000
return on a 10% drop (minus equity loan charges, brokerage, capital gains, etc.)
for your brilliant insight. BOoring! So you leverage your stake by ten times to
short 500,000 shares. Nice one! Time for a long lunch with your fellow "masters
of the universe", something involving lobster, champagne and generous helpings
of Columbia's finest. You return at 3:30pm to find that during its quarterly
results the groundnut people revealed that their attempts to cultivate peanuts
are not going as well as hoped, but let slip that in the process of trying to
plough their land they have unexpectedly struck oil. The share price has gone
crazy and now sits at 600 per share. You have to cover your position by 5pm
tonight, that's 50,000 shares at 600, that's, er, 30,000,000 you need to find,
or 25 million (minus the 5,000,000 you made selling the 50,000 shares at a 100
apiece this morning). Uh oh...

Of course real life trading doesn't work like quite like this. For one thing
there are things called stop-loss orders which will try and set a level of
things going wrong that will automatically try an liquidate your position to
limit your losses. Also, given the risk of unlimited losses with shorts, they
are rarely taken out on their own. They're more usually part of a hedge or
straddle or a component of more complicated instrument which we will look at
later in derivatives. Nonetheless numerous traders have demonstrated over the
years that its possible to lose a whole lot more than 25 million euros when the
game goes bad. Self-styled "Rogue Trader" Nick Leeson managed to land Barings
bank with $1.4 billion in debt it didn't know it owed until the discovery of
that particular financial black hole killed it.
Currency Markets
Trade & balance of payments

It should always be remembered that the joint stock company, the origin of
stocks and bonds, were first created to service international trade.
Specifically, England invented the joint-stock company to finance its Virginia
colony in America and for the British East India Company, royally chartered to
manage the trade with India and the spice islands. The evolution of financial
markets then has always been alongside international trade.

International trade requires changing money from one national currency to
another, this was carried out in the past by money-changers in markets and
temples (religious centres have always been strategically placed on trade
routes) throughout the pre-capitalist world. In the modern financial order,
money-changing is carried out in an electronic, de-centred global market that
never sleeps and operates 24 hours a day, every day. The full story of the
historical development of the successive regimes of global financial orders will
be covered in more detail in the article to follow this one, but for now we want
to look at one recent feature of international currency and financial flows, the
rise of the Eurodollar.

Stateless Money - the rise of the Eurodollar

A Eurodollar is a US dollar that is deposited in a bank outside of US control.
In finance the prefix euro- to a currency means deposits of that currency
outside of the control of the regulation or control of the state or central bank
that issues that currency. It has nothing to do with Europe or the Euro
currency. As well as Eurodollars there are now Eurosterling, Euroyen and even,
since 1999 and the introduction of the Euro currency, the linguistically
abominable, Euroeuro.

The Eurodollar has its origins in the cold war. Due to import and export
business, the Soviet Union had stocks of US dollars. In the aftermath of their
invasion of Hungary in 1956 they were terrified that their deposits of dollars
in the states might be seized or embargoed in retribution. To avoid this they
moved all of their dollars out of US jurisdiction and into European registered
banks that they controlled. At this time banks around the world would only take
deposits in the national currency of the country they were registered in. The
Soviet-owned banks in Europe decided that they may as well put these dollar
deposits to work to earn some interest, so started offering them for loan to
corporations on an anonymous, no questions asked as long as you pay the interest
basis. The Moscow Narodny Bank, a soviet-owned British registered bank was one
of the main players in this activity and its telex address was "Eurbank" - hence
the name Eurodollars. Given the amount of US dollars outside the states due to
the Marshall Plan and a negative balance of payments (i.e. the US was paying
more dollars out for imports than it was receiving back in for exports), the
market, once established grew explosively.

The main activity in Eurodollar trading was inter-bank loans. Given the
volatility of these Over-The-Counter (OTC) loans, interest rates for individual
loans varied by the hour and the minute. Eventually there was a need for an
average interest rate measurement and this was set up by the biggest traders of
Eurodollars, who were based in London, and is known as the London Inter-Bank
Offer Rate or LIBOR. More on which later.

The importance of this Eurodollar, or more generically, Eurofinance market, was
that although based on currencies issued by state national banks, they were
outside the jurisdiction of any state monetary body. In other words they were
stateless money. The role of this state-control free money market in undermining
and helping the bring down the Keynesian Bretton Woods system will be told
properly in the article that follows this one. Our interest is in the impact the
Eurodollar money market had on the development of financial, as opposed to
commodity, derivatives. The first entirely cash-settled futures exchange was
opened in Chicago by the Chicago Mercantile Exchange (CME) to trade interest
rate futures in Eurodollars in 1982. Eurodollar futures are used to hedge
interest rate swaps, the first of which had taken place between the World Bank
and IBM in August 1981. As Eurodollar deposits are time deposits that cannot be
traded, Eurodollar futures were of necessity the first futures intended never to
result in actual delivery of the underlying asset.

The futures rates were set in relation to the LIBOR which has continued to this
day to be the main international reference interest rate. As national currencies
have their interest rate which is set by the national banks, so the stateless
currencies have their interest rates in the LIBOR, set by market trading.
Derivatives and Hedges
The future is unwritten - Risk

The warning on the adverts for investment trusts always say "remember that the
value of your investment may go down as well as up". This is true of all
financial dealings so the twin to the capitalist obsession with profit is an
obsession with risk. Risk is always linked to time, so any financial contract
that involves an element of time (and they all do, otherwise there would be no
need for a contract, an immediate transaction would suffice) must, of necessity,
also involve an element of risk. The estimation of the probabilities of those
risks and their possible size is a continuing necessity for capitalists. What's
more, the search for ways to guard against those risks and putting in place
damage-limitation measures to limit the impact of negative events, if they
occur, is an important, and these days profitable, part of financial activity.
Hedging is the process of putting in place damage-limitation instruments in case
the future moves of the market turn out to be against your best hopes. Hedging
is widely seen as one of those "good capitalist" or "legitimate" operations. It
is usually opposed to its evil twin, "speculation" carried out by those "bad
capitalists" who are motivated solely by seeking profit at the expense of
anything else. In fact, both the "good" capitalists seeking to hedge risk and
the "bad" capitalists seeking to make money through "speculation" are operating
in the same market, using exactly the same financial instruments and carrying
out the same operations. It is also the starting point of this article that in
fact all capitalists are motivated above all else by the drive for profit. But
before we can discuss sensibly on the validity or otherwise of the
hedging/speculating dichotomy, we must first look at the financial instruments
they use to trade in future profits and risk.

The derivatives revolution

Up until the 1970s derivatives were a marginal part of capitalist financial
activity, being limited mainly to guard against the risk of movements in future
prices of commodities. However from the late 70s and through the 1980s a radical
transformation came about. Derivatives moved out of being an adjunct to the
commodities market and proliferated in every area of financial trading. Further
the volume swelled enormously until it has now become by far the largest part of
financial trading activity. What was a marginal activity at the periphery has
moved into the very centre of the capitalist world financial system. What was a
side dish has now become the main course. This rapid and radical transformation
took place against the background of, and was driven by, the transformation of
the regime of global financial governance from the "Bretton Woods" or Keynesian
order, to the new order that we live in today, which has attracted various names
such as "neo-liberalism" or even globalism. But before we can look at the
meaning of the derivatives revolution and its relation to the big picture of
changes in regimes of global financial governance, we must first look at the
mechanics of derivatives.


Derivatives originated from the need to protect against the risk of
unpredictable rise or fall of prices of commodities, particularly agricultural
commodities whose annual production and price are at the mercy of the weather
and other unpredictable factors.

Consider the wheat farmer and the miller. Before sowing his fields with wheat
the farmer is faced with an uncomfortable risk, what if after all his work, he
finds at harvest time that the price of wheat has fallen so low that selling his
wheat will not cover his overheads and cost of living? On the other side, the
miller, who consumes wheat as an impute wants to protect himself against the
risk of the price of wheat rising.

The solution is what's called a forward contract. At the beginning of the year
the farmer and the miller make a contract for a transaction of an agreed amount
of wheat at a agreed price, come harvest time. If at that later time the actual
current market price (called the spot price) of wheat is lower than the forward
contract then the miller is paying more for that amount of wheat, but at least
he has protected himself against the risk of the price rising and, more
long-term, he knows that the same farmer is going to be around to grow more
wheat next year. If the price goes up then the farmer has lost the difference
between the forward contract price and the spot price, but this is a small price
to pay for being able to plan your annual income and have certainty of still
having a farm next year.


These forward contracts have two disadvantages. First if the spot price moves
substantially away from the forward price, one side of the contract is always
tempted to break the contract. Secondly, there is the disadvantage of being to
tied to a direct relation between the buyer and seller, tied to particular
place, etc. This forces the seller to locate an individual end user before he
can fix a price.

By standardising amounts, quality and places for delivery, forward contracts can
be replaced by futures contracts. Futures can be bought by producers/sellers
without having to worry about who the eventual consumer/buyer will be. They can
be freely circulated and traded - that is to say they have "liquidity". Further,
as they are a means of protecting the difference between the desired future
price and the actual spot price, they can be redeemed for the cash value of that
difference, independently of the actual transaction of ownership from seller to
ultimate buyer.

Historically the first futures to be settled by cash rather than physical
delivery of the underlyings, were the Eurodollar futures first traded in 1975 at
the Chicago Mercantile Exchange. These were also the first futures on financial
instruments rather than physical commodities. Chicago has played a central role
in developing the new futures and other financial derivatives based on their
historic role at the nexus between the agricultural produce of the mid-west and
the rest of the USA and the world. The first traders in eurodollar futures had
previously cut their teeth on trading pork bellies, mid-western grain and Great
Plains beef.

In our example above, the farmer buys a "put" future to sell his grain at
harvest time for a given price. The miller buys a "call" future to buy grain at
a given price come harvest time. When that later time comes, the farmer sells
his grain on the open market at whatever the current spot price is and, if the
spot price is lower than his future, gets cash payment from the holder of the
other side of the future for the difference (on the contracted volume of wheat).
Similarly for the miller, from the other perspective.

There are other technical differences between a forward contract and a future
(futures are "rebalanced" daily to stop large potential losses growing up
between start and finish time, also they are guaranteed by the exchange, rather
than having to seek costly redress through the courts in the case of a default
on a forward contract), but the separation of the ownership of the underlying
asset from the future-proofing against the risk of price change is what makes a
future specifically a derivative, as we will look at later.


Another disadvantage of forwards that also applies to swaps, is that both sides
are bound into the transaction. Wouldn't it be nice if you could get a contract
that would fix a future price for either selling or buying that would protect
you against movements in price that would hurt you, but that you had the option
not to go through with if the eventual spot price turned out to be better than
the one you had fixed at the time you bought the contract. No surprises then
that financial markets came up with a forward-type contract with this optional
get-out clause called, perhaps inevitably, options. There are two types of
options - "call" options which allow you the option of buying in the future at
the agreed "strike" price, or "put" options which allow you to sell at the
strike price. Note, however, that for these contracts to work, one side must be
under an obligation to buy or sell at the agreed price if the buyer of the
optional side decides to exercise his option. So in our original example above,
the farmer could, at the start of the growing season, buy a put option for a
price he can live with. The cost of this option is a very small fraction of the
"principal" - i.e. the full amount to be paid if he exercises the put option at
harvest time. That initial price is not refundable. So if the farmer gets to
harvest time and finds that the spot price is now considerably higher than the
strike price for his put option, he has lost the price he paid for that option,
but counts it a small price not to have to sell his produce at a pre-agreed
price well below the current market rate. Should the spot rate turn out to be
lower than the strike price the writer of the farmer's put option or the current
holder of the other end of it, if it has been traded in the meantime, is forced
to buy the agreed amount of grain at the strike price and take the loss.
Similarly for the Miller buying a call option.


The other main derivative is something called a swap. Unlike futures and
options, swaps did not originate from dealing in physical commodities, they are
specific to financial assets. Conceptually a swap is two cash-settled futures
contracts in succession. The first to set up the swap, the second to swap back
to the original status quo. What is swapped here is not rare stamps, football
cards or other collectors bric-a-brac, nor yet commodities, but cash payment and
income streams. Swaps started in the foreign exchange markets.

For example let's take a US multi-national corporation wanting to set a branch
in a new South Asian country. It needs to raise finance in the currency of the
new country to hire premises, employ staff, etc. So it needs to borrow the local
currency. But it has no reserves of that local currency to repay the interest on
the loan. Now it could import dollars to the foreign market and buy the local
currency in a forex transaction, but if that country has exchange controls
stopping foreigners buying large volumes of their currency at market rates (or
is trying to impose some kind of Tobin tax) then this is inconvenient. If the US
company can find a company in the South Asian country that has similar but
opposite needs (i.e. it wants to get a loan in the US but has no dollars for
repayment) then they can set up an arrangement between themselves to each pay
the other's loan repayments. Here both companies are not actually transferring
ownership of anything so no forex transaction costs occur and any exchange
controls or Tobin tax are evaded.

Following on from this, it's no prizes for guessing that swaps were first set up
for the very purpose of multinationals evading the exchange controls under the
Bretton Woods system of global governance in place until the 1970s. From these
semi-clandestine origins, the abolition of Keynesian currency controls started
by Margaret Thatcher in 1979, allowed the first public swap to take place in
August 1981 between IBM and the World Bank, organised by Salomon Brothers.

To go through this first transaction as an example, the World Bank (which is
Swiss-based) wanted to borrow a sum in Swiss francs (Sfr) and IBM wanted to
borrow a similar value in US dollars (USD). They were both going to do this by
issuing bonds. At home in the US IBM would have had to pay a fairly poor base
rate plus 45 basis points (US treasury interest rate + 0.45%), but due to the
rarity of IBM bonds in Swiss markets, was able to issue bonds there for the Sfr
base rate. The World Bank could issue bonds at base rate plus 20 basis points (+
0.20%) in Switzerland and base rate plus 40 in the States. So IBM could borrow
SFr cheaper than the WB and the WB could borrow USD cheaper than IBM could. IBM
issued the bonds in Switzerland and the WB in the US. IBM loaned the WB the SFr
at Swiss base + 10 and the WB loaned the USD to IBM at US base + 30 bp - result
being, IBM gained 15 bp and the WB 10. The net repayment was transferred between
them for the life of the loans (and Salomon was paid an undisclosed amount for
setting it all up).

However, despite their origins, once concocted, swaps proved to be altogether
more potent than anyone initially could have suspected. The types of swaps have
proliferated greatly from the simple fixed-fixed interest swaps like the above
into a vast diversity of instruments.

Once again, like futures and options, swaps do not require any transfer of
ownership of the underlying assets they are deriving their payment flows from.

Swaps, however, bring something entirely new to the toolkit. Forwards, futures
and options, particularly in the commodity markets they originated in, each
remained tied to markets segregated by the underlying instrument. Futures or
options in pork bellies, could only really be compared against the spot market
for pork bellies. Of course you could liquidate - i.e. sell for money - you
position in pork bellies and invest in futures for grain, but you couldn't rate
your pork belly future against the grain spot market directly. Similarly, the
old world, bonds were bonds, stocks were stocks and forex contracts were forex
contracts. Now, thanks to the power of swaps, all these segregating divisions
are dissolved. Swaps have the werewolf DNA that allow one type of financial
security to be mutated into another directly - or have the option to swap nature
by means of a "swaption", combining an option and a swap. They allow direct
comparison of rates of risk, volatility and any other generic attribute to be
competitively compared across markets that, until now, had no means of directly
comparing themselves. Swaps are the philosopher's stone of finance capitalism
that allows the direct transmutation of lead futures into gold options.


The four derivatives mentioned above are what's called plain or "vanilla"
derivatives. In practice they are the basic building blocks which are assembled
into complicated arrangements linking different derivatives in different
underlyings to make more complicated instruments. There are a large menagerie of
different species of these compound or "exotic" derivatives in the modern
financial markets. However they can all be derived from these three basic types
of derivatives and the powers they embody - the time-fixing of futures, the
contingency of options and the mutability of swaps. Together the bestiary of
derivatives these three have spawned have broken out of their original pens in
the commodity and foreign exchange markets and spread across all financial
markets. These basic tools have created a strategies going by the names of Bear
Spreads, Naked Puts, Collars, Straddles, Strangles, Butterflies and even Vanilla
Options, a veritable explosion of polymorphous perversity creating a new Kama
sutra of financial positions.


The transformations that have taken place from the era of derivatives as a
marginal, commodity market-based phenomena, to its current role in transforming
capitalism's international financial order can be looked at in the following areas:

* Volume
* OTC, State control and Market visibility
* Price setting
* Dis-assembling


The volume of derivatives trading has exploded by factors of 50 and more in the
last 15 years. From the position in the 1970s where derivative volumes were
completely marginal to total world trading, derivatives now account for a large
majority of the total volume of global financial trading. The largest global
financial market by far, is the foreign exchange market which, at the last
reckoning, does over 3 trillion dollars worth of trading every single day. Two
thirds of that is derivatives. To give you some idea of scale, the total value
of global international trade in goods and services in a whole year barely
reaches 6 trillion dollars - a mere two days of forex trading. The entire
aggregate gross national product of the Irish Republic amounts to 200 billion
dollars - that's every single cent made by every man, woman and child in this
country, from the richest to the poorest, in a whole year - amounts to little
more than an hour and a half's worth of trading on the global forex market.

Over The Counter - Under The Radar...

In our discussion of swaps above, there was one additional difference between
swap and futures and options that we have not so far mentioned. That is that
swaps are overwhelmingly not exchange-traded instruments like futures and
options. They are nearly exclusively arranged as what's called "Over The
Counter" trades - that is, direct arrangements between the two counter-parties.
Naturally this was the only way to operate in the early days of clandestine
currency swaps undertaken to bypass currency controls. However, as the
instrument is for transforming the payment/income stream for an agreed period,
rather than hedging against (or taking a punt on) the future price movements in
an underlying, it has continued to be arranged almost exclusively by direct,
bi-lateral and customised agreements. Nearly 80% of all derivatives trades are
OTC swaps, 75% of them being interest rate swaps. In addition to this we have to
add the "off-balance sheet" nature of these arrangements. That is, that as no
actual exchange of ownership is taking place, no evidence of it need appear on
the companies audited balance sheets.

All of this has added up to a huge increase in the opacity of financial markets.
Far from increasing transparency and perfecting "market intelligence" (a
contradiction in terms, if ever there was one), the explosive growth of OTC
derivatives has meant that increasingly governments, regulators, risk assessors
and all market participants have less and less idea what the real exposures of
other players is. This is one of the major factors in the current international
banking crisis sparked by the sub-prime mortgage fiasco in the US. The actual
size of the sum at risk from bad sub-prime loans is relatively small, the fear
in the financial markets is a fear of the dark - no-one can see where the actual
bad debt is, they just know it's out there somewhere.

Price Setting - The cart before the horse

One of the effects of derivatives trading that has been observed empirically has
been the apparent inversion of the price setting relationship between spot
market prices and futures prices. The conventional relationship is that the spot
market ultimately determines the value of futures at expiration time. However in
more and more markets the tendency is for the futures market to determine the
spot market price. The causation for this role reversal has yet to be determined
exactly but it appears to be an effect of the shift from physically settled
futures to cash-settled ones. With the dominance of cash-settled derivatives,
the ratio of volumes of physically delivered futures contracts to "paper"
derivatives, where no physical delivery of the underlying asset is ever
intended, has in many cases evolved to where the paper trades outweigh physical
trades by ten to one or more. The amount of trading going on creates a situation
similar to that of "if the mountain will not come to Mohammed, Mohammed must go
to the mountain". In other words the force of derivative markets is determining
the price over the struggle over the cost for production. This represents a
major shift in the power of competition over future costs of production.
A deafening silence
Considering the scale and importance of the transformation that has taken place
in the last couple of decades, there have been surprisingly few attempts to
analyse its wider social implications. This becomes a little easier to
understand if we look at the groups that we might have expected to carry out
this analysis. On the one hand, the people with the most knowledge of the new
developments in derivatives are the professional traders and dealers in these
instruments. However, the interests of this group are limited to the narrow
perspective of the implications for the search for profits in capitalist
markets. So despite the proliferation of textbooks and courses on how to
understand, price and use derivatives, virtually none of this sector have any
interest in the wider social implications. The horizon of profit is a narrow one
relative to the full scope of the human drama.

The academic and professional economist sectors, who from the outside, could
have been expected to be interested in this question, are in practice crippled
by zealous adherence to the dominant economic dogmas. According to the dominant
neoclassical "perfect market" dogma, the entirety of derivatives trading amounts
to a zero-sum game which has no overall value. Further that with the increasing
perfection of markets, the need or opportunities for hedging or speculation will
increasingly disappear. In any case neoclassical economism tends to have a
knee-jerk reaction against any analysis containing the word "social" unless it's
a Panglossian paean to markets delivering the best of all possible worlds. The
marginalised economist critics of such pro-capitalist positivism, are equally
blinkered by a slavish adherence to an orthodox Marxist dogma (not to be
confused with Marx's actual contribution to the critique of capitalism which
still has useful material) which states that, as exploitation can only occur in
the sphere of production, the entirety of financial market operations, including
derivatives trading, is in the sphere of circulation and thus can be safely
ignored as either having no impact on "real" capitalist relations or being
"unproductive" - an orthodox Marxist swear word meaning "something bad that
should be got rid of". If the Neoclassical's position is a denial of reality on
a par with the man who sailed round the world preaching that the earth was flat
(true story), then the orthodox Marxist position is akin to closing your eyes,
sticking your fingers in your ears and loudly proclaiming "Nya, nya, nya, I'm
not listening!". In between the dominant Neoclassicals and the marginalised
orthodox Marxists are the (neo)Keynesians. While not explicitly anti-capitalist,
like the ortho Marxists, they are advocates of the need for state intervention
and regulation to make capitalism run efficiently and with some vague concession
to popular needs. However, the Keynesians have no more idea what to make of
derivatives than their neoclassical or Marxist economist colleagues. If
anything, they tend to follow Keynes' distinction between the "real economy" and
speculative market trading, thus siding with the Marxists.
Breaking the silence
Given the lack of interest or dogmatic inability of the bulk of professional
market traders and the partisans of the various economic orthodoxies, the work
of trying to analyse the social implications has been left to those few
economists critical or sceptical of capitalism as a force for good, but not
bound by the blinkers of orthodox Marxism. Among these contributions is last
years book by two Australian academics Bryan and Rafferty, referenced in the
acknowledgements below, and on which a lot of the following is heavily reliant.
Ownership & Competition
Bryan and Rafferty and a number of other authors they reference, liken the
recent takeover of financial markets by derivatives to the impact of the
introduction of the joint-stock company in the mid-nineteenth century.

Like the current rise of derivatives, the introduction of the joint-stock
company was seen by many commentators of the time as threatening the productive
economy with the disruptive and parasitic effects of speculators and bringing
with it the threat of volatility and new crises of instability. It was also an
innovation that transformed the scale that it was possible to do business on,
both in terms of capital and labour employed and distances covered, while
changing profoundly the relationship between the directing of production, its
ownership and the distribution of its profits. Corresponding to this was an
extension and intensification of the relations of competition between businesses
and between capitalists and labour.

In a similar fashion these commentators claim that the derivatives revolution is
introducing a similarly epochal change in these three aspects of capitalism. B&R
label this "Three Degrees of Separation".

The first degree of separation is the separation of people from the land and the
means of self-sufficiency to create a class society of individual
owner-capitalists, rural or industrial, and a dispossessed class of
wage-labourers. In this stage of separation, control over production and
ownership of the means of production are united in the body of the "masters".
Competition is primarily the direct conflict between master and "hands" over
profit versus survival.

The introduction of the joint stock corporation transforms this network of
relationships. The process of incorporation gives a degree of legal recognition
of the business as a legal entity having rights. Ownership is now spread amongst
the shareholders who have no individual rights to the property of the
corporation. The direction of production is entrusted to a person demoted from
the condition of being a "master" into being a mere "boss", themself an employee
capable of being fired by the concerted will of the shareholders. While the
conflicts between bosses and workers are equally capable of ferocity, the effect
of ownership by stockholders who can compare the return of their shares in a
given company, to that of a competing firm in the same industry and, if
profitable, transfer funds to find the most profitable, means that competition
now extends between firms within a given industry. The conflict between boss and
workers is mediated by the conflicts and conditions of production in all the
competing firms in that industry. Much has also been written about the possible
conflicts of interests between bosses and shareholders. Shareholders may often
find short-term gain in courses of action that may be damaging to the firm or
even lead to its premature extinction. Similarly bosses may find to enrich
themselves at the expense of the shareholders and workers. But both, to some
extent, find their freedom of movement and power over the enterprise constrained
by the legal recognition of the corporation as an entity with rights and the
intensified conditions of competition with other players in the market.

The third degree of separation through derivatives involves a further loss of
power and autonomy by both bosses and shareholders in the face of a third body,
the derivatives dealers who derive profit from the performance of their
corporations without having or needing any legal ownership claims at all.
Further the ability of derivative instruments to relate and compare performance
across different industries. The joint-stock corporation had made it easy to
compare productivity and profitability between different firms in a given
industry (in a given currency area) but difficult to relate the productivity of,
say chalk miners with cheese-makers without selling out of the chalk mining
industry and investing in the cheese business. Derivatives have evolved
specifically to relate previously incommensurable activities directly, without
any need for change of ownership in underlying stocks. With derivatives chalk
and cheese can be compared directly and the achievements in advancing
productivity in one industry can be set competitively against the other.

At this stage it must be mentioned that B&R are not proposing that these be seen
as "stages" in the sense that one gives rise to, and is replaced by, the next.
Although each has provided the basis for evolving the next level, each prior
level continues to co-exist with the later ones. Along with the 21st century
"third degree of separation" of derivatives-dominated financial capitalism, the
east Asian "enterprise zone" clothing factory owners whose sweated workforce
make the sportswear for the post-industrial workers of the west, are operating
very clearly in the framework of the first degree. Derivatives feed off the
multinational joint stock corporations they evolved to serve.
Implications for the class struggle
The Left Bereft
Ever since the fracturing of the nascent socialist movement in the late 19th
century, the non-anarchist fractions of the left, despite other agreements on
doctrine and methods, have been united by a common belief in the nation state as
the indispensable tool for delivering socialism.

This fervent belief in the nation state as the sole possible means of our
collective deliverance has given the state socialist left an huge emotional
investment in denying the possibility that the power of the state to
substantially limit or manage the flows of contemporary capitalism has been
fatally undermined by the developments of the 1970s and 1980s. Many of them
still cling to the belief that the deconstruction of the Keynesian international
financial order that took place in that period was entirely the result of a
purely political "neoliberal" conspiracy or coup that can simply be rolled back
when truly social-democratic governments come back into power.

As we have seen in the section on interpretations above, most of these state
socialists or social democrats are aided and abetted in this position in a
Keynesian or Marxist (the two are in practice much closer bed-fellows than
either would care to admit) economic dogmas which prevent them from even looking
at the mechanics of the systemic changes that have taken place, never mind
trying to analyse them.

The fact is that the Eurodollar money markets and clandestine currency swaps of
the 1970s were not just attempts to get around the regulatory architecture of
the Keynesian world order, they were successful attempts. Today's proponents of
measures like the Tobin tax have yet to explain how they will tax operations
like currency swaps or other derivatives based operations which achieve the same
end as foreign currency transactions but without any actual taxable exchanges
taking place. The same logic applies to the arguments of those who propose the
re-imposition of Keynesian exchange controls - how to prevent them being
bypassed by the very mechanisms that evolved specifically for that purpose? The
state socialist dream of using the power of the capitalist state to discipline
and control capitalism for the benefit of workers is definitively dead. They are
a Left bereft.

But more importantly, from an anti-capitalist point of view, is that the "lost
paradise" of Keynesian social-democracy that these nostalgics long to regain,
was a deal based on workers accepting their place within capitalism and
submitting to wage-restraint deals. It was worker's smashing of these wage
restraint deals in the late 60's and 70's that drove the inflation that in turn
pushed up the interest rates in Europe that sucked dollars out of the US and
into the Eurodollar market. Keynesianism was not simply undermined by capitalist
innovation in the area of derivatives, but by worker's struggles in Western
Europe and, on a global level, by the heroic resistance of the Vietnamese people
to US imperialism. We will cover this history in the next article in the series,
but the point remains - will the state socialists in their turn adopt the
position taken by the Western European Communist Parties in the 60s and 70s that
workers must accept wage restraint "in order to build the productive forces", in
the Marxist jargon? This line has nothing to offer the struggle for the
break-out from the prison of capitalist social relations.
Beyond Industrial Unionism
Under the first two degrees of separation the class enemy directly visible to
the struggling masses were first the masters and then the corporations with
their bosses and shareholders. Even today in the anti-globalisation movement,
the majority of the non-communist activists see the "bad guys" as the loathed
MNCs - the Multi-National Corporations. From the beginning the analytical
communist tendency was able to say that the ultimate enemy was neither the
masters, the bosses, the shareholders or the corporations, but capital. Yet
capital remained a theoretical abstraction only, inferred as an emergent
tendency of the collective action of the actual, visible class enemies. Now with
the rise of the financial derivatives capital markets, before which the
corporations, even the multi-national ones, are expendable pawns, a new
situation has arisen. As people witness the increasingly visible power of this
new actor, they will ask us, "What is it?". We will finally be able to respond,
"It is the enemy of whom we have long spoken. It is Capital made flesh". No
longer an abstraction, the rise of the third power makes capital a concrete,
directly visible enemy. And an enemy we can see directly, we can fight directly.
The outlook for the future of the class war
So in summary, while the state socialists may either mourn or remain in denial
about the passing of the nation state as a platform for reforms to mitigate the
evils of capitalism, we communists see the developments for what they are. We
see that we will need increasingly to link our struggles across industries,
across borders and across identities. That with the increasing impossibility of
fighting for reforms and half-measures, we will be forced more and more to
confront a newly visible capitalism itself directly. Then we must say, without
under-estimating the likely savagery of some of the struggles to come, that this
is a most excellent development.
Acknowledgements & References
To try and properly footnote and reference the above text would have been too
intrusive for what is, after all, not an academic text. Nonetheless some
acknowledgements and references are both proper and handy as guides for further

For general "unpolitical" reference material on financial markets (and much of
the glossary) I have made extensive use of the open source Wikipedia
(en.wikipedia.org/wiki). In the category of copyrighted but freely available on
the web material, I must also mention the extremely well-informed and lucid
www.riskglossary.com. For pure statistics the Bank for Internation Settlements
(BIS) produce the best available estimates of derivative volumes (www.bis.org)
and the OECD (www.oecd.org) are good for general global financial statistics.

In the category of works contributing to a critical and political perspective,
as already mentioned above, the best book available is "Capitalism with
Derivatives", Dick Bryan & Michael Rafferty, Palgrave Macmillan, 2006. I would
particularly also like to acknowledge the influence of the work and generous aid
of my comrades Dave Harvie and Massimo de Angelis, many of whose texts on this
and related topics are freely available at www.thecommoner.org.

Some Figures and Statistics

Global equity capital $51.2 trillion (wikipedia: Reuters March 2007) $165
trillion "total traded securities" (Economist, 19/01/2008)

Global physical trade

Daily ForEx trade volume $3.2 Trillion (BIS 2007)

Total Derivatives Nominal $516 trillion (BIS 2007)

Total Derivatives Value $11.1 trillion (BIS 2007)

Total Swaps Nominal $408 trillion, 79% of all derivatives

% Interest Rate Swaps 75 (BIS 2007)
A - I N F O S N E W S S E R V I C E
By, For, and About Anarchists
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