The Other School of Economics

The curious paradox of Hedging & Regulation is a case for Common Decency

For all its drama and tragedy the Global Financial Crisis has been a time of such intense focus on all things Finance and Economics that one of its positive collateral effect could have been to increase the mainstream’s literacy on the topic. There has not been a week without media outlets dissecting the most arcane concepts from securitisation to over-the-counter trading.

In the avalanche of forensic investigations conducted to explain how we got there, and more importantly how to avoid doing it again, two topics stood out in your correspondent’s mind: Hedging and Regulation.

The point of this post is to discuss how they paradoxically both carry the seeds of a moral failure that is not only at the origin of the Financial Crisis but also the reason why our market-based system needs profound reforms.

To give an indication that this not just another whinge about exhausted topics, your correspondent has been hearing first hand the following thoughts and concerns from people as unlikely as former Goldman Sachs traders (yep).

Hedging

If you spend a bit of time thinking about it, hedging actually underpins a lot of what is going in Finance, and to a larger extend how our society works.

Hedging (Arbitrage in French) is the technical term used to qualify the activity which consists in making a profit from an abnormal price difference between ‘what should be’ and ‘what is’.

Traders have several ways to ‘hedge’ their position. They can play the ‘location’, for instance by buying equities on the NY Stock Exchange to resell them instantaneously in Tokyo at a better price. They can play on the ‘timing’ by securing a higher resell price for the future. Or they can exploit ‘legal differences’ and buy in a given jurisdiction benefiting from tax advantages to resell in another jurisdiction for a profit.

Classic examples are Future Contracts on agricultural commodities negotiated to take advantage of the seasonal variations of supply and demand. Closer to home, we all do hedging when buying premium wine the year of its release, knowing that it will cost 10 times the price 10 years later when ready to drink.

A more controversial example would be what happened in September 1992 when George Soros’ Quantum Funds made $1.8b by shorting British pounds and buying German marks, earning Soros the title of “Man Who Broke the Bank of England”.

All hedged transactions have one thing in common: they realise profits without risk. They exploit gaps in the market without going illegal.
So you understand why they are investment banks’ favourite past time. To the point that years ago, when what we know of today’s financial system was still in its formative years, some cluey golden boys left the big banks to set-up their versions of financial start-ups: Hedge Funds, which by the way, should really be called as per their French name – ‘Speculative Funds’.

As the finance insiders would tell you, according to the economic theory hedging would not be possible in a ‘perfect’ market; however because financial products are so complex, market ‘imperfections’ pop-up every now and then. Traders who spot them exploit them to make a profit. These guys don’t care whether such or such situation is fair on unjust: their job is purely to focus on detecting them and making buck out of it. To reach their goal, they will use the best resources made available to them: lawyers, IT systems, and tutti quanti.

The reason why Hedging is so important to understand is because it is much more than just a financial activity: it is a philosophy and an attitude towards life. It is the student who applies for the dole, the employee who found a new job and tries to be made redundant to get a pay out, the middle-class family who gets money from the social security they don’t deserve. The list could go on for ever.

In a way, our finance-driven consumption-obsessed society is architected in a fairly simple manner: we have rules and regulations to tell people what they can and cannot do, and the rest is left to the law of Offer and Demand. That’s it.

The almighty market has made us hedge-traders who can not tolerate not optimizing our economic relationship with the system. This is the case for executives who do not see why they would have to cut down their salary given their workload and pressure, unemployed who do not see why they would have to look hard for a job when they can live on the dole, bankers who cannot understand why their profits are seen with such contempt given their contribution to the economy. All those attitudes are frowned upon but none of those guys have done anything illegal. Besides, as a society, we have not agreed any official superior moral imperative that would condemn what they are doing.

So here we are, in a system where individual ethical principles and economic relationships are totally uncorrelated. Instead we prefer to put our faith into more detailed regulations and a more sophisticated market to sort things out. Individual morality – the common decency so dear to George Orwell – has disappeared. We have collectively agreed to operate in a system guided by competitive behaviours, where – it seems – we have no other choice but to systematically hedge ourselves.

The trouble with Regulation

So to counter-balance these cunning hedgers, we regulate.

As a general principle your correspondent is rather on the pro-regulatory side. As far a general policy making goes, regulation usually leads to good outcomes for the public. We should be rather happy than cows are not fed with meat and bones anymore after the UK mad-cow outbreak of the mid 1990’s.

However for global financial markets around the globe it is more and more becoming a never ending game of cats and mice between policy makers and financiers who will put the best lawyers on the case to find the loopholes that new regulations ineluctably contain.

Not only relying solely on regulation seems ineffective, but it also carries the seeds of moral failure.

As Joseph Stiglitz points out in this article published in the Guardian:

[Bankers’s] innovations focused on circumventing accounting and financial regulations designed to ensure transparency, efficiency, and stability, and to prevent the exploitation of the less informed.

Stiglitz also highlights somewhere else in his works that bankers are not born greedy and selfish: they just have more opportunities and incentives to become this way.

So why is it that the concepts of hard work and duty to the rest of society have given way to investor and hedging mindsets? To answer this question might help fix the current issues and move forward…

Is it that the root of this moral failure is in the disappearance of the link between professional activity and solidarity? Have we forgotten that the initial purpose of shoemakers is to make shoes for others, farmers are to supply milk to the community and doctors to cure people around them? Not to optimise their bottom line!

“Sorry, but business is business” or the death of Common Decency

How many times do you hear that personal considerations should always put aside in a corporate context? The nirvana of managerial ethics seems to be attained when you are able to drive a business on pure economic rationale: determine the “value pools”, understand where “profit margins” will be made and you are assured to be best in class. The end of year bonus is likely to be pretty good.

Things have developed as if the promulgation of regulations has given extra incentive – or excuses – to corporate behemoths to systematically remove the concepts of solidarity and care from their operating models.
As if the policies themselves gave a license to become totally oblivious to the moral intend that the texts aim to promote.

The game has become to get as close as possible to the edge (no h!) in order to maximise returns. Think of those Oil Companies who where in all seriousness lobbying the White House to lift a ban to drill in protected natural parks in Alaska…

So as painful as it is to admit it, those who argue that regulation kills virtues have got a point.

The trouble is that when corporate and market money-makers are trying to sell the view point that (over) regulation is bad and will damage the system, they are certainly not motivated by those noble philosophical considerations of virtue.

Where to from here? As mentioned above, maybe the beginning of a solution for Policy Makers and motivated Corporate Leaders is to (re)read Orwell and his principles of Common Decency and start pondering how they can build on it.

{ leLaissezfaire }