Written months before the banking crash of the Autumn of 2008 this is the first part of a series of articles investigating the
capitalist financial markets from a critical perspective. It explains in some detail what the various financial instruments are that were to be blamed for the crash and what implication they have for class struggle.

Hedging is widely seen as one of those "good capitalist" or "legitimate" operations. It is usually opposed to it's 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.

Just around the corner

Written months before the banking crash of the Autumn of 2008 this is the first part of a series of articles investigating the
capitalist financial markets from a critical perspective.



It explains in some detail what the various financial instruments are that were to be blamed for the crash and what implication they have for class struggle.

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 globe.

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
it's 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.

Bonds

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 it's 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 dividends.

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 it's 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 it's 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.

Forwards

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.

Futures

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.

Options

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.

Swaps

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.

Proliferation

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.

Transformations

The transformations that have taken place from the era of derivatives
as a marginal, commodity market-based phenomena, to it's 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

Volume

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.

Interpretations

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, it's 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 reading.

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)